While the sole proprietorship is the simplest form of doing business, some sole proprietors may wish to form a limited liability company, or LLC. While converting a sole proprietorship to an LLC can be as simple as following the steps to LLC formation, the ease with which a sole proprietor can do this, and indeed whether it makes sense to do it at all, depends upon a variety of factors.
Limited Liability Issues
Protection of one's personal assets from the claims of civil plaintiffs constitutes one of the greatest benefits of forming an LLC. Under the limited liability shield, LLC members receive protection from suits arising out of torts committed by co-members and employees. If your sole proprietorship has or will have employees, or if you intend to bring in a partner, converting your business to an LLC can give you some protection against the mistakes of others. If your sole proprietorship has no employees and you have no plans to expand your operation in the future, an LLC will offer nothing in terms of protection from suit. Members are always liable for their own acts.
LLCs are also attractive business entities due to their flexible tax treatment. Members can receive the benefit of pass-through taxation, where the company's profits flow directly onto their tax return and are only taxed once. A sole proprietorship, however, is also taxed on the sole proprietor's individual return. As single-member LLCs can only be taxed as corporations or sole proprietorships, LLC formation will not always produce a tax benefit for a sole proprietor. Decisions involving issues of taxation should always be made in conjunction with your certified public accountant.
Future Transferability Issues
LLCs are created and governed by the law of individual states, which vary in terms of whether and to what degree an LLC can be transferred. A single-member LLC, which your sole proprietorship will become if you elect to form an LLC, may dissolve upon your death, whereas you can pass your shares in a corporation to your heirs. Your state may also specify that your LLC will dissolve if you file for bankruptcy and it may prevent you from selling the entity even if you don't file. Sole proprietors seeking limited liability who expect to transfer the company at some point in the future may wish to form a corporation instead of an LLC.
Although LLCs are relatively simple to form and operate in comparison with other forms of business, each state imposes its own requirements for forming an LLC and keeping it going. Despite the many benefits of LLC formation, it may be of little use to the entrepreneur who does not file his annual reports on time or does not invest the time and effort into keeping company and personal assets separate. Failure to follow the requirements of the law could result in a court disregarding the LLC in the event of a lawsuit, bypassing the limited liability shield.