Setting up the legal structure of your business is one of the first and most important steps to becoming a functional and profitable business. You will want to put a good deal of thought and consideration into choosing the framework that best fits your business model and desired outcome. In this chapter we break down the pros and cons of the most common legal structures for your business and provide insight into how to make the most of each for various business situations.
There are five legal frameworks that are typically used for a design business, each with its advantages and disadvantages. A general description of each one is listed below to help you decide which one best fits your goals and objectives. These are great for reference and to serve as a starting point for your decision, but in order to make a fully informed decision regarding what is best for you, talk with your lawyer, accountant, insurance agent, and banker.
1. The Sole Proprietorship
“Sole proprietor” describes a business owned and operated by one person. Most Freelancers do business this way. Owners may use their own name, or they may name the business anything they want, as long as the name doesn’t imply that the business is incorporated and doesn’t violate the restrictive laws of the state in which the business will be operating. These laws vary from state to state.
1: It’s very easy to set up.
There are very few legal hoops you have to jump through, and it costs practically nothing in most states to establish a sole-proprietor business.
If you’re not going to hire any employees or give the business a name other than your own,
All you have to do is register with the division of taxation in that state. This could include registering for sales tax if your state taxes services. You may also have to register for employment taxes depending on if you will hire any employees or plan to subcontract any portion of your work out. The application process is pretty easily completed online. If you intend to use a name that might indicate that others are involved in the business (Joe Smith Design Studios, or The Joe Smith Company), then you will need to file a certificate, usually called a ‘“DBA” or “doing business as” with the county clerk or other such local authority. Again, this can all be done online in most areas and it will vary based on location. You need this certificate to open an account and to deposit or cash checks made out to the company. People who might extend credit to you also may check on your certificate to find out just who the principals of the Joe Smith Company are.
2. You’re your own boss.
You can do whatever you please with your business. You have only yourself to answer to. Making needed changes to the business model and approach will never be faster than it is for a solo proprietorship.
3. You control profits.
As a sole proprietor, you and you alone get to keep the profits and decide what to do with them. You can put them into the business or you can go on vacation with them.
1. Unlimited liability
This is by far the biggest disadvantage. With a sole proprietorship, the finances of the business and the owner are the same. This means your personal assets, like your home and car can be confiscated if you fail to pay your debts or a lawsuit is filed against you.
2. Personal Income Taxation.
The income (or losses) of the business are treated as personal income and taxed as personal income. Tax rates grow steeper at higher income levels. There’s also a self-employment tax that needs to be factored in. Anyone who has a significant additional source of income, such as a spouse’s salary, or dividends, will end up paying higher income taxes.
3. Limited Client Opportunity.
Many potential clients are nervous about dealing with a one-person design firm. They don’t think that a single person can keep up with deadlines and meet all of their needs. For that reason, one-person design firms end up doing most of their work for other design firms or advertising agencies. Few are able to deal directly at the client level, which can limit their ability to grow beyond the mere production services.
2. The General Partnership
Designers who are not content with freelancing on their own and want to start a “real” design firm often decide to form partnerships. Oftentimes, these partnerships are formed by junior designers who are newer to the industry.
In order to form a partnership, you need at least two partners. Under a partnership structure, all partners are deemed as owning their pro-rata share of the partnership assets. Partnerships do not pay tax at the entity level, rather the profits flow down to the partners at the individual level, similar to a sole proprietorship.
The reason many junior designers start out in partnerships with other junior designers or copywriters are readily apparent:
1. It costs less.
Setup is similar to a sole proprietor, but we recommend hiring a lawyer to draw up a partnership agreement. You will want to agree on how profits are shared, how and when to take distributions, and how to allocate income for tax purposes. Most importantly, how one “gets out” of the partnership or what to do upon the death or disability of a partner. Think of it like a pre-nuptial agreement. Each partner only has to come up with a portion pro-rata share of the money capital.
2. It allows them to pool their labor and take on larger jobs.
If two designers have slightly different skills and interest, perhaps one is a wonderful illustrator while the other is great at designing ads, they can complement each other’s capabilities.
3. It’s a morale booster.
There is a certain psychological lift in being able to share the many pleasures and burdens of a business. Just having someone with whom you can discuss a job or bounce creative ideas off of, can be a real advantage.
Furthermore, there’s security in being able to rely on someone who has a real stake in the business, who can cover for you in times of illness, or while you’re on vacation. The strain of feeling that you alone are keeping the business going can quickly wear you out.
Close relationships are intense and can be hard.
The majority of designers we interviewed shared a similar history; at one time or another, early in their careers they had formed a partnership with one or two other designers, and had later dissolved the partnership to go into business for themselves. Partnerships can be intense relationships. Financially and in terms of the time that you spend together, they can be as intense as a marriage. Even the very best of friends and the most compatible of designers often find it is much more than they bargained for.
