A sole proprietor who wants to transfer assets and debts to a newly-formed limited liability company, or LLC, can ordinarily do so, but only under certain circumstances. The transactions will be governed by the state law that authorized the formation of the LLC and any agreements between owners restricting capital contributions or withdrawals that change ownership interests. If you are converting a sole proprietor business into a single-owner LLC, you have a lot of leeway to determine how you capitalize your interest in the new company, but you must account for asset transfers properly for state and federal income tax purposes.
Types of Entities
A sole proprietorship and an LLC are two different types of business entities. A sole proprietorship is merely an alter ego of an individual, so business income and expenses are recorded on the individual's personal income tax return. Debts and assets that are accumulated by the sole proprietor in the course of operations are his personal responsibility, even if he uses a trade name to run the proprietorship. Conversely, an LLC is an independent legal entity that operates like a separate individual. Debts and assets that are in the LLC's name belong to the entity.
Since the sole proprietor owns the assets of his business in his own name, he can choose to transfer those assets to a startup LLC. He has the option to treat the transfer as an equity contribution that establishes his ownership interest in the company or as a sale or a lease. If he treats the transfer as a sale or a lease, he must establish the amount of money the LLC will pay him for the transfer. The owner can defer payment by the LLC until the company has sufficient cash flow and can even charge the LLC interest for this convenience.
An LLC cannot as easily assume the debt as the assets of a sole proprietorship. Debt that was acquired during the operation of the sole proprietorship is really the personal debt of the owner. If he fails to pay, the creditor can come after the owner's personal belongings, such as his house. Debt that an LLC owns belongs to the company as an independent legal entity. The owners of the LLC are not personally liable for company debt, in most instances. Most creditors will not allow a sole proprietor to transfer the debt into the name of the LLC because it limits their ability to collect on the debt to just what the LLC owns. Alternatively, you can ask the creditor to add the company to the debt agreement as an additional responsible party or co-signer. In this way, the company can pay the debt, but if it fails to pay, the creditor can still proceed against the owner of the sole proprietorship personally.
Transfers of assets and debts into an LLC impacts the owner's ownership interest in the company. Asset transfers that are treated as equity contributions increase the percentage of the owner's interest in the company. Outside debt that belongs to the owner personally can be paid by the LLC as a loan from the company to the owner to be recouped from future profits or paid back by the owner with or without interest. These transfers are recorded in the owner's capital account, which keeps a running tally of the owner's equity in the company and any money he has to pay back.
Transferring assets and debts from a sole proprietorship to an LLC can have significant tax consequences. In effect, the sole proprietor is disposing of personal assets and must record a gain or a loss on his personal income tax return. Likewise, the assumption of debt by the LLC can be considered income to the owner. It is important to check the tax consequences of transfers before completing the transactions.
- Internal Revenue Service: Sole Proprietorships
- Insperity Presents; Capitalizing Your Company; Jim Blasingame; April 2003
- Citizen Media Law Project: Limited Liability Company
- University of Pennsylvania Law School: Uniform Limited Liability Company Act (1996)
- Internal Revenue Service: Do You Need a New EIN?