Sole proprietors and other small business owners often wonder whether establishing an LLC is a smart choice for their business. The answer to that question varies based on a number of factors.
If you’ve decided it time to transition your business out of “sole proprietor” status, you may be considering an LLC. But should you?
Here are some of the reasons business owners choose LLC status (over corporation) when transitioning from a sole proprietorship–and some reasons why you may not want to make the transition.
What Is An LLC?
LLC stands for Limited Liability Corporation. Its is a type of business structure that establishes the business as a separate entity from the business owner.
When you are a sole proprietor you and your business are one in the same. The business operates under your social security number and its risks and rewards are passed on to you personally.
For example, if the business takes on debt, that debt is your personal responsibility. However, with an LLC, the company can take on debt, and if the debt is not repaid only the assets of the company are at risk — not your personal assets.
Flexible Ownership
An LLC can provide for flexible ownership of your company. This all depends on how the LLC’s operating agreement is written.
LLCs can be single-member organizations, having the sole proprietor as the only member, or they can have multiple members.
What’s more, ownership percentages of members can vary. For example, one owner can have a 50% stake while two other members can each hold a 25% stake.
In addition, LLCs can continue to exist even if the original owners pass away or sell their stakes. There’s no need to form a new LLC if ownership stakes change.
Related: 1099 Vs. W-2: What’s The Difference?
Reduces Personal Risk
Likely the most common reason sole proprietors consider converting their businesses to an LLC is for legal protection.
When you as a sole proprietor are threatened with legal action — such as client disputes, business neglect, or business failure — your personal assets are at risk.
While a sole proprietorship run as an extension of yourself — running your business as an LLC creates an independent business organization, largely protecting your personal assets from lawsuits pertaining to your business.
This is an attractive feature of the LLC to many business owners.
Pros Of An LLC
There are several common benefits to establishing an LLC for your business.
Ease Of Establishment
Compared to corporations, LLCs are easy to establish. Of course, establishing a sole proprietorship is the easiest when it comes to business ownership.
However, LLCs run a close second. The steps to open an LLC in most states are very easy, even though each state has different requirements for LLCs.
Opening an LLC begins with determining your state’s requirements for LLCs. For that reason, you’ll want to visit your state’s department of economic development or similar department.
From there, you’ll want to determine a name for your LLC. This free tool can give you ideas for names for an LLC in your state.
You’ll also need to file your LLCs Articles of Incorporation with your state. There are free sites that can help you write your LLC’s Articles of Incorporation.
Having a registered agent is another part of opening an LLC. Registered agents manage legal notices and help you keep on top of filing responsibilities for your LLC.
You can choose your own registered agent from your LLC’s member list, or use a service that provides a registered agent.
Operating agreements are another important part of filing to establish an LLC. An operating agreement outlines how your business will be operated, who’s in charge of what duties, and more.
While operating agreements for LLCs are typically not required by the state, it’s always a smart idea to have one in place.
You’ll also need an EIN and a bank account under your LLC to wrap up the process. It’s a much simpler and cheaper process than the many steps needed to establish a corporation.
Related: Do I Need an EIN For My Business?
Legal Protection
We talked a bit about this above, but LLCs are an optimal choice for sole proprietors and other small business owners that want to protect their personal assets from legal issues arising from business operations
The acronym LLC stands for Limited Liability Company. The name in and of itself gives a lot of clues to the benefits over sole proprietorships.
LLC status for your business can protect your personal assets from many types of legal actions. However, it can’t protect you from all legal actions.
For instance, operating your business under the legal shield of an LLC can protect your personal assets against:
- Business failure
- Business bankruptcy
- Certain types of lawsuits
- Unpaid debts or other types of obligations
This is a valuable benefit given that 50% of small businesses fail within the first five years.
Protecting your personal assets against these types of events by forming an LLC is simply a matter of smart business in many cases.
However, LLCs don’t protect your personal assets against all types of business quandaries. For instance, LLCs won’t protect your personal assets if there’s intentional fraud on your part.
Nor will the status protect you if you personally or intentionally commit an illegal act against the LLC or a client. Direct and personal injuries by members aren’t covered by LLC status either.
In addition, loans to the LLC guaranteed personally by you or by another member will still affect the guarantor’s personal finances in the event of a business default on that loan.
So, while establishing your business as an LLC won’t protect your personal assets from every legal entanglement your business could wind up in, it will protect from many.
