When To Set Up a Corporation or Other Business Entity
The Sole-Proprietorship
Until the artist sets up a formal entity, he or she is by default a sole-proprietor, which is how most artists operate. The sole-proprietor simply means one owner (even though a husband-wife team can file as joint proprietors). If you do nothing else, you will be automatically set up as a sole proprietorship. The main feature of this form is that it is identified with and intertwined with you. If the business makes a profit, it automatically is income for you. If the business incurs a debt, it is your personal debt as well. If the business gets sued, you will be sued personally as well. This is both the strength and weakness of the sole proprietorship. You have complete flexibility, and can instantly shift the direction, policies and focus of your company. Yet, if there is a problem, the potential for the damage extending throughout your personal life is ever present.
The Partnership
When I talk to clients I often describe the partnership as a multi-person sole-proprietorship because the two entities are taxed in a very similar manner. Unlike the sole-proprietorship, which files its taxes as part of the owners' 1040, the partnership files its own separate income tax return (the Federal form 1065) where it reports the total income and expenses of the business. The partnership then passes the net, "bottom line" income or losses directly to the partner's personal income tax return via the Federal form K-1. This means that the partnership almost never pays any income tax directly, but passes the income or loss directly to the partners to be dealt with on their personal returns. This is the reason partnerships are often referred to as "flow-through" entities, i.e. the income or loss "flows through" the partnership onto the partner's personal income tax return. The partnership also has the unique and critical advantage of what is called "special allocations." Simply put, special allocations allow the partnership to customize the distribution of income and loss through the use of the partnership agreement. Partnerships can also, if properly structured, have tax advantages relating to film and sound recording activities.
The partnership can be easily formed on a handshake but is rarely that easy to dissolve, so be very careful when forming a partnership. It can be a little like being married without being in love! You will get to know all the bad things there are to know about your partner. It can destroy friendships, and most importantly, you are completely and personally liable for whatever your partner does (we are speaking here of the common general partnership; the exception to this is the limited partnership in which a limited partner has some limited liability). For instance, if your partner commissions a dozen paintings, and then skips town with all the money in your account, not only will you be out the money, but also you will be liable for paying for the paintings when they arrive. Partnerships can certainly work, when there is a clear division of responsibilities and abilities. If you are an actor, musician, visual artist, or writer, but you lack management or promotional skills and your paperwork is usually a shambles, and your potential partner is a good agent, meticulous and detail oriented, but does not have your artistic abilities, the two of you may be natural match.
Another benefit of the partnership is to raise more capital. Your partner's contribution may be what you need to launch your business venture or project. You may have noticed that many major films are produced within the limited partnership (and its newest relation, the LLC) form of entity. That is because the partnership is a natural way to split the profits from a specific project like a movie, book or other artistic endeavor. When the project is completed the partnership will typically dissolve.
If you do contemplate a partnership have a clearly defined partnership agreement drawn up by an attorney. The agreement should address operation issues and specify what happens if one of the partners decides to quit. What if one of the partners dies? Who will do what jobs within the operation of the partnership? How will decisions be made? What happens if you can't agree? Who will pay for what? These things all should be settled beforehand, before they have a chance to cause disruption in the business. Nothing kills a business faster than feuding partners.
The Corporation
The third form of business is the corporation. It is NOT a magic bullet, like some seminar promoters would have you believe. There are two main advantages to incorporating.
- You can have people invest in your company and raise money.
- Because the corporation exists legally as a separate entity, there is a liability shield between you and your personal assets and the business. If the company gets sued, you have some (not ironclad) protection. Company debts are separate from your own financial situation.
For tax purposes there are two main types of corporations, the subchapter "C" and subchapter "S" (They refer to subchapters of the tax code). The "C" Corporation is your "standard" corporation. All the companies listed on the stock exchange are "C" corporations. You can have unlimited shareholders (investors). If you sell 100,000 shares at $10 each, you've got a million dollars in capital to work with. The investors can be people, mutual funds, companies, and foreigners, etc. The disadvantage to the "C" Corporation is that of double taxation. If your business earns $100,000, the first thing that happens is that a corporate tax is paid. Then if you want to draw a salary (for in a corporation you are in fact an employee), you must declare that salary and pay personal income tax. The same money gets taxed twice before you get to spend any of it. Recognizing the unfairness of this to the small business, the "S" Corporation was formed.
