Going It Alone - Part 4: Structuring Your Business
Note: This is the fourth in a six part series about business essentials that artists and crafters who run a business need to know. The series, “Going it Alone,” runs every two weeks. The first installment dealt with motivation, the second discussed taxes and record keeping, and the third dealt with accounting and finances.
There are many questions you have to ask yourself before you decide to “Go It Alone.” Some of these questions deal with finances (How much should you charge for the painting you created or the craft you made?), some deal with how to advertise or market your services (Should you attend art and craft fairs?), and some may deal with how to run your new venture (What hours will you work or will you sell your products online?)
One question that you will want to answer is how you are going to structure your new business. In the application to sign up for Artists, Crafters, and Tradesman (ACT) liability insurance, one of the questions asks what your business type is. The options include a Sole Proprietorship/Individual, a Corporation, an LLC (Limited Liability Company), or a joint venture or partnership. There are advantages and disadvantages to each, and that is what we are going to highlight in this fourth installment of ACT’s “Going It Alone” series.
This is the simplest form of a business structure. With a sole proprietorship, you are considered the business. One thing you need to be aware of is that if you have not taken the steps to create a separate business organization (an LLC or a corporation, for example), then you are automatically considered a sole proprietor.
This also means that the majority (more than two-thirds) of American businesses are sole proprietorships, with about 99 percent of them earning less than $1 million per year. Sole proprietors can own and manage any type of business—including creating art from home or selling your crafts at a retail establishment.
- You Get the Money: One of the advantages of operating a sole proprietorship is that you as the proprietor receive all of the profits (because you assume all the risk—see the disadvantages.
- It’s Simple to Set Up: Another advantage is that setting up this type of business structure is usually very simple, as few legal forms are involved and the cost to set up a sole proprietorship is minimal—if there is a cost at all. Setting up a sole proprietorship differs from state to state—and even city to city—so you will want to check the laws in your area. These laws usually involve things like zoning requirements, obtaining appropriate licenses, etc.
- Flexibility: Another benefit is that there is a lot more flexibility for you if you operate your business as an individual. You get to make the decisions—how much to charge, when to go on a vacation, etc.—and be the boss. In addition, you only pay personal income taxes on the profits you make, which is recorded on your personal income tax return.
- You Take All the Risk: The biggest disadvantage of operating a sole proprietorship is that you, as the sole owner of the business, bear all the risk and burden of any losses or liabilities that the business (you) incur. In other words, you have unlimited liability for all debts the business has. Debtors can not only go after the business assets you have (supplies, equipment, etc.) but they can also go after your car, your house, and any other asset you own, whether you use the asset for your business or not. This unlimited liability is a major factor to be considered when you decide which business structure to choose from.
- Raising Money Can Be Difficult: Another disadvantage is that it can be tough to raise money for your business. Many times banks or other financial institutions will want to see that the business has a history of making money before they give you a loan. If you are just starting out as a sole proprietorship and don’t have that history, you may be limited to using your own funds or asking family or friends for a loan to start, run, or continue your business.
Another way to set up your business is to form a corporation. Setting up a corporation is much, much more difficult to start than a sole proprietorship and the rules governing a corporation are, as you can imagine, also much, much more complicated.
A corporation is a separate legal entity from the owner. Under federal and most state laws, a corporation is a “person” and enjoys many of the same rights and privileges that U.S. citizens enjoy, including most rights guaranteed by the Bill of Rights of the Constitution.
Because the rules of forming a corporation are so complicated, you should seek the services of an attorney or some other expert to help you form correctly.
Going through all the ins-and-outs of setting up a corporation could become a series of blog posts on its own, so this blog post will just bring up a few highlights of the advantages and disadvantages of creating a corporation.
- Limited Personal Liability: Because the corporation is considered a separate legal entity, you as the owner (shareholder) will not be held responsible for the corporation’s debts. To have this advantage, however, there are many rules you must follow to keep this status. Failure to follow the rules could take this advantage away.
- Corporate Tax Treatment: Once again, as a legal entity, the corporation pays taxes separate from the owner. Because you will likely be an employee of the corporation, any salary or other reimbursement you are given are taxed just like most other people. As you probably guessed, there are rules to follow to keep this status.
- Raising Money: It is a lot easier to raise money as a corporation than it is as a sole proprietor. Often times financial institutions are much more willing to offer loans and other resources to you as the owner of the corporation.
