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Is it the right time for you to convert your sole proprietorship to an LLC or Corporation?
Updated: Dec 7, 2021
A successful small business owner has been doing business as a sole proprietorship for many years, and his biggest concern is whether he should convert his business to an LLC or Corporation. The questions are simple: why it so important to convert from a sole proprietorship an LLC or Corporation, and how do you know which business entity is the right type of your business?
I have seen a sole proprietorship earning $10 million a year, and I have seen a corporation earning $300 a year. The choice of business entity is not depended on the business revenue and expense; it is depended on many business factors, such as tax, long term development, risk, liability, and others.
Let’s briefly learn about the three types of business entities: sole proprietorship, LLC, and Corporation
Sole proprietorship = simple single entity
In a simple definition of a sole proprietorship, the owner of the business and the business are a single entity. Only one person owns the company and the owner pays a personal income tax on any profit. A sole proprietorship has less paperwork, for instance, the business owner just needs to file a simpler tax return (Schedule C on 1040). In addition, there are fewer regulations for a sole proprietorship. If you make a profit in your business, that is all yours. On the other hand, if your business faces a lawsuit, that is all yours too.
Corporation = double tax entity
Corporation separates your business assets from your personal assets. In case someone suits your business, it will only suit to your business level, and it will not touch on your personal assets. Furthermore, one person or multiple people can own a corporation. However, if you are considering incorporation your small business, you will want to convict your business to S corporations. It is not usually required to pay corporate taxes; instead, they only pay taxes on dividend earnings.
If you want to grow your business fast and attract third party investments, you can issue stock of your business. A C corporation will allow you to issue stock and set up a board of director, but you will have to pay corporate taxes. C corporation is a double tax entity. In other words, the net profit (gross revenue minus all the expenses) from the business is taxed one time, and it will be taxed for the second time once you receive a dividend from the corporation.
LLC = protection for the owners
LLC, a Limited Liability Company, is similar to a corporation, which an LLC offers protection for the owner’s personal asset in the event of lawsuit or debt. The owner, which called members of the company when it's business entity is LLC, can collect the business profit without paying corporate taxes in many states. However, there are many business regulations for an LLC, and an LLC is required to pay an annual fee.
The reason why you want to convert from a sole proprietorship to an LLC or Corporation
Converting from a sole proprietorship to an LLC or Corporation can protect your personal assets by separating them from those of the business. In the event of a company lawsuit or bankruptcy, your personal assets will not be at risk.
If you are running a business that is high risk for being sued or has risky finances, it is wise to convert to a corporation or LLC for an extra layer of protection. Obviously, there are some circumstances in which you can still be liable, such as getting business liability insurance.
When is the best time to convert from a sole proprietorship to an LLC or Corporation
The quick answer is as soon as possible. Since a corporation protects your personal asset, so you should take the benefit as quickly as it is available. However, if it is closed to the end of the year, you might have to wait until next year to make the convert. If your business operated as both a sole proprietorship and a corporation during the year, you will have to file two tax returns—one for each type of business—and therefore incur additional tax preparation costs.
What business entity is the right type of your business
The answer is strongly depended on the type of business you have, the owners, and your financial and business growth goals. Generally, an LLC is ended by the death or bankruptcy of the only member. The corporation will continue without regard to these events.
If your business is a technology startup, your business goal is to develop a unique mobile app. You plan to issue shares of your business to other people in exchange of development fund, a corporation would be the best choice.
Ultimately, there is no single solution that works for every type of business. If you feel it may be advantageous to convert your sole proprietorship to a corporation or LLC, consider all the variables and choose the entity type that will be most to your advantage.