Posted by Neha De
December 16, 2020 | 6-minute read (1146 words)
Partnerships, LLCs, DBAs, S Corps, C Corps, B Corps — the world of business structures can be a complicated place. However, understanding these legal entities is crucial if you have a side hustle. According to a Bankrate report, one in three Americans have a side hustle that brings in an extra $8,000 annually.
Most people run their side hustles as sole proprietorships, where there’s no real legal distinction between the person and their company. However, the type of business structure you choose can significantly lower your tax liability and help you protect your assets in case of a legal dispute. It also allows you to position yourself well to secure funding or transfer ownership of your company.
What is an LLC?
To safeguard themselves against business risks, many sole proprietors choose to form limited liability companies (LLCs). The LLC was first offered as a business structure option in 1977 in Wyoming. It promised the best of both worlds — the limited liability of corporations and the favorable tax treatment of partnerships.
An LLC is a business structure in the U.S. that offers the pass-through taxation of a sole proprietorship or partnership as well as the personal liability protection of a corporation. It is considered the easiest way of structuring a business in order to protect personal assets in the event the company is sued.
An LLC can have one or more members. An LLC with one owner is a single-member LLC, and an LLC with more than one owner is a multi-member LLC. An LLC could also help reduce the tax burden of an organization.
Pros and Cons of an LLC
An LLC is a hybrid business structure that combines the flexibility, simplicity and tax advantages of a sole proprietorship or partnership with the liability protection of a corporation. It comes with its own set of advantages and disadvantages for business owners. Check out these pros and cons to help you decide whether an LLC is the right structure for your company.
These are the benefits of structuring your business as an LLC:
- Limited liability: An LLC gives its members limited liability for business debts and obligations. This means that their personal assets, including their homes, bank accounts, cars and other assets and investments, are protected from creditors, as long as the business is run legally.
- Pass-through taxes: An LLC is a pass-through entity, unless established otherwise by its members. This means that the members don’t have to file a corporate tax return. They report their share of profits and losses on their individual tax returns, and avoid double taxation. And if the company loses money, the members can shoulder the hit on their returns and lower their tax burdens.
- Management flexibility: With an LLC business structure, members can opt to manage themselves, or they can assign managers who can be either outsiders or members themselves. This is useful if members don’t have the necessary experience in running a business and would prefer to hire someone who does.
Note: In several states, an LLC must be managed by a member by default, unless explicitly stated otherwise.
- Easy startup and maintenance: Although there are huge variations in LLC fees and taxes in different states, the initial fees and paperwork for setting up an LLC are relatively light. Also, the process is quite simple for entrepreneurs to handle themselves. That said, it is always a good idea to get legal help when dealing with legal matters.
- Enhanced credibility: Partners, lenders and suppliers tend to look more favorably on a company when it is set up as an LLC, as opposed to a sole proprietorship or a simple partnership.
Now consider these possible drawbacks before registering your organization as an LLC:
- Limited liability: Even though limited liability is a positive with an LLC structure, it can also be a negative. For example, in a court proceeding, a judge can rule that the LLC structure doesn’t protect the personal assets of the members. This may happen when business transactions and personal transactions have not been separated clearly, or if the business is being run fraudulently and has resulted in losses for others.
- Self-employment tax: Depending on elections made by the LLC and the number of members, the Internal Revenue Services (IRS) will consider an LLC either as a partnership, a corporation or as part of the owner’s tax return. For income tax purposes, it treats an LLC with only one member as an entity disregarded as separate from its owner. And a domestic LLC with at least two members is classified as a partnership for federal income tax purposes, unless it files Form 8832 and elects to be treated as a corporation.
If taxed as a partnership, the government views the members of the LLC to be self-employed, which means they are personally liable to pay Social Security and Medicare taxes (collectively known as self-employment tax) based on the organization’s total net earnings.
However, if the LLC files to be taxed as a corporation, all members pay Social Security and Medicare taxes only on actual compensation, and not on the company’s pre-tax profits.
- Member turnover consequences: In many states, if a member goes bankrupt, dies or leaves the company, the LLC must be dissolved, and the remaining members are accountable for all remaining financial and legal obligations necessary to terminate the company. In that case, these remaining members will have to set up a whole new LLC if they want to continue the business.
When Should You Switch Your Business Entity?
Here are five signs it may be time to change your business structure:
- You’re making a lot of money: An LLC offers many tax benefits and personal finance protections. So if you are making a significant amount of money, you’re probably losing a lot by remaining a sole proprietor.
- You have a lot of customers: While more clients mean more money, it also translates to more legal risk. Any client could one day turn into a legal liability. An LLC can help reduce your liability in the event of a lawsuit.
- You’re about to hire your first employee(s): Hiring also carries some legal risks. For instance, if there is any conflict over salaries, discrimination, healthcare coverage or some other kind of worker protection, you could end up paying huge legal fees out of your own pocket.
- You’re looking for funding: If you are looking to raise capital for your company, you will have to prove to the potential investors that you’ve structured your business properly and can manage your finances efficiently.
- You’re getting ready to exit your business: If you’ve been contemplating selling, handing over your business to your kids, retirement or even planning to start something new, you’ll need to think about your business structure to make the process as smooth as possible.