Over time, your business can undergo significant changes. What may have started as a humble, one-person operation can grow into a more complex company, with multiple owners, employees, an evolving mission statement, and increasing risks.
As the scope and goals of your business shift, an accompanying change in business structure might be warranted. There are many reasons to consider changing your business’s entity type. Whether you are simplifying or expanding, it is important to understand the different options available, weigh the pros and cons, and take all of the necessary legal steps.
Reasons for Choosing an Entity Type
Selecting a business structure is one of the first major decisions an entrepreneur makes when launching their enterprise. Before registering your business with the state, you will need to choose a structure for it.
The type of legal entity you choose impacts your tax liability, ability to raise funds, paperwork requirements, and personal liability. One of the main reasons for a change in business structure is a change in your business’s needs, such as the following:
- Adding employees. Workers are an asset, but they can also increase your risk of liability. A limited liability company (LLC) or corporation, which separates business assets from personal assets, can ensure that owners are not personally liable for lawsuits brought by employees.
- Growth. Employees are just one source of potential liability. As a business grows and expands, it takes on new relationships with customers, vendors, lenders, and other parties. Switching from a sole proprietorship to a business structure such as an LLC or corporation offers protection for business owners against personal liability for lawsuits against the business or claims for business debts.
- Investors and financing. Attracting business investment—whether in the form of a bank loan or an investor acquiring an ownership stake—may require a more formal business structure (i.e., a corporation or LLC). These structures clearly delineate rights and responsibilities using documents such as articles of incorporation or an LLC operating agreement, so all parties involved know how the arrangement will work and what their options are. In addition, they provide a shield against personal liability for business debts and obligations.
- Lower taxation. A top reason why businesses change entity type is to improve their tax burden. For example, under certain circumstances, business owners might prefer a C corporation over an LLC taxed as a partnership if their personal tax rate is higher than the corporate rate. On the other hand, there is a risk of double taxation because the C corporation is taxed on its profits, and shareholders are taxed again if they receive dividends that they must report on their individual tax returns. An LLC taxed as a partnership or S corporation may be able to deduct a number of business expenses and can claim a qualified business income deduction of up to 20 percent of their qualified business income, making it a desirable entity choice for some. Keep in mind that an LLC can be taxed as a partnership or can elect to be treated as a C or S corporation for tax purposes by filing a form with the IRS. Choosing a C or S corporation tax election may also help business owners avoid paying self-employment taxes. It is important to consult a tax advisor to ensure that the legal entity you choose is the best one for your particular circumstances.
Typically, as small businesses grow, their operations move from simpler to more complex. Forming your home-based business as a sole proprietorship may have been adequate for the start-up days. But as you take on new owners, enter new markets, and face more risk of liability, you may benefit from forming an LLC or corporation.
Although less common, some business owners may benefit from simplifying their business structure. The fees and bookkeeping requirements of your current business structure may prompt you to scale down operations. A simpler business structure can also make sense as part of a divestiture strategy.
Switching from a corporation to an LLC may be more difficult than moving in the other direction, because it may have adverse tax consequences. There may also be jurisdiction-based restrictions on converting to a different business structure: some states do not allow all types of conversions. Unintended dissolution of the business could even result from changing structures.
How to Change Business Structures
Considering a change to your business structure? The first thing you will want to do is consult with professionals such as attorneys and accountants to fully consider the tax and legal implications.
If you decide to change your sole proprietorship to an LLC or corporation, the steps involved depend on what your current business structure is and the entity type you are changing it to. However, the following are some examples of what you may need to do:
- The first step for any new entity is to register the new business entity with the state. Paperwork filings vary depending on the business structure (LLC or corporation). Check with the relevant state agency for the requirements. Filings are usually made with the secretary of state or a subdivision, such as the division of corporations.
- In addition to filing state paperwork, the business may have to create a legal document that spells out the rights and responsibilities of the owners. LLC operating agreements and corporate bylaws may not be required but are always strongly recommended.
- A registered agent is required for a statutory entity (limited partnerships, limited liability partnerships, LLCs, and corporations).
- Corporate governance may come with additional state requirements related to officers, director qualifications, stock certificates, and annual meetings.
- Depending on your business’s needs, your business lawyer might recommend additional documents such as buy-sell agreements, nondisclosure agreements, employee handbooks, and contractor and vendor agreements.
Once you have completed these steps, there may be more work before you start operating as a new legal entity, including the following:
- If you are changing your business’s name, register your company’s new doing business as (d/b/a) name with the relevant authority, usually the secretary of state.
- Reapply for a general business license and other necessary licenses and permits.
- Obtain a new Employer Identification Number (EIN) from the Internal Revenue Service.Notify banks and insurance companies about the revised structure and update accounts and records accordingly.
- Let vendors, suppliers, customers, and employees know about the change if it affects them.
A change in legal structure indicates a fundamental shift in your business. After the filings have been made and the documents have been drafted and signed, operational changes could be on the way, for example, different recordkeeping duties.
Our small business lawyers have the expertise to help you choose the right entity, walk you through the registration process, put the proper agreements and protections in place, and give you the confidence that everything is done by the book. For legal advice and assistance, please contact us.
Emily Heaslip, When—and Why—to Consider Changing Your Business Entity, CO (Nov. 19, 2020), https://www.uschamber.com/co/start/strategy/when-to-change-business-entities.