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| WHEN TO SET UP A CORPORATION OR OTHER BUSINESS ENTITY By Peter Jason
Riley, CPA I think of this as the "should I incorporate?" discussion because that invariably seems to be the opening volley on this topic. The artist will generally have talked to a colleague or family member who has told them they must incorporate immediately for whatever purpose, most frequently for the extensive tax benefits offered. So let's look at the choices the artis has for setting up a business entity: Sole-Proprietorship, Partnership, Corporation, Limited Liability Company. The Sole-Proprietorship
The sole proprietorship is the first order of discussion because this is how most artists operate. Until the artist sets up a formal entity, he or she is by default a sole-proprietor. The sole-proprietor simply means one owner (even though a husband-wife team can function as joint proprietors). You will be automatically set up as a sole proprietorship if you do nothing else. The main feature of this form is that it is identified and intertwined with you, which gives it both strengths and weaknesses. If the business makes a profit, it is automatically income for you. If the business incurs a debt, it is your personal debt. If the business gets sued, you will be sued personally as well. It gives you complete flexibility that enables you to instantly shift the direction, policies and focus of your company. But, if there is a problem, any damage can potentially extend into your personal life. To limit this potential liability you may choose to set up a “single-member” LLC. The “single member” LLC customarily operates as a sole-proprietor and might offer some liability protection (ask your attorney about this before moving forward).
The Partnership When talking to clients I describe the partnership as a multi-person sole-proprietorship because these two entities are taxed in a very similar manner. The sole-proprietorship files its taxes as part of the owners Form 1040, whereas the partnership files its own separate income tax return (on federal Form 1065) that reports the total income and expenses of the business. The partnership then passes the net, “bottom line” income or losses directly to the personal income tax returns of the partners via the federal Form K-1. This means that the partnership itself 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. You can see why 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 does have the unique and critical tax advantage of “special allocations.” Simply put, special allocations allow the partnership to customize the distribution of income and loss by mutual consent through he use of the partnership agreement. For instance, two partners may own the business 50%/50%, but choose to split any losses 75%/25% if that yields a better tax result for them. Partnerships can also, if properly structured, have tax advantages relating to film and sound recording activities.
The Corporation The The third form of business is the corporation. Incorporation gives two main advantages:
For tax purposes there are two main types of corporations, the subchapter “C” and the subchapter “S” (the letters refer to subchapters of the tax code). Both are corporations in the legal sense but the taxation of income and losses is handled differently.
The Limited Liability
Company A relatively newer form of business entity is the LLC, or Limited Liability Company. The Internal Revenue Service does not have an "LLC" tax forms. Probably the most common business form LLC’s take for tax purposes is as a partnership but they can also be S corporations and sole-proprietors. If you are considering setting up your business as a partnership, look long and hard at the LLC it is generally preferable over the standard partnership. The LLC combines many of the features of a partnership with those of an “S” corporation, without the restrictions that applied 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 parlance of an LLC), but provides some of the liability protection of a corporation. The LLC is also a “flow-through” entity that generally files the same federal income tax forms as a partnership, Form 1065, and it does allow for the use of “special allocations” we discussed in the section on partnerships. As with a standard partnership you do need two individuals to set up an LLC although a “single-person” LLC, can be established for a sole-proprietorship.
When and Which Entity
Would the Artist Set Up? In essence artists have three choices of business entity, the sole-proprietorship, partnership/LLC and corporation. First the artist’s decides whether he or she even needs to set up a separate business entity. Having decided, he or she must determine the type of entity to create. Deliberations 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 explain the legal benefits of setting up a business entity as well as actually create the entity in the legal sense. Your accountant and tax advisor will clarify what new expenses; responsibilities and functions will be entailed in your new business entity. Commonly, the attorney and tax professional will need to confer on behalf of their client because the legal and financial matters are interrelated. What occasions considering the establishment of a business entity is that the artist has an issue or problem that cannot be solved any other way. Unless there is a clear need or reason to set up an entity, don’t consider it. They are costly to set up and maintain unless they can serve a clear and identifiable purpose. Furthermore they complicate the operation of your business. Accounting and tax filings as well as the associated fees increase. With the help of an attorney and an accountant the artist needs to do a careful cost-benefit analysis, which will help him or her, decide whether it is worth setting up the business entity (a cost-benefit analysis is where you weigh the cost incurred vs. the benefit received). It might be that personal liability is the issue for the artist. A cost-benefit analysis may find that insurance is a more effective solution. An artist desiring to bring someone into the business might be better served by simply hiring an employee. So, what are some of the situations or needs that might finally lead the artist to set up a separate business entity?
Taking our four artists (from the NEW 3rd edition of the Tax Guide for Writers, Artists, Performers & Other Creative People, by Peter Jason Riley, C. P. A.), let’s look at when and why an artist might chose to set up a separate business entity.
