As sole proprietors, business owners enjoy the advantage of simplified income tax reporting via the use of Schedule C (“Profit or Loss From Business”) within their Form 1040 (“U.S. Individual Income Tax Return”). However, sole proprietorship status can expose a business owner’s personal assets to the risks and liabilities of their business operation.
State statutes generally allow a sole proprietor to conduct business as a limited liability company (LLC). The intent is to provide a broader protection from liability. The concept of the LLC statute is that the owner (technically referred to as a “member”) does not have any liability for business debts solely by reason of being a member or owner. Of course, this does not relieve the owners of responsibility for their personal actions or for debts that they have personally guaranteed. But personal assets would be protected from claims arising because of ordinary business transactions. This liability protection could be particularly advantageous when there are employees working in the business. With a sole proprietorship, employees’ actions may expose the business owner’s personal assets. Sole proprietors interested in limiting personal liability should consult an attorney to more fully explore the protections that are relevant to their particular business situation.
The other attractive aspect of LLC status is that IRS regulations allow the business owner to continue reporting for income tax purposes as a proprietor, despite forming an LLC under state law. Gaining the extra legal protection of an LLC will not entail any extra filing with the IRS.
Of course, there will be transaction costs to create the LLC. It will be necessary for an attorney to draft an LLC document to be filed with the state. The attorney can provide an estimate of this cost, as well as any initial or recurring fees that must be submitted to the state office. Also, when conducting business as an LLC, it will be necessary to consistently use the LLC designation on business letterhead, the business’s checking account, business licenses, and the like. The business owner would need to make sure someone goes through the process of adding the LLC designation to the various contracts and documents under which business is conducted.
In summary, a sole proprietor should weigh the advantages of the liability protection from LLC status against the initial legal and administrative costs of accomplishing the conversion. For most proprietors, the added liability protection will merit the costs of converting to LLC status, but this should be explored more fully with legal counsel.
If you have any questions or wish to discuss this further, please give me a call. I would be happy to review any tax implications from the conversion or refer you to one of the expert attorneys in my network.