QUESTION ON How to Convert a Sole Proprietorship to an LLC
I currently have a business structured as a sole proprietorship. I work full-time and my husband runs the business. How do I know when to convert from a sole proprietorship to a corporation or an LLC? We currently have two helpers that we are paying as independent contractors but we are getting more business and may need to start paying them as employees. In addition, is it possible to file business taxes separate from personal taxes? I did not do that this year and my tax refund is almost nothing. I am afraid that if the business continues to thrive, I may end up owing next year. I would appreciate any advice you could give.
– Barbara, MD
If you are in a service-based business, you may want to consider forming a corporation or LLC right away, if only for the limited liability protection these entities provide. As a sole proprietor, your personal assets–your home, car, savings, investments–are at risk while you do business, because you ARE the business. If a dissatisfied customer or disgruntled contractor were to successfully sue over a business-related claim, your personal assets could be attached to satisfy the judgment.
With that in mind, the question becomes whether to form a corporation or LLC.
Of the two entities the simplest to manage is the LLC. LLCs are not subject to the same formalities and recordkeeping requirements (e.g., annual shareholder meetings, board resolutions and meeting minutes) as corporations. LLCs provide pass-through taxation; the net taxable income of an LLC passes through to its owner(s) and is taxed at the owner(s)’ individual income tax rate.
In the case of an LLC with only one owner, the IRS disregards the LLC for tax purposes and treats the business as a sole proprietorship. So, at tax time, you would prepare the same Schedule C that you do now to report your business profit or loss and attach it to your 1040 individual income tax return. And, like sole proprietors, as a “self-employed” owner of an LLC, you would be responsible for payment of self-employment tax in addition to income tax. So not much will change by forming an LLC–except that you would have limited liability protection, since owners of LLCs are generally not liable for the company debts/obligations.
Corporations also provide limited liability protection (shareholders are generally not liable for corporate debts/obligations), but they are taxed differently. Corporations are taxed at graduated corporate income tax rates which start at 15% and go up depending on the amount of net taxable income. And, while corporate formalities and recordkeeping requirements may be cumbersome for a small business, they may be well worth the time and effort as corporations can take advantage of certain tax deductions that LLCs cannot (e.g., certain employee benefits including medical expense reimbursement plans).
It should be noted that, if you form a corporation, you would need to pay yourself a salary as an employee in addition to any other employees you will have. This is because owner-officers who provide services on behalf of a corporation are considered employees. Employee salaries are subject to employment tax but any monies paid in the form of shareholder dividends are not, so you may potentially realize a savings in this regard compared to a sole proprietorship or LLC (since sole proprietors and LLC owners must pay self-employment tax on ALL of the net taxable business income). The salary you receive would be taxable income to you personally but would be deductible by the corporation as a legitimate business expense.
In addition to federal income tax, most states impose a corporate income tax as well, so this should be factored in when considering the costs associated with forming a corporation. Another factor to consider is the dreaded “double taxation” associated with corporations; income is taxed at the corporate level, and then taxed again at your individual income tax rate if/when that income is paid to you in the form of a shareholder dividend. Of course, many corporation owners avoid double taxation by simply receiving compensation in the form of a salary only and foregoing any shareholder dividend payments.
A final note: If both the simplicity of an LLC and the tax treatment of a corporation appeal to you, you have another option. You may form an LLC and then make a special election with the IRS to be taxed as a corporation. Your company would be recognized as an LLC for legal purposes but would be treated just like a corporation for tax purposes. As I have said in the past, there is no one-size-fits-all business structure. Bottom line: You should consult a CPA for tax advice and guidance on selecting an appropriate structure for your business.
Recommended Resources on How to Form LLC:
- LLC or Corporation?: How to Choose the Right Form for Your Business
- Surprisingly Simple: LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies
- Form Your Own Limited Liability Company
- Forming an LLC and Electing to be Taxed as an “S” Corp
- Advantages of S Corporations
- LLCs and C Corporations: Similarities and Differences
- How to Limit Liability and Gain Tax Advantage for Corporations
- How to Change from Sole Proprietorship to Corporation