When you start generating regular revenue from your creative work or services, you are likely to ask yourself, “Should I start a business?” The reality is that you started your business when you made your first sale. The next step is to be intentional about the form your business takes. You need to control the business you start, not let it control you. This post examines the business structures available for starting a creative business, or any business.
You probably recognize the five “W” questions in the title of this post: who, what, where, when, and why – plus the “H” question — how. The answers to the 5W’s and the H are a journalist's key to a complete news story. My father was a newspaper editor, I learned these essential questions at a young age. The 5W’s and H are also useful to ask when considering how to structure your business. They help you gather the information you need to answer the overarching question, “Should I start a business?”
Here are quick links to the sections of this post so you can jump right to my answer for your biggest question:
Who Should Start a Business?
A solopreneur is someone who runs their business alone. You have the freedom and flexibility to choose your work, your schedule, and your customers. You also have the freedom and flexibility to choose whether you want to formalize your business structure. As a solopreneur, you can use the simplest business structure available — a sole proprietorship. A solopreneur can successfully operate for years as a sole proprietorship. You can also choose a more complex business structure if it makes sense for your situation.
If two or more entrepreneurs are working together, they need to explore more sophisticated business structures that define ownership, revenue splits, plan for growth, and minimize individual risk. All business relationships need to be based in trust, but they should also be in writing. When two or more individuals start a business there needs to be a structure that accounts for the responsibilities of each and sets out the limitations of all.
What is the Best Structure for a New Business?
There is more than one way to start a business. In fact, there is a whole spectrum of choices. The business structure that works for you could fall anywhere along the spectrum from a simple and easy to implement solution all the way up to a more sophisticated and complex solution or anywhere in between.
The simplest form of business entity is a sole proprietorship. In many states, you can choose a business name and use it without going through any legal formalities. You buy a domain, set up a website and you’re in business. In fact, the availability of domain names often determines the name of your business.
These days it doesn’t take much to set up an online business and start accepting payments for the sale of your work or services. The basic online services needed to run a business generally don’t require a formal business entity. Amazon and PayPal only require a tax ID number and bank account, for instance. The tax ID number can be your Social Security number. The bank may require you to have what is known as a DBA registration. DBA stands for “doing business as.” DBA registrations can be obtained from your state’s corporate registration or charter office. The purpose of a state DBA registration is to create a public record of the operating entity behind your new business.
single member limited liability company
Limited liability companies, or LLCs, are recognized in all 50 states. A single member LLC means that you’re in business alone, you are the only member of the company.
An LLC is what is known as a pass-through, or disregarded, entity. That means that the profits and losses pass straight through to your tax return. Any income that passes through to you is taxed at your personal income tax rate, plus you pay self-employment taxes on that income up to a certain level. If you handle the taxation issue this way, you won’t be required to file a separate tax return for your LLC.
You do have the option to elect to have your single member LLC taxed as a corporation. This requires a separate tax filing. It will be interesting to see how the new tax law changes the calculation for this decision.
multiple member limited liability company
A multiple member LLC means you are in business with other individuals or business entities, like other LLCs. If you are in business with someone else you should always have a written agreement that controls everyone’s obligations and expectations.
The written agreement for a multi-member LLC is called an Operating Agreement. An Operating Agreement sets out the deal between the members of the company – who makes the decisions, how the decisions are made, whether you can sell your stake in the company, how a company dissolution is handled, and many other issues. Think of the Operating Agreement as a pre-nup in a marriage – it’s best to sign one while everybody still likes each other. It’s easier to reach an agreement that way.
When you choose to start a business at this level of complexity, you start to incur attorney’s fees. You will also incur accountant’s fees at tax time because a K-1 must be prepared for each member of the company to report the pass through profits or losses on their own tax return.
In a multi-member LLC, you have business partners, limited liability, pass-through income, and possibly employees. Once you start paying professional fees, you know you have achieved a certain level of business sophistication.
In an S-Corp, or an S-Corporation, instead of being a member of an LLC, you are a shareholder of a corporation. An S-election is then made with the IRS. Like LLCs, S-Corps are pass-through tax entities so there is no double taxation.
If you are going into business with other shareholders, the document that controls the decision making in the corporation is called a Shareholders (or Stockholders) Agreement. This is a critical document that is often intensely negotiated between founding shareholders.
Where Should I Start a Business?
These are the variables to consider when choosing where to start a business: overall convenience; filing fees which can vary greatly from state to state; annual fees and filings, also great differences; whether franchise taxes are imposed; the ability to maintain your privacy in state filings; a state's corporate income tax structure; and whether a business license is required.
Most states do not require a general business license. Depending on the type of business you want to run, some states do require a business to be licensed. For instance, professionals like lawyers need to be licensed. Operating a retail store may require a sales tax license. But selling art, setting up a publishing company, or working as a freelance writer or editor can usually be done without a business license. Here's a state-by-state guide to obtaining a business license.
A sole proprietor will necessarily start their business in their home state, the one in which they file taxes as a resident. Creating your LLC or S-corp in your home state is generally more convenient for small business owners but the fees can add up in some states like California and New York.
Delaware has always been a popular state for setting up an LLC or a corporation. It has corporate friendly courts, provides mechanisms for maintaining the privacy of members and shareholders, and has beneficial tax laws. For larger companies, Delaware makes a lot of sense. Investors like working with companies based in Delaware. If you set your company up in Delaware, you will have to register in your home state as a foreign corporation. You will also have to hire a service to act as a registered agent on your behalf in Delaware.
