What is an LLC, and when do you need one for your side hustle?
Business legal entities are necessary to understand if you have a side hustle. Let us break them down for you.
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LLCs, partnerships, S corps, C corps, B corps, DBAs—the world of business structures is a vast and wondrous place. It’s like Willy Wonka’s chocolate factory but with rolling hills of paperwork, rivers of ink, and attorneys instead of Oompa-Loompas.
No, not really. The topic of business legal entities is about as dull as it gets, which is why so many entrepreneurs, freelancers, and side hustlers don’t think about it. Or so I thought, until I worked alongside CPAs and CFOs at inDinero and found out how exciting business structures can be—that is, if you like saving as much money as possible.
But for most entrepreneurs or even startup founders, an entity isn’t something they pay much attention to until they have no choice but to think about it. A massive tax bill, a lawsuit from a disgruntled customer, or an inaccessible bank loan can make business structures suddenly very interesting.
Don’t wait until your livelihood or financial future is in jeopardy. Here’s what you need to know about the different business entities out there, along with why and when to switch from a sole proprietor and incorporate your company.
Why do business entities matter?
An “inc.” or “LLC” does more than make your business look official. The type of business structure you choose can significantly lower your tax liability and help you protect your assets in the event of a legal dispute or creditor’s claim.
Plus, by changing from a sole proprietorship to another kind of business entity, you position yourself well to secure funding and transfer ownership of your company when you’re ready to move on.
What is a Sole Proprietorship?
If you recently started your business or have been operating for a while on your own without thinking much about your organizational structure, you’re almost certainly a sole proprietor. That means there’s no real legal distinction between you and your company; you are your business. Countless freelancers, self-employed people, and gig workers are sole proprietors.
You can choose to remain a sole proprietor—there’s no penalty you’ll pay, so to speak—but you may be missing out on serious tax savings and investment opportunities. You also might be putting your personal finances at risk. If someone sues your business, they’d be suing you. Your money and property—your car, your house—would be on the line. Make no mistake: sole proprietorships are risky endeavors.
What is an LLC?
To insulate themselves against their business risks, many sole proprietors choose to form limited liability companies, otherwise known as LLCs. An LLC is what it sounds like—it limits your liability when someone comes after your business. It separates your personal finances from your business finances.
An LLC could also help you reduce your tax bill. The mechanics of how this works are beyond the scope of this blog post (and better left to an accountant, lawyer, or tax professional), but essentially you can avoid paying a portion of your self-employment taxes—the 15.3% of your income that covers Social Security and Medicare. If you make five or six figures or more, we could be talking about thousands of dollars saved per year.
Other than that, you can more or less run your business however you’d like. There’s some basic documentation you’ll have to fill out and some low payments (ranging from $0 to several hundred dollars, depending on your state) you’ll need to make every year, but your company will remain largely unchanged, making this an easy choice for many.
Other Business Entity Options: S Corps, C Corps, and More
LLCs may be an attractive option for small business owners and entrepreneurs, but you do have alternatives, each with different pros and cons.
S corporations are a step (okay, several steps) above LLCs. You may be able to save even more on taxes, but how and when you file those taxes will be different. You’ll also need to abide by specific rules governing company management and financial reporting. Consider this option if you’re serious about turning your side hustle or freelance career into a real, scalable company with employees, shareholders, bylaws, a board of directors, and so forth.
C corporations are less restrictive than S corps but generally reserved for bigger companies. Again, exploring the various particulars would be beyond the scope of this article, but you should know two things:
- C corps are subject to complex taxes (owners are “double-taxed,” which is about as fun as it sounds).
- C corps can have any number of shareholders. This is perhaps the most administratively robust route—the best option for a company seeking big investors or aiming to go public.
B Corporations are a newer kind of business structure, but they’re rapidly gaining in popularity. When you own a B Corp, you hold yourself and your company accountable to the greater good. You have an obligation to engage in sustainable and socially responsible practices. This may sound like extra work—and it is—but it makes your company more attractive to customers and investors. Oh, and it makes the world a better place. So there’s that.