The "S" type corporation is a "flow-through" entity much as a partnership. "S" Corporation income or loss is simply reported on the personal income tax returns of the shareholders, just as income from a proprietorship or partnership would be. The standard "C" Corporation files a federal form 1120 annually; the "S" Corporation files the Federal form 1120S annually.
The Limited Liability Company
The newest form of business entity is the LLC, or Limited Liability Company. If you are considering setting up your business as a partnership, look long and hard at the LLC; it is generally a preferable form over the standard partnership. The LLC combines many of the features of a partnership with those of an "S" type Corporation, but lacks many of the restrictions that apply to "S" Corporations. It allows the reporting of income or loss directly on the personal income tax returns of the "partners," (or "members" in the case of an LLC) but with some of the liability protection of a corporation. The LLC is a "flow-through" entity that files the same Federal income tax forms as a partnership, form 1065. The LLC also allows for the use of the "special allocations" we discussed in the section on partnerships. Like a standard partnership, in most states, you do need two individuals to set up an LLC though all states now allow the "single-person" LLC. The single person LLC is taxed as a sole-proprietorship.
When and Which Entity Would the Artist Set Up?
In essence you have three choices of entity, the sole-proprietorship, partnership/LLC and corporation. The artist's first decision is whether he or she even needs to set up a separate business entity. The second question is what type of entity to create. The discussions on this matter should involve both an attorney and a tax professional. I would generally advise the artist to never set up a business entity without obtaining separate legal and financial/tax advice. Your attorney will be able to explain to you the legal benefits of setting up a business entity as well as actually creating the entity in the legal sense. Your accountant and tax advisor will be able to clarify what new expenses, responsibilities and functions will be entailed in your new business entity. Often times the attorney and tax professional will need to confer with each other on behalf of their client due to the interrelationships of the legal and financial matters.
I generally think the choice of when and which business entity to set up is a situational matter. In other words the artist has an issue or problem that can only be solved by setting up a separate business entity. If there is no clear need or reason to set up an entity, don't consider it. Separate business entities are costly to set up and maintain and should not be done unless it is serving a clear and identifiable purpose. Furthermore the business entity tends to complicate the operation of your business. Accounting and tax filings are increased as well as the associated fees. The artist, with the help of an attorney and accountant needs to do a careful cost-benefit analysis in order to decide if setting up the business entity is worth doing. For example if personal liability is the issue the artist may find that insurance is a more cost effective solution. Often when an artist desires to bring someone into the business, they would be better served by simply hiring an employee.
So what are some of the situations or needs that might lead the artist to set up a separate business entity?
- Need for the liability protection provided by a corporation or LLC
- Need for more than one owner in the business
- Need to isolate some specific business venture or project like a film, book, musical or other artistic venture
- Separation of ownership and control of business operations
- Desire to shift income to other family members, associates or friends thereby taking advantage of other family members to lower income tax rates
- Need to raise capital for a specific venture or project by bringing in investors
- IRS audit concerns: sole-proprietorships have been for many years and will probably continue to be #1 on the IRS audit hit parade; other formal business entities are less likely to be audit targets
- Tax savings available in particular entities; for example the potential payroll tax savings available in "S" type corporations
- Working in a multi-state environment - corporations are probably the most portable and practical entity for artists working across state lines
In Closing
Keep in mind that very few artists at the beginning of their career would have any need to set up a formal business structure. In fact, many successful artists never set up any formal business entity. In any case, it would rarely be cost effective at the early stage in his or her career, and more importantly the direction and scope of the artist's ultimate activity would not be developed enough to make effective decisions regarding business structures.
© Copyright 2001-2007
Riley & Associates, P.C.
Written by Peter Jason Riley, CPA and reprinted from www.artstaxinfo.com
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