Becoming a sole proprietor is a cost-effective and straightforward solution when starting a new business. However, as your business grows, you should know when to start an LLC. Otherwise, you could expose your personal assets to risk and miss out on the many benefits forming a limited liability company (LLC) can offer.
An LLC is a type of business entity with fewer regulatory requirements and formation documents than a corporation. Like a sole proprietorship, the business owner pays taxes on the business income on their personal tax return without those profits first being taxed at the business level. By setting up a separate business entity, the LLC owner usually has personal asset protection from liability for business debts.
In this article, you’ll learn everything you need to know about when to start an LLC and how to do it when you’re ready.
You’re not required to get an LLC before starting your business. However, when starting a new business, many begin as either an LLC or sole proprietor. Both options have benefits and downfalls, so the decision depends on which of them will best meet the needs of your business.
An LLC offers protections you won’t be able to take advantage of as a sole proprietor. On the other hand, a sole proprietorship business structure could allow you to start your business at a lower cost with less paperwork.
If you’ve already started operating as a sole proprietor, you may be asking, “At what point do I need an LLC?” When weighing the choice between operating as a sole proprietor versus an LLC, many begin as sole proprietors due to the lower costs and simplicity of getting started. However, after experiencing suitable growth, they often become LLCs.
Operating as a sole proprietor is a simple way to operate when you first begin your business. However, a sole proprietorship provides no personal liability protection for the owner, meaning that the business and the owner are the same legal entity. If someone sues the business, they’re suing the owner and could go after their personal savings, home, car, etc.
For that reason, the longer you’re in business as a sole proprietor, the longer your personal assets are at risk. Those risks increase as the business grows. Starting an LLC can shield you from the legal liabilities and debts of the business.
Forming an LLC, or a limited liability company, benefits business owners in several ways. These benefits make operating the company a much less stressful experience for the business owners, who are called “members” in an LLC.
One of the most important reasons to consider forming an LLC is that it allows the business to exist as a legal entity separate from its owner.
This means the limited liability protection the LLC provides will usually protect your personal assets from claims regarding the business’s debt. Additionally, it will usually safeguard your personal assets if a lawsuit is filed against your business.
In most cases, an LLC will be viewed as a more legitimate and credible business than a sole proprietor or general partnership. This process can ultimately increase your customers’ trust in your business, boosting its success.
Furthermore, the business will also appear more legitimate to banks and other creditors. Respectively, you’ll be more likely to receive credit when needed to help run and grow your business.
LLCs are typically considered “pass-through entities,” meaning that the business itself typically doesn’t pay federal income tax on its profits. Instead, the responsibility to pay income taxes falls only on the individual. This is in contrast to a typical corporation, in which profits are taxed at both the business level and the individual owners’ level. This is called “double taxation,” whereas LLCs have pass-through taxation by default.
Single-member LLCs (LLCs with a single owner) don’t have to file a separate federal return for their LLC. Single-member LLCs report the LLC income on their personal income tax return (Form 1040). But a multi-member LLC must file a separate information federal return for the LLC, Form 1065. Then each LLC member reports their share of the profits on Schedule K-1 and attaches it to their own personal federal tax return.
Although LLCs are taxed as sole proprietorships or general partnerships by default, LLCs also have the option to be taxed as corporations. Some LLC members choose to classify their businesses as an S corporation or a C corporation, which can be advantageous in some cases. In particular, many LLCs elect to be taxed as S corporations because it can save the members money on self-employment taxes (the taxes earmarked for Social Security and Medicare). You can learn more on our “What Is an S Corp?” page.
If you’re currently operating as a sole proprietor and are ready to convert your business to an LLC, you’ll need to know what steps are involved. Below, we’ll provide a detailed explanation of how to convert your sole proprietorship to an LLC.
You’ll need to give your LLC a name if you’ve been operating under your name rather than the name of your business. Furthermore, you should check your state’s naming requirements regarding the name you choose.