(Note that B corps and other structures aren’t an either/or. Your business can be both an S corp and B corp, for instance. It’s an add-on certification overseen by an independent organization—B Lab—rather than by the government.)
A DBA (which stands for “doing business as”) isn’t a separate legal entity, but a “fictitious” name a company uses to refer to itself. It’s an alias. An LLC or corporation can register a DBA if the company wants to do business under something other than the name on its official paperwork. There are marketing and business differentiation purposes for this. If I wanted to highlight my writing, for example, I could register a DBA: Hollis Copywriting. Or, if there was another Melissa Hollis who was well-known in the market, I could register a name like Melissa’s Kickass Words & Co.
If you currently own your company with one or more other people, your business is probably a partnership. Partnerships are similar to sole proprietorships in terms of tax savings and asset protection, in that they don’t offer much of either. Members of a partnership can convert the company to an LLC or other business entity to secure the benefits offered by those structures.
8 signs it’s time to switch your business entity
Okay, that’s a lot of information about an extremely dry subject matter. The more exciting part of this topic is the strategic component: When should you convert to a new business entity? When will you benefit most from switching?
Here are a few signs it’s time to reconsider your business structure:
1. You’re making a ton of money.
The more money you make, the more you’re potentially losing by remaining a sole proprietor. There are major tax benefits and personal finance protections you’ll gain by switching to an LLC.
If you already run an LLC and you’ve been raking it in recently, it may be time to move on to S corp or even C corp status. Both entities necessitate certain accounting and financial reporting procedures that, while complicated, pay off significantly in the long run. Add B Corp certification into the mix and you’re well on your way to becoming the next Patagonia.
2. You have a lot of customers or clients.
More business means more money but it also means more legal risk. Not to scare you, but every client or customer you take on could one day turn into a legal adversary. Reduce your liability (read: protect your stuff) in the event of a lawsuit by incorporating.
3. You’re thinking about hiring your first employee(s).
Hiring also brings legal risks. You can technically hire an employee when you’re a sole proprietor, but I’ll go out on a limb and say it’s probably a terrible idea. If there’s a conflict over wages, healthcare coverage, discrimination, firing, or another kind of worker protection, you could end up paying hefty legal fees out of pocket.
4. You’re looking for investors or funding.
Want capital for your business? You’re going to need to show that that business is a business—that you’ve taken the time to structure it and manage your finances properly.
Many investors prefer backing C corps (and to a lesser extent, S corps) over LLCs and sole proprietorships. Keep in mind that corporate structures benefit their tax situations as well.
5. You’re getting ready to retire, sell, or otherwise exit the business.
You can’t transfer ownership of yourself. But you can sell your LLC or corporation—or give it to your kids, your grandkids, or your friend Bill. If you’ve been contemplating retirement or your next venture, you’ll need to think about your business structure.
The type of entity especially matters when structuring a merger or acquisition. For tax reasons, many business buyers want to purchase C corps and S corps rather than LLCs.
6. You just paid your taxes.
Speaking of taxes, yours are likely quite high if you’re a successful sole proprietor. If you just filed your annual return or are feeling the sting of quarterly estimated taxes, take it as a sign: maybe right now is a good time to switch to an LLC or another business entity.
7. You’re moving to a new state.
This is another opportune moment to examine your company’s business entity. If you’ve been thinking about switching to an LLC or corporation, it may be a good idea to wait until you relocate, so you can incorporate the business in your new state. You could save money and see additional benefits given that some states (hello, Delaware!) are considered better for incorporation than others.
That said, you can always incorporate your business out-of-state (sup again, Delaware?) to take advantage of different local laws, but it’s costlier and more complex (Double taxation! Who invited you to the group chat?) than many people realize.
8. It’s a new year.
The end of the year is an ideal time to sit back with a glass of nog and think about business entities. After all, you’ll have plenty of time to reflect after everyone walked out of your cocktail party. Moreover, it’s neater and most cost-effective to switch between years rather than in the middle of one.
Or hey, maybe you like things like super-complicated taxes. You did just read a blog post all about the differences between business entities.
Have any tips you’d like to share about structuring a business? Recipes for cocktails strong enough to make conversation about this kind of thing bearable? Share ‘em with us in the comments below.