4 Reasons You Should Convert Your Sole Proprietorship Into an LLC or S Corp

If you currently operate your business as a sole proprietorship, you may be wondering if it’s worth it to convert your business structure to a limited liability company (LLC) or S corporation.

As attorneys with dedicated experience advising small business owners, TONG LAW has helped countless clients make this decision. In this article, we’ll explain the key potential benefits you can unlock for your California business by structuring it as an LLC or S corporation.

1. Reduced Personal Liability Protection

One of the biggest motivators for converting is the liability protection for personal assets an LLC or S corp provides. As a sole proprietor, you and your business are considered to be one when it comes to legal and financial liability.

If your business is sued or incurs substantial debt that it can’t pay, your personal savings, investments, home, and other assets can be seized to settle those business debts.

Transitioning to an LLC or S corporation establishes your business as its own distinct legal entity separate from yourself personally. This protects your personal belongings in the event your business faces a lawsuit or bankruptcy. Creditors typically can only go after the assets tied directly to the business, not your other personal assets.

For example, if you run a restaurant as a sole proprietor and someone slips, falls, and decides to sue, all your personal assets may be taken to pay that settlement or judgment. However, with an LLC or S corp structure, only the restaurant’s assets and business insurance would typically be impacted.

2. Tax Benefits

In addition to liability advantages, converting your business structure can unlock tax perks as well. S corporations and multi-member LLCs are considered “pass-through entities” for tax purposes under California law.

This means:

• The business profits/losses pass through the company directly to you and other owners’ personal tax returns.
• The business itself does not pay taxes on income.
• You’ll still have to pay personal income tax on those profits, but pass-through taxation avoids the dreaded “double taxation” that happens with standard C corporations.

As a sole proprietor, though, your business income gets lumped in as personal income on your own tax return. You pay ordinary income tax rates on those profits, which now top out at over 37% at the federal level and 13.3% at the California state level.

But for pass-through entities, you may qualify for more tax deductions and income-shifting opportunities. For example, you can potentially reduce your self-employment tax liability by reclassifying some of your income as dividends rather than salary. There are also tax deductions you can take at the corporate entity level before profits pass through to your personal tax return.

You should consult a tax professional as part of your educated decision-making in this process. Nothing in this article should be construed as tax advice as TONG LAW is not a tax law firm and we do not specialize in tax law.

3. Credibility & Professionalism

There’s also something to be said about the elevated business credibility and professionalism that comes with converting from a sole proprietorship to an LLC or S corporation.

Customers often perceive these business structures as more stable and established than sole props. This instills confidence in clients to trust you’ll be around for the long haul and have the infrastructure in place to handle their business reliably.

Investors and lenders also view LLCs and S corps as less risky to fund than sole proprietorships. So converting can increase your chances of securing business loans, lines of credit, angel investment, or even private equity down the road.

Generally speaking, forming an official LLC or corporation conveys more business sophistication than sole proprietorship status. Completing proper legal filings establishes credibility by distinguishing the company’s identity and signaling stability.

4. Administrative Changes

Finally, transitioning your structure will require some administrative adjustments for your business.

To set up your LLC or S-corp in California:

1. Establish separate business bank accounts and accounting procedures from your personal finances
2. Adopt corporate formalities like by-laws/operating agreements, designating officers/management roles, and holding annual member meetings (for multi-member entities)
3. Register your new business structure by filing articles of organization (LLC) or articles of incorporation (corporation) with the California Secretary of State
4. Designate a registered agent in California to handle official communications and legal notifications on your company’s behalf

While this may seem daunting, TONG LAW is experienced in helping California entrepreneurs navigate these administrative changes when forming an LLC or S corp. With the proper legal guidance, you can ensure full compliance with California business structure regulations.

Frequently Asked Questions

What forms do I need to file when converting my California sole proprietorship to an LLC?

When converting a sole proprietorship to a California LLC, you need to file the Articles of Organization form (Form LLC-1) with the Secretary of State along with a Statement of Information (Form LLC-12).

You also must file for a new Employer Identification Number (EIN) from the IRS and notify appropriate California agencies if you will have employees, sell food, etc.

What are the main differences in taxes when converting from a sole proprietorship to an S corporation in California?

The main tax differences when converting from a California sole proprietorship to an S corp include: S corps don’t pay taxes themselves & income/losses are passed onto owners’ returns, may reduce self-employment tax liability, may allow for more business tax deductions, and S corp profits distributing to owners as dividends have different tax rates than salary. Make sure to speak with a tax professional or specialist about how an S corporation might benefit your specific tax situation.

Does converting my sole proprietorship to an LLC or S corporation in California provide more protection if I get sued?

Yes, transitioning a sole prop to an LLC or S corp will provide liability protection separating your business and personal assets. With sole props, owners have unlimited personal liability, but an LLC or S corp establishes your business as a distinct legal entity, so typically, only business assets are targeted in lawsuits/debt collection.

Ready to Level Up Your Business Structure?

Contact the experienced attorneys at TONG LAW today for personalized guidance on whether transitioning from a sole proprietorship to an LLC or S corporation is the right choice to take your business to the next level while limiting legal liability and tax burdens.

We offer affordable and responsive legal support to help California’s small business owners and entrepreneurs thrive. Reach out now to schedule your initial consultation.