- Fees and Costs: Setting up a corporation costs a lot of money, sometimes more than $10,000. If you hire an attorney to help you, the cost can be even higher. However, if you don’t pay an attorney to help and problems arise, for any reason, you could end up paying huge fines and fees and then attorney costs anyway to help settle or fix the problem. The fees and costs differ from state to state, but just know that if you are going to set up a corporation, you are going to be paying a lot of money to do it.
- Rules, Rules, Rules: There are many rules and laws that apply to corporations that you must follow, both in setting up a corporation and also keeping the status afterward. You must file paperwork, hold the required meetings, and follow the tax codes that go along with corporations. Failure to adhere to any of these rules or laws could mean forfeit of the advantages that come from a corporation.
- It’s Not Your Money: Any money you earn is not technically yours—it’s the corporations (remember it is considered a “person”). Unlike a sole proprietorship, you cannot just take any profits you make and put them in your bank account. That’s called embezzlement, and you could go to jail. To get additional money above your salary, you will have to go to the board of directors and get their permission, document the reason, and file additional financial statements. (And yes, you do have to organize a board of directors, even if your business is mainly just selling your crafts at a local event or only selling your paintings online. There’s a whole new bunch of laws that go with the board of directors as well.)
Limited Liability Company (LLC)
An LLC is a relatively new form of business organization. They are governed by state laws and statutes, which means they often differ depending on where you live. Just like with the other business organizations, there are advantages and disadvantages to forming an LLC.
- You and the Business Are Separate: One of the biggest advantages of an LLC is that, like with corporations, your business is considered a separate entity, so the money you are liable for if you are sued is limited to the amount of your original investment.
- You Can Choose How to Be Taxed: Another advantage is that, in some cases, you can choose how to be taxed. And while there is a lot of paperwork to fill out and rules to follow, they are not nearly as cumbersome as those of a corporation. You also have options when it comes to managing your business.
- Moving Your Business Is Difficult: A major disadvantage to forming an LLC is the fact that you probably cannot move your LLC from one state to another without having to reorganize and/or pay more fees. If you do plan to move from one state to another, you will want to check the rules and laws of the state where you are moving.
- Less Legal Precedence: Another disadvantage that may or may not come up with you, is that there are relatively few (at least compared to corporations) law cases that have been brought before judges when it comes to LLCs. This sounds good, but what it means is that there are not as many precedents and ways that courts have interpreted statutes when it comes to LLCs. So, if your LLC is taken to court, it might mean you are disadvantaged when it comes to your court case.
It should also be noted that in general, when an issue is not covered by an operating agreement or LLC statute, the principles of partnership law are usually applied. This blog post will only cover a few of the many different laws, advantages, and disadvantages that come with forming a partnership. You might want to learn a little more about this form of business before you set up an LLC.
Partnership or Joint Venture
Partnerships are formed when two or more people agree to do business as … wait for it … partners. Each of the partners in the venture has rights, duties, and obligations that come from doing business together. A joint venture is similar to a partnership, except that it only lasts for limited activity or a single transaction. As with all the other business forms, there are advantages and disadvantages to forming a partnership or joint venture that you need to be aware of.
- Someone to Help: One of the biggest advantages to forming a partnership is that, at least in this instance, you don’t necessarily have to “go it alone.” You have a partner—or partners—you can rely on (hopefully—see disadvantages) to help you run the business.
- Flexibility to Operate Business: With a partnership, you have flexibility to run the business. However, this flexibility is between at least two people, which means that everyone must agree on how things are run. So, while there is flexibility, it does not give you as much freedom as a sole proprietorship.
- Profits and Losses Are Distributed Equally: In most cases, though this rule is not always the case, partners distribute profits and losses equally. While you do have to share the profits (which can seem like a disadvantage), you also split the losses in case things don’t go as planned.
You (and Your Partners) Are the Business: Similar to sole proprietorships, a partnership means that you and those you have gone into business with are the business. This means that all your assets—including your house and car—are up for grabs in a liability claim.
There’s even more of a disadvantage than a sole proprietorship with a partnership because you can be held liable for any debts your partner has as well. So, say your partner goes into massive debt—even if it is without your knowledge—and can’t pay the bills, you are also responsible for paying off the liabilities, and that liability is unlimited. Be very careful who you form a partnership with.
- You Don’t Get All the Say: Because it is a partnership, you don’t get to always run the business exactly the way you would like. Both partners must agree (unless there is another arrangement spelled out in the contract) on everything that has to do with the business.
No matter which business organization you choose, it is a good idea to become familiar with the rules and laws that apply to the form you want to choose. This blog post is only intended as a basic beginning to what you need to know, so you should definitely do more research, and possibly hire an attorney, to help you know which business structure is best for your circumstances.