The requirements for your LLC’s name will vary based on your state. However, all states will have the legal requirement that you choose a business name that’s not already taken by another company in your state.
If you find a name but aren’t quite ready to file, most states also allow you to reserve an available business name by completing a form and paying a name reservation fee.
When registering your business, you’ll also be required to appoint a “registered agent” (also called a “resident agent” or “agent for service of process” in some states). A registered agent receives legal documents (such as service of process and subpoenas) and certain official correspondence and official documents on behalf of your limited liability company. That can include paperwork such as tax notices or state compliance documents.
In most states, the registered agent must be available in person at a designated registered office during regular business hours so they can receive notices in person. The registered office must be a physical address in your state. Most states allow you to designate yourself, another resident of your state, or a registered agent service like ours to serve as your agent.
You must also file your Articles of Organization, sometimes called a Certificate of Organization or Certificate of Formation, with the Secretary of State. Depending on your state’s requirements, this form will usually list the name and business address (or any other mailing address), the email address, its appointed registered agent, and various information about the LLC and its members.
Most states will give you a variety of ways of filing your Articles of Organization, such as postal mail, fax, and in-person, but online filing is usually the fastest method.
You’ll be required to pay a state filing fee when you submit the Articles. This is likely to be the largest of the administrative costs when you start an LLC. The average cost of filing fees is hard to determine because filing fees vary so much from state to state.
Although most states don’t require you to create an operating agreement, it’s crucial for your business. This document, which is similar to corporate bylaws for a corporation, outlines the rights and responsibilities of current and future members of the LLC, in addition to establishing the rules and other important information for the business.
If you’re not sure how to go about creating an operating agreement for your LLC, we have a customizable template to help get you started.
Unless you’re a single-member LLC without employees (and sometimes even then), you’ll likely need to get a Federal Employer Identification Number (EIN) (also known as a federal tax identification number) from the Internal Revenue Service (IRS). Even if you don’t legally need an EIN, getting one can help you open a business bank account, and some business licenses may require one.
You can get your LLC’s EIN through the IRS website, by mail, or by fax. If you don’t want to deal with that particular government agency, we can get it for you. Our EIN service eliminates the hassle.
Once you have your EIN and have completed the other basic steps required for starting an LLC, you may have more to do depending on your individual circumstances, such as your location, industry, professional service, etc. You may be required to get certain LLC business licenses and permits to operate. You’ll likely also need to register to pay business taxes in your state, county, and/or city. The list of taxes could include sales taxes for physical products you sell, franchise taxes, and, if you have employees, payroll taxes, unemployment insurance tax, and other employment tax filings.
It’s also wise to create a separate business bank account with a business credit card (and possibly a debit card) so that you can separate your personal and business finances and start establishing a credit history for your LLC.
You may also have some ongoing compliance obligations for your LLC. Most states require you to file an annual report or a biennial report to update your LLC’s information with the state. Our Worry-Free Compliance and annual report service can help you stay on top of these.
Consulting a business lawyer can also help you with compliance requirements and legal protection. Many law firms specialize in helping small businesses.
If you’re ready to create your LLC, ZenBusiness can help you get started today for $0 with our business formation services. We’ve done thousands of business filings and have an extensive suite of services that will eliminate much of the stress of creating an LLC. In addition, we provide you with all the tools and resources necessary to streamline the process so you can focus on your business.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
If you want to protect your personal assets from actions against the business, it’s wise to set up your LLC before doing any business. However, it’s not required to start making money.
Having the LLC entity type is not necessary to start a business. However, it provides many benefits to your business, including personal liability protection, more respectability from clients and others, and more options for how your business is taxed.
You should choose an LLC when you want to provide a sound business structure and protect your personal assets from business matters. It’s a wise business strategy.
Start an LLC in Your State
When it comes to compliance, costs, and other factors, these are popular states for forming an LLC.
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