Chances are that when you start thinking of going into business for yourself, you’ll opt to become a sole proprietor, as it is the simplest and least expensive business model to establish. More than 70 percent of U.S. businesses are successfully run under this most common company legal structure. A sole proprietorship is an unincorporated business model owned and operated by an individual. There is no legal distinction between you, as the business owner, and your business.
A sole proprietorship is an attractive business model for the new business owners as there are really no formal actions required to start. If you are a freelance writer, for example, your writing is the activity that makes you the owner/sole proprietor of your writing business. Depending on the nature of your business, you might need to fork out a few bucks to obtain necessary permits and licenses regulated by your state and local government. Also, if you decide not to use your own name for your business, you’ll have to file a fictitious name or DBA (“doing business as”) name – it’s up to you to make sure your chosen name has not been already registered.
As you and your business are one and the same , your business is not taxed separately – whatever income you make from your business is considered your personal income and you are responsible for all of it, including self-employment taxes. The good news is the tax rates for sole proprietorships are the lowest of all business structures. All business profits and losses are reported under a Schedule C in addition to the standard 1040 form, which makes it easy to file.
Establishing a sole proprietorship might be cheap and simple, but there are certain drawbacks that need to be mentioned. As there is no legal separation between your new business and you, as the owner, you alone are personally responsible for the failures and debts your business incurs. Also, raising money for your startup might be extremely challenging, as most investors are hesitant to jump in because you cannot sell stock in business, and the banks rarely lend money to sole proprietorships, regarding them as high liability risk.
Being in complete control of your business and accepting the ultimate responsibilities for your business’s ups and downs might work for you, especially if you are the only one employed by your startup and you consider your business a low-liability risk. Some sole proprietors, however, might become too overwhelmed and burdened by being personally responsible for every aspect of running the company; or they might want to expand the scope of their business and look for outside investors. In that case, they might eventually decide to incorporate their small business to protect their personal assets, reduce personal liability, and grow their operation.
If you have reached this point, you will want to know not only when you should incorporate and what legal entity would be the best fit for your business objective, but how to incorporate your sole proprietorship and switch it to a more complex business model to have more legal and financial protection.
The good news is, you, as a sole proprietor, can incorporate your business, even if you are the only person in your company. So, when is the best time to incorporate your sole proprietorship? Since corporations will protect your personal assets, you should make the switch as soon as possible. But you should look at the calendar and decide if it might be advantageous to wait until January 1st, to avoid additional costs by filing two tax returns – one for your sole proprietorship, the other for your corporation.
What Legal Entity Would Be the Best Choice for Your Business? Should You Choose a Corporation or an LLC (Limited Liability Company)? What Is the Difference?
There is no single solution that works for every type of business. Your decision to incorporate or form an LLC will depend on your business objectives and industry, your financial goals, and your business growth plans.
A corporation will separate your personal assets from your business assets and give your company credibility to secure funding. S Corps are specifically designed for small businesses and as such, they are not required to file corporate taxes (keep in mind that you are responsible for paying taxes on any dividend earnings, though.) If you are planning on growing your business fast and issuing stock, you would do the best to incorporate your business as a C Corp, in which case you will have to pay corporate taxes. An LLC is a different type of business entity and one of the most popular business models for small businesses with fewer legal requirements and many of the same benefits as an S Corp. It offers protection for the members’ personal assets against bankruptcy or lawsuit, but just like a sole proprietorship, you pay taxes on your entire net income. Also, there is greater flexibility in how profits can be distributed amongst the owners than in corporate structures.
To learn more about whether an S Corp, C Corp, or LLC is the right structure for your business, it’s a good idea to consult with an attorney before you make the first step towards incorporating your sole proprietorship.
The Process of Incorporating Your Sole Proprietorship
Changing your sole proprietorship business into a corporation or an LLC could become complicated, depending on your business history. It is extremely important to document each step of this process. You can do your own research and if you feel confident, you may start the process on your own, but it might bring you peace of mind to consult a small business attorney to help you with terminating your sole proprietorship and creating a corporation
Choose the Name of Your Company: Once you’ve chosen your preferred business model, you have to decide if you should keep the name of your business or select another. When you pick a business name, check with the local register of businesses to make sure the name has not already been trademarked. We suggest you register a corresponding domain name for your new company’s website, even if setting up your online presence is not your first priority.
Transfer Your Financial Information: You’ll need to close your old bank account and open a new one for the corporation, as well as obtain a new federal tax identification number (EIN) from the IRS. You may also need to apply for a state tax identification number depending on which state you incorporate your company in. We recommend you file a final tax return under the old DBA and request that the IRS close out the account and tax ID for the sole proprietorship. Do this after obtaining a new EIN for the new corporation to appropriately complete your business taxes and income tax returns.
If your sole proprietorship was part of any contracts, insurance policies or estate planning documents, make any necessary changes to these documents to reflect the change from the old entity to the new corporation.
You may also need to notify any creditors that the sole proprietorship no longer exists and has been replaced by the incorporated business. It will help prevent business liability if creditors continue to believe the business is operating as a sole proprietorship.
File Articles of Incorporation: You can find help online with drafting the documents that will clearly define a statement of purpose, articles of incorporation, and bylaws for your business. These documents will provide the legal guidelines you will adhere to while operating your company. Once you are satisfied with your final drafts, you’ll need to file them with the local and federal authorities, including the Internal Revenue Service. After you register your new business entity with the local business department, you’ll have to obtain any required business licenses and permits under your state’s laws. If you have previously obtained all the permits and licenses for your sole proprietorship, you will just have to transfer them to your new corporation.
Transfer the Assets: Once you have created your corporation, transferred your name (or registered the new one), and obtained (or transferred) the necessary permits and licenses, you’ll need to transfer all your assets from your sole proprietorship to the new business entity. Depending on the complexity of your previous company, you might need to hire a professional to evaluate your assets. You can transfer physical assets, like equipment, vehicles, property, computers, and furniture as well as intangible or intellectual property like patents, trademarks, royalty agreements, brand names, copyrights, etc.
While the transfer from your sole proprietorship to your corporation is now almost complete, you have to make sure to wrap up the process and finalize the switch. Here are a few more things you need to pay attention to:
You need to cancel any insurance policies like liability insurance from your old business and open new ones for the corporation
You should notify the clients of the changes to your business and update all the existing contracts
Make sure to update corporate documents, including letterheads, websites, business cards, telephone listings, and other contact information to reflect your new corporate information.
Incorporating your small business is a big decision that may benefit your business substantially. But if you’re unsure which path to take or even if incorporating might be the best decision for you, consult a small business lawyer or tax professional. They can help you come to a decision that makes good fiscal and business sense for your company.