This post is directed toward those who have been making money as a sole proprietor but are ready to bite the bullet and transition to a business entity. Before you make this change, you need to understand what type of business entities exist and decide which one is the right choice for you.
Changing from a Sole Proprietorship to Anything Else
When you began making money as an individual you instantly gained the title of sole proprietor. You can continue to work under the title, but what many people discover is that transitioning to a form of small business can help you gain tax advantages and protect you from liability.
Or maybe you have been working well with another individual and you two have decided you would best be served by forming a partnership. The process can be as simple as signing a Partnership Agreement, while more advanced business organizations-such as Corporations (including S- and C-Corporations), or Limited Liability Companies, (LLC) will require more effort and paperwork. At a minimum, Articles of Incorporation or Organization will have to be filed with the appropriate state authorities. Corporations must also establish Bylaws and conduct a formal meeting of shareholders, while LLCs are often less strictly regulated.
Converting a Partnership or Limited Liability Company to a Corporation
The situation is different when you want to change a business entity from one formalized type to another, such as when switching from a Partnership or a Limited Liability Company to a Corporation. To accomplish this, generally you will have to form a new Corporation and then dissolve the old business entity, but check with your Secretary of State because some allow you to convert the business instead.
The transfer of assets and liabilities from the old company to the new one is usually done through one of the following three methods: by directly transferring assets and liabilities from the old entity into the new Corporation, distributing assets and liabilities to the owners who then transfer them to the new Corporation, or contributing partnership or LLC shares to the Corporation. All three exchanges trade capital interest in the old business for corporate stock in the current one. The old Partnership or LLC is considered terminated upon the liquidation of its assets. Note that while the conversion is technically tax free, gains made through the process, such as reduced liability, have to be reported and may be taxed.
Converting a Corporation to an LLC
One of the potentially most expensive conversions is one that changes a C-Corporation into a Limited Liability Company. The exact cost is determined by the value of company assets and whether or not a loss is being generated. The conversion can be accomplished by dissolving the corporation and forming an LLC with the assets of the liquidated corporation, although some states offer a simplified conversion process. Note that any reorganization that does not liquidate the original corporation entirely may be scrutinized by the IRS with all the consequences that entails.
Converting a Corporation or LLC to a Partnership or Sole Proprietorship
Often, the simplest way to convert a business is to dissolve, and totally liquidate the assets of, a corporation or LLC, distributing the assets to shareholders and/or owners. Sole proprietor status is conferred immediately upon beginning business, while Partnership hinges on the Partnership Agreement being signed. Check with your Secretary of State to find out the exact process, because you may be able to convert to a different business entity instead of dissolving it in some cases.
In Conclusion
Note that changing your business entity may have additional consequences. For example, if you are running a business that requires licensing, you will have to apply for a new license for the new business entity. Always make sure to review and comply with local and state regulations, preferably by consulting a qualified attorney and checking the rules with your Secretary of State. Ask a lawyer or your tax professional to get the personalized guidance you need to change your business entity the right way.
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