Example One Actor Ima Starr is beginning to hit it big and make some serious money. She decides to set up a corporation for her acting business (sometimes referred to as “loan-out” corporations). With this setup the film companies would pay her corporation for her services and she would in turn be an employee of her own corporation. The benefits to Ima could be that (1) she is able to shift income to later tax years and allow her to delay payment of income taxes, (2) she might save payroll taxes (FICA taxes) by operating as an “S” corporation, (3) she may use the corporation to shift income to other members of her family or household (and into lower tax brackets). The corporation would help her limit her personal liability, and at the same time potentially lower her chances statistically of being audited and it would isolate her business activity from the rest of her life. The IRS frequently zeros in on “loan out” corporations so they have to be structured with great care to sidestep the punitive personal holding company rules. Ima is also considering an LLC to produce her own film, book or other project. The project would be produced inside the LLC when the project was sold the LLC would distribute the profits to the investors/members and perhaps dissolve. If Ima already has the corporation why would she set up a separate LLC for her film project? She would do this to isolate this one project from the rest of her business activities. From both a legal and financial point of view she would want to do this in order to not involve the individuals that are members of the LLC in her primary operations inside her corporation. Also since the LLC operates (for tax purposes) as a partnership she may have some advantages in writing off the costs of the film.
Example Two Musician Sonny Phunky needs some investor money in order to make a new recording with a big band. He could set up an LLC, much the way Ima did, to attract investors and isolate that activity, and later to channel the profits directly to the investors from the ultimate profits of the recording. Sonny’s band, “The Over the Hill Gang” set up an LLC for a showcase US tour. The band subsequently had a song picked up as a theme for a hit cable TV show and had royalty income of over $100K. Having been discovered a major tour is being planned and Sonny is worried about touring liabilities concerning his band and crew. His lawyer advises him that he could set up all the band members as “single member” LLC’s and these in turn would be the members of the primary band LLC “The Lido Shuffle.” Income from the tour will be paid into the band LLC and the crew would be employees and band members would all be paid distributions directly to their own “single member” LLC’s. This will help limit Sonny’s personal liability in case of accidents and other unforeseen problems. His tax advisor also discussed setting up a music equipment leasing company that would own all the equipment used by the band on the tour. Sonny’s LLC would then lease (pay rent) to the leasing company for the use of the sound and lighting equipment. If the leasing company was an LLC it would give Sonny an additional layer of liability protection. The leasing company can be set up by Sonny and his attorney using a generic name. A generic name gives Sonny some privacy, in that people need not know that Sonny owns the leasing company. Such a move can be very tax efficient as it gives Sonny another means of receiving profits from the band’s activities. Should Sonny’s songwriting continue to grow, as it seems to be now he is considering setting up a second LLC (or other business entity) to control his songwriting activities.
Example Three Suppose our visual artist, Liz Brushstroke befriends an individual who becomes her business manager and agent, and as such is a vital and essential part of her artistic activities. Liz decides to make this person a legal part of her business by setting up a corporation or LLC (either one would probably work, but the LLC would be more flexible and user friendly) and giving him or her a real equity stake in her artistic life. By making this individual a shareholder or member of her business Liz legally recognizes this person’s importance in her business life and will be able, depending on how the entity is structured, to give him or her a share of the profits. Liz’s advisors told her that she could simply hire her friend as an employee but Liz preferred setting up the business entity. Liz has an investor interested in funding the publication of a limited edition book of her works, and for this her attorney and tax advisor both recommended an LLC. The LLC will be structured to receive cash from the investor. In turn, it will receive all the income for book sales, pay all the expenses of the publication, then distribute the net profits to Liz and the investor according to their LLC agreement. After all the books are sold, the final profits will be distributed, the LLC would file a final income tax return and fold.
Example Four Guy Focal has his first big year as a writer when one of his books is sold for a major film adaptation. He decides to incorporate his writing activities and sets up an “S” corporation. His agent or publisher will pay his royalties directly into the corporation from now on. The corporation will allow him to put some family members who are helping him with his correspondence and research on his payroll, thus diversifying his income into their lower tax brackets. The corporation will also give Guy some liability protection. With knowledge gained from this recent film experience, Guy decides to try and adapt and make a film of another of his books. He finds some investors and sets up an LLC to act as a production company for the film project, because he does not want the investors to be a part of his “S” corporation. If the project doesn’t succeed the LLC investors/members will most likely be able to use the losses on their personal income tax returns. If the project succeeds and sells, the income from the film will become income on the member’s income taxes.
In closing The issue of setting up a business entity is something that tends to happen later in the artists career. At the beginning of a career very few artists have any need to set up a formal business structure, and many successful artists indeed never set up any formal business entity. At the early stage of an artist’s career it would rarely be cost effective, and more importantly the direction and scope of the artist’s ultimate activity would be insufficiently developed to make effective decisions regarding business structures. By the way, most of the rules relating to income and expenses still applies to any structure you may happen to operate in. While the mechanics may change, in general, the IRS view of taxable income and what it considers a justifiable expense does not alter much across the spectrum of different business entities. Please keep in mind that we have barely scratched the surface on this very complex topic. You can see this whole subject is a balancing act between financial, legal, estate and income tax concerns. Any decisions are subjective and relate directly to personal financial goals, so what works for the colleague you spoke to at a party may not work at all for you. Be VERY careful of anything that sounds like a boilerplate solution. I feel that most financial decisions are far more personal then most people realize, and business structure is very much in that camp. Make any decisions in this area after careful discussions of your personal desires, goals and concerns, which would include other strategic issues such as estate planning. © Copyright 2001-2010 Riley & Associates, P.C. 978.463.9350 All Rights Reserved Site Designed and Hosted by NetCasters, Inc. 978.887.2100 |