Independent Existence And Ownership Flexibility
Another pro to establishing an LLC is that the LLC exists independently and is not tied to ownership changes. In other words, if one of the members of the LLC quits, is fired, or passes on, the company doesn’t need to dissolve.
Instead, you can add a replacement member and keep all other company details as is. This flexibility in ownership comes with flexibility in responsibilities and duties as well.
You can run your LLC as a single-member company or as a multi-member company. It can be managed by members or managed by managers.
Each individual member can have as much — or as little — responsibility as the LLC members decide they should have. This is a wonderful feature that allows for easy adjustments as your company grows and as your business needs change.
Easier Compliance
LLCs offer less paperwork and less recordkeeping than a corporation. Annual meetings aren’t required, nor is a board of directors.
So, if you’re deciding between converting to a corporation or an LLC, and simplicity is key, the LLC is the way to go.
Cons Of An LLC
LLCs aren’t perfect. Here are some of the challenges you might face when running an LLC.
Outside Investors Can Be Difficult To Obtain
While it can be easier to obtain investors for an LLC than a sole proprietorship, corporations have an even easier time wooing potential investors.
LLCs can’t issue shares as corporations can. Any potential investor in the LLC must also become a member of the LLC. And that type of obligation can scare off many potential investors.
Leadership Challenges
And if you decide to have more than one member in your LLC, leadership issues can arise. If duties aren’t clearly established, there may be conflict over who is in charge of which decisions.
As Jane Austen once said, “Too many cooks spoil the broth.”
Leadership challenges can indeed be a major problem with LLCs. However, most of these challenges may be avoided by establishing clearly defined duties in your operating agreement.
Time And Expense
And at the end of the day, LLCs are still more expensive and time consuming than a sole proprietorship is. You’ve got to create and file the correct paperwork, pay state filing fees, and more.
Sole proprietorships are simply easier — and less expensive — to manage.
How To Decide If You Should Establish Your Business As An LLC
At this point, you might be working to determine the answer to that question. You might be wondering if you should form an LLC for your business or continue operating as a sole proprietorship. The answer to that question depends on a couple of different things.
What Type Of Business Are You Running?
The type of business you’re running can help determine whether a sole proprietorship is sufficient for you or whether you should consider converting to an LLC.
For example, I have a few different sole proprietorships, including my freelance writing business and my business as a real estate agent.
In my writing business, it’s just me and my keyboard — and of course, Google docs. The business runs like this:
- I’m solicited to write articles for websites
- I write those articles
- The businesses I write for send me money
It’s quite an uncomplicated business and there are no other employees or independent contractors involved. If I ever wanted to expand my business and take on other writers, whether contracted or W-2, it might be wise to convert to an LLC.
However, if it remains running as me and my keyboard, there’s probably not much benefit to converting to an LLC.
Now, real estate is a different animal. Many realtors run their businesses as LLCs. They may have team members working under them.
Or they may simply be concerned about the many legal risks involved with helping people buy and sell houses. Realtors get brought to their state boards regularly with accusations of underhanded dealings.
Granted, the majority of realtors operate above board, however, the risks of a lawsuit still exist. In the case of a real estate business, you may want to form an LLC — especially if you’re managing your own rental properties.
Risk, in fact, is a big determination to consider if you have a sole proprietor business.
What Is Your Level Of Risk?
For instance, let’s say you’re a sole proprietor running a small handyman or construction business. You have one or two people working for you, and your company performs small remodeling jobs.
If you have a business where other people are working for you and there are safety or performance risks, an LLC is probably a better choice than a sole proprietorship.
Where my writing business poses little to no risk of a lawsuit, a business that involves other workers or poses safety hazards is a different story.
Other risks involved in business operation that could happen are:
- Risk of operator or employee fraud that could result in financial loss
- Business failure that results in financial losses for clients
- Physical injury of customer or employees
- Having to file bankruptcy
- Crimes committed by members of your organization
The higher the risk level of the varying potential hazards in your business, the more likely you’ll be better off with an LLC as opposed to a sole proprietorship.
When these types of risks are realized in your sole proprietorship organization, your personal finances and assets are targetable by law.
In other words, you and your family could lose your home, your savings, and more.
Establishing your business as an LLC can protect you from these types of risks, thus protecting your personal and family assets in the process.
Conclusion
It’s up to you to decide whether a sole proprietorship or an LLC is better for your business. However, if you find that your daily business operations come with a fair amount of risk to you, your team members, and/or your clients, you may want to consider forming an LLC.
Operating your business as an LLC to minimize risk is one of the best ways to protect your personal and familial assets from loss due to business risks.
