There are many benefits in making the jump from a sole proprietor to forming a Limited Liability Company (LLC). The most important reason you should convert to an LLC is to limit your liability. As a sole proprietor, you are personally responsible for all debts and legal obligations of your business. Separating business assets from personal assets is the smartest decision for most business owners as you want to protect your personal assets if there is a claim against your business. It's good practice to own as little as possible in your name.
A single owner of an LLC is called a "Single Member LLC". Instead of being called an owner, you are a member of the LLC. A member's personal liability is generally limited to the amount of investment in the LLC unless you guarantee a transaction. A creditor is generally precluded from acquiring an interest in your personal assets if the judgment was entered after the LLC was formed.
An LLC is not recognized as an entity by the IRS. An LLC is considered a pass-through tax entity, which means it passes its income and tax liability to the single member-owner, which is you. You will file the same tax return as a sole proprietor (unless you elect to be taxed as an S Corporation) and are responsible for self-employment taxes (Social Security and Medicare).
An LLC is recommended for many types of properties, especially for real estate investments. If an investor owns multiple real estate rental properties, it's highly recommended (some exceptions) to form and operate a separate LLC for each rental property. As for your primary residence, transferring title to a living trust is preferred due to tax advantages and the homestead exemption.
The main reason for forming a separate LLC for each rental property and each business is that an injury on its premises or claim can be costly even with an insurance policy. Forming an LLC for each entity limits claims to each property or business. If the LLC owns other assets, those assets are at the risk of being exposed to creditors. However, establishing an LLC will not be enough to be sheltered from personal liability. If the LLC formalities are not adhered to, or there is a personal guarantee against the property or business, the Member's personal assets will likely be exposed to the creditor.
Separateness: Since the primary purpose of forming an LLC is to limit your liability, if you fail to keep your business finances separate from your personal funds, you will lose the protection from personal liability. For example, you are paying personal expenses with your LLC checking account. This lack of formality will give more weight to the argument that the LLC should be disregarded as a separate legal entity. Other incidents that jeopardize the limited liability protection of an LLC include engaging in reckless, dishonest, or fraudulent activity, being late with paying taxes, and not following compliance formalities of being an LLC.
Note: Creditors have other recourses that go beyond this article's scope, so seek the advice of an attorney to get a thorough understanding of what they are. The one remedy that is generally available to a creditor is called a "charging order." A charging order allows a creditor to seize assets that have been distributed to members, but not the assets that the Member (s) may potentially be entitled to receive under their ownership interest in the LLC.
Where to begin in forming your LLC:
An LLC is a registered business entity type formed under state laws. The first step to creating an LLC is to file the correct forms with the state you will be doing business in. Each state has different rules, regulations and procedures; however, there are common steps that you will follow in each state. Check with the Secretary of State office and your local government agencies to ensure you understand what is required for your LLC. If an LLC has more than one owner, it is called a multi-member LLC or a partnership for tax purposes.
Unlike an LLC, sole proprietors do not have to file formation documents. If a sole proprietor wants to operate the business under a name other than the owner's legal name, filing a "Doing Business As" (DBA) is needed to register the fictitious business name. As with other business types, sole proprietors must obtain required licenses and permits to do business legally in their jurisdiction.
Select a name and check with the Secretary of State to see if the name is available. You will not be allowed to use the same name as another LLC or corporation that offers similar products or services. You should also have a trademark search to make sure no one in another state has claimed the business name for use throughout the United States. At the same time, through a DNS registrar service, check whether the website domain name you want for your business is available. You don't want to register a business name to find out all the URLs around business names have been taken.
You will want to reserve and lock in your business name to ensure no one else takes the name before filing the actual LLC registration paperwork.
Select a Registered Agent. If you are the only employee of your company, you should select yourself as the Registered Agent. Each LLC needs a representative to receive critical legal documents like subpoenas, lawsuits, etc. etc. This Registered Agent will be responsible for getting these documents to you, the LLC owner. There are dedicated companies that provide Registered Agent services to LLCs. We are one of them.
You will file your articles of organization with the state. The fees for filing the articles of organization differ from state to state. Some of the information you may expect to provide include:
- Name and principal address of the business
- Purpose of the business
- Name and address of the Registered Agent
Register your business in other states if you are doing business in multiple states. Check what each state requires and submit the documents accordingly.
Create an LLC Operating Agreement. An LLC operating agreement is a plan describing the LLC members' rights and responsibilities, how the company will be run, how the LLC's income will be allocated, how the ownership interests will be broken down, what the voting rights are, what will happen if an LLC member is incapacitated, how the business will be governed, etc. etc.. The LLC operating agreement solidifies its separateness from its owners. Although not all states require an operating agreement, you should always create one for each LLC.
Get an employer identification number (EIN) from the IRS. An EIN is a tax ID number. Even if the business owner had an EIN as a sole proprietor, they must file for a new one.
If you are doing business in multiple states, you must file articles of organization with each one. Be sure to check what each state requires and submit documents accordingly.
Open a business checking account in the name of your LLC once you receive your EIN, and the state approves the organization's articles. Do not use your existing sole proprietorship business bank account.
Check if you need to reapply for your business licenses and permits or transfer them to the new LLC. Some states and local licensing agencies will allow for transfers.
Decide if you want to be taxed as an S Corporation. As mentioned, an LLC itself does not file a return since it is a disregarded entity for tax purposes, and business profits are passed on to the members (owners), which are subject to self-employment taxes. In some cases, it may be beneficial to elect to be taxed (by filing IRS Form 2553) as an S Corporation to decrease self-employment taxes. As an S Corporation, the LLC will receive the pass-through tax treatment; however, only the owner's wages and salaries are subject to Social Security and Medicare taxes, not the distributions which are only subject to the dividends tax (in most cases). The LLC will file form 1120S and distribute a Schedule K-1 to each Member (owner), so they can report their share of the profits on their 1040. Whether taxing as an S Corporation is beneficial depends on many factors, so you should consult your tax advisor.
Compliance obligations for an LLC are different in every state. They include filing an annual report (or other frequency), maintaining a registered agent, reporting and paying taxes, renewing business licenses and permits, holding annual meetings and writing minutes, etc. Abiding by the compliance requirements will dodge hefty fines, penalties, the loss of liability protection, and possibly a forced dissolution of your business.
Remember that an LLC is a business, and it must be operated as a business. When members of LLCs deviate from the standards and when they believe their LLC is an enforceable legal entity, problems are likely to occur, and protection against creditors will be lost. Handle with care and consider reaching out to an attorney and tax advisor for guidance.
You can also contact Alto CPA Group to ensure that all your needs are met, including business formation and compliance filings.
About Michael D’Amato, CPA and Alto CPA Group, LLC.
Michael D’Amato is the founder of Alto CPA Group, LLC. and is a member of the American Institute of CPA's and the New Jersey Society of CPA's. Michael has more than 25 years of enterprise accounting, finance, operational, and technology experience to go along with his accounting firm experience. Alto CPA Group provides accounting/tax and cloud solution services. As one of the early adopters of Virtual accounting and tax services, Alto CPA Group is big on automation. Michael and his family lives in Red Bank, New Jersey.