Nevada has many of the same benefits as Delaware when it comes to starting a business. They've been working hard to cast their state as business-friendly to steal some of the volume from Delaware.
When is the Best Time to Start a Business?
Making the investment of time and money to set up a business entity depends on whether you're in business alone or with partners. If you're setting up with partners, put the ownership, investments of money and time, and revenue sharing in writing at the start.
A sole proprietorship starts when you begin keeping track of revenues and expenses in order to file a Schedule C with your taxes. When your business gets to the point where you are hiring employees, buying or leasing capital equipment, or entering complex contracts, you need to consider moving from sole proprietor status to an LLC or S-corp.
How Do I Start a Business?
Having the proper paper work for the business structure you choose is how you start a business. Do it right from the beginning, it makes the anniversaries happy times.
You start a sole proprietorship by telling the IRS about it. Once you start earning income from your company, the IRS requires you to report it. Income from a sole proprietorship is reported on your individual 1040 using a Schedule C. Schedule C reflects business expenses in addition to income so you are only taxed on your net earnings. Schedule Cs are attached to your tax return. You can file as many Schedule Cs as you need – one for each sole proprietorship, if you operate more than one.
[Note: Operating a sole proprietorship and using a Schedule C allows you to deduct business expenses. If your expenses exceed your revenue, your business will show a loss. If you show a loss on your Schedule C for too many years in a row, the IRS may decide that you are not really in business and are just hobbyist. If that happens, all those deducted expenses for past years will be added back into your income and may become taxable. You should aim to get to profitability as soon as possible.]
Sole Proprietor with an EIN
If you want to add a level of protection to your social security number, you can use an EIN with your sole proprietorship. An EIN is an employer’s identification number. It is assigned by the IRS after completing a short online application. You need an EIN when you begin to hire employees or operate a retirement plan. Until that time, you can start a business and manage your sole proprietorship reporting to the IRS with your own social security number on a Schedule C.
Some banks may require you to have an EIN to set up an account in the name of your sole proprietorship. It’s not unreasonable for a bank to require some kind of government documentation before they allow you to begin depositing checks that are not in your name. I prefer the state DBA registration option over an IRS employer identification number because I like to keep my relationship with the IRS as simple as possible for as long as possible.
The two arguments in favor of getting an EIN at the sole proprietor stage are: (1) it provides an additional layer of protection for your social security number against identity theft; and (2) it clarifies your independent contractor status if you are working as a freelancer. The argument against getting an EIN at this stage is that it adds a layer of complication to your taxes. Entities with EIN’s must file a separate federal income tax return.
limited liability company
A limited liability company is created by filing Articles of Organization with your state’s corporate registration or charter office. The requirements and filing fees are different in each state.
An S-corp is created when one or more shareholders files Articles of Incorporation with the state, then files a Form 2553 with the IRS. This turns your corporation into a pass through entity for tax purposes. You get the benefit of limited liability with the tax rate of the individual shareholders. It is only available for domestic (U.S.) companies with no more than 100 shareholders.
An S-corp issues stock and is governed with directors, officers, and shareholders.
Why Should I Start a Business?
There are personal reasons for starting a business -- you want the freedom to be your own boss, you have a passion you want to share with the world, you see an opportunity and want to take it, you have experience in your field, you want to build a legacy. I leave those soul-centered reasons to you.
There are practical reasons for choosing a particular structure for operating your business. Here's a summary of the important reasons for choosing a particular form of business.
A sole proprietorship is the simplest form of business entity. It's easy. There's nothing to set up, you just start selling. There's no real need for professional legal or accounting services to get started. As a solopreneur, you can operate as a sole proprietor with minimal risk because you are in control of the decision-making. There's no one else in the mix who might make a bad decision on your behalf.
From a liability perspective, as a sole proprietor you are personally liable for all the contracts you enter and any intentional or negligent actions done in the name of your business. You have no protection from lawsuits by third parties. But depending on what your business sells or does, limited liability may not matter to you.
There are tax benefits to a sole proprietorship. You can deduct travel, phone bills, and home office expenses, for instance. Be sure to keep track of revenue and expenses for the Schedule C that gets filed with your taxes in order to take advantage of the tax benefits.
A sole proprietorship is a nimble business structure. You can use it to validate new product or services ideas. If they are successful, you can choose to evolve to a more formal business structure later. If your new concept doesn't pan out, there's no great loss because there were no great start-up costs.
limited liability company
The risks involved when working with others increase exponentially. You’re not the only one who impacts the performance of the business. There are individuals other than you who have decision-making power with respect to the business.
A limited liability company protects your personal assets from the company's creditors unless you have signed a personal guarantee. If the company gets sued and loses, your personal assets are protected. There are some exceptions in which a creditor might "pierce the corporate veil" and get to your personal assets, but those are rare circumstances.
Business Practice Tip
There are limits to limited liability. Neither an LLC nor a S-corp structure will protect you personally from allegations of copyright infringement, violating someone's right of publicity, or invasion of privacy. If you write a book or create a piece of art and one of these claims is made, you are likely to be sued individually as the creator/writer. Assigning the copyright in the piece to your company will not prevent this.
An S-corp can protect your personal assets much like an LLC (and with the same limitations). It is flexible when it comes to increasing a owner/employee's income from the business. As a shareholder, you can set a reasonable, but smaller, salary for yourself with regular payroll deductions and pay income tax on that salary. The rest of the profit can be taken as a distribution subject to income tax only. Self-employment taxes do not need to be paid on those distributions.
If you're looking for the best structure for your new business and have a question that wasn't answered in this post, drop it in the comments.
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