It is pretty natural for people to start their businesses as sole proprietors. Most often, the reason behind starting a business with such a model is that they do not want to plan the business properly.
Instead, they just want to start selling services or products right away.
Likewise, some just do not want to go through the effort or put in the cost of incorporating unless they know that the business is viable or not.
But you know that you need to incorporate it at one point, right?
When Should You Convert from Sole Proprietorship to LLC?
Generally, people will make the switch from a sole proprietorship to an LLC if they find the requirement of one or more factors of the following:
When you are rolling with sole proprietorship, you are your business. In other words, all legal issues and debts are your concerns. However, your business becomes a separate entity when you shift to an LLC.
At that point, the business’s debts will belong to the business. The same thing applies to legal issues.
Yes, that is the basics of limited liability! So, why would you want limited liability?
Imagine a scenario where someone sues your sole proprietorship. In that case, they are not suing your business; they are suing you!
That means you will be paying with your money. What will happen if the damage exceeds the amount that is in your bank accounts?
You will need to liquidate your assets or declare personal bankruptcy.
On the other hand, if someone decides to sue your LLC, they are not suing your personally.
Instead, they are suing the business. But if the damages are awarded, they will go to the assets of your LLC, not you! And if the damages exceed the assets of the LLC, your assets are typically out of the limit.
When running a sole proprietorship, you have little input on how your business needs to be taxed. You will either fill out a Schedule on the C-EZ or C to calculate the profits and losses of the business. And you will enter the totals of your return.
Generally, members of the LLCs go through the taxation process the same way. They will need to fill out the same forms and pay the same taxes for self-employment.
However, LLCs do not need to keep their default tax status. As an LLC, you can choose to be taxed as a corporation.
It can be pretty hard to raise money to run your business as a sole proprietor. In fact, the most common ways that people fund their businesses is through their own money, equity, or debt.
Although you will be on your own in the first option, LLCs will give you more opportunities when it comes to equity financing and debt financing.
Debt financing is when the business borrows money that the owner needs to pay back. Different forms of debt financing include credit cards, loans, or lines of credit.
You will not qualify for lots of business loans as a sole proprietor. That will leave a personal loan as your only option. The same thing applies to credit.
On the other hand, equity financing is where you give up the ownership interest of the business in exchange for financing. In a sole proprietorship, investors can not buy membership interests or shares of stock.
So, you could say that there is no way to opt for equity financing as a sole proprietorship.
That said, although corporation offerings have the highest possibilities for equity financing, LLC can add members. That gives ownership percentage in exchange for capital contributions.
Still wondering at what point should I transition from a sole proprietorship to an LLC? You need to make the transition whenever you feel the need for limited liability, tax flexibility, and proper funding options.
One of such requirements states that it is time for you to change the business!
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