If you intend to set yourself up in a partnership; approach it professionally. Don’t enter into the agreement lightly and don’t assume that your friendship will be able to survive the strain that a partnership may place on it.
Each partner should get their own lawyer and draw up a legal, binding partnership agreement that spells out in as much detail as possible what each partner’s responsibilities and commitments will be. In the course of drawing up the agreement, you’ll be amazed how many points of disagreement will likely come up.
The problems partnerships run into are usually personal, but many of them have their roots in the basic legal structure of the partnership.
Like the sole proprietorship, the partnership structure also has the problem of unlimited personal liability for business debts. However, in a partnership the actions of any one partner, or even of that partner’s spouse, can affect the personal assets of all the other partners. This means that if one of the partners misuses finances then, all the other partners can be held equally responsible for his or her actions. Even if their personal partnership agreement limits the liabilities of each of the partners, a creditor can still move to attach the assets of all or any members of the partnership, and even the assets of partners’ spouses.
Regardless of how honest, fair, and well meaning the partners may be with each other, the unlimited liability feature of a partnership structure is a very serious disadvantage.
Don’t even consider entering into a partnership arrangement without first talking to your attorney and insurance agent to help reduce the potential risks.
3. Freedom of decision.
A partnership structure, by its very nature, restricts the ability of each partner to make decisions without regard to the wishes of other partners.
If either the partner or the partner’s spouse dies, problems created by the disbursement of the estate and the estate taxes could completely wreck the financial structure of the firm and of all the surviving partners. Before you enter into a partnership agreement we strongly recommend extreme caution. Don’t ever enter a partnership with family or close friends without asking some very hard questions about yourself and the persons you are partnering with. A few of these include:
- Are the partners capable of carrying their own weight in terms of seeking business, as well as servicing design projects on their own? Or, will they be too dependent upon the reputation or abilities of the other partner or partners?
- Are the personalities of the partnership compatible? Have you worked together long enough to test this under a series of different potential circumstances?
- Are the partners’ spouses also reliable and trustworthy?
- Do the partners have similar long-term goals? Are their attitudes toward their work and their business goals similar?
- How do the partners handle disagreements?
If the answers to all of these questions are encouraging and all of the partners wish to go ahead with a partnership arrangement, each partner should get a lawyer to begin drawing up a partnership agreement. The items that must be addressed and agreed upon.
- How much money will each of the partners contribute to the establishment of the business, and when will these contributions will be made?
- What will the name of the business will be?
- How will the profits or losses will be shared?
- What will the partners be paid and how they will receive the money: by salary, draw, commission, etc. Will there be any expense allowances, automobiles, health insurance, or other “perks”?
- What will be expected from each partner in the in terms of performance, degree of responsibility, managerial control, decision-making, and employee management?
- How long will the partnership agreement last? The rest of our lives is not an answer. Define it. You can and probably will renew the vows in the future if things go well. But setting a date for that discussion can give you an out that will let you maintain friendships if the partnership doesn’t work.
- How will the partnership handle the problems of death, retirement, disability, or merely the desire to dissolve?
- How will the partnership handle disagreements? Is there a stated arbitration policy, or not?
- What kind of behaviors will be absolutely forbidden and which will be absolutely required?
- What will the accounting method of record will be? How will the company administer the books and which of the partners will be responsible for doing this?
- How will the partnership deal with violations of the agreement?
3. Corporations (C-corporation)
In the eyes of the law, a corporation is a completely separate entity from the people who comprise it. What the corporation does and what each of the owners do personally have no relationship to each other. In most states, a corporation can consist of one person, or an unlimited number of people.
While it is true that creating a corporation is a bit more complicated than creating a sole proprietorship or partnership, for a relatively inexpensive fee, your lawyer should be able to simplify the process. A fee in the $500 to $1200 range is typical for drawing up the necessary papers. For this fee your lawyer will check to see if the corporation name you have chosen can be used, help you issue the necessary stock and set a value on it, write up adocument of incorporation, and file the necessary papers. In all likelihood, your lawyer will also advise you about how best to handle your corporate taxes.
To reduce the costs, some of these things can easily be done by the individual.
There are many advantages to forming a corporation. Some of them include…
1. Limited Liability.
The greatest advantage to the corporate structure is that it limits the liability of the individual owners- or stockholders, in this case. The investors will lose only the money invested. They do not have to worry about losing their personal belongings if the business fails.
The corporation can be set up to last indefinitely. Should one of the founders die, the corporation will not die with them. him or her. This is comforting not only to the surviving stockholders, but to potential creditors and lenders as well (although the latter may still require stockholders to pledge their personal assets as collateral for loans)
If more capital is needed, the corporation merely has to issue more stock and find someone to buy it (which is not always easy, but it is still a good option to have).
The main problem with the corporate structure, other than the need for more paperwork, is that it must pay taxes on any profits before it can distribute them in the form of dividends; then the stockholders must pay personal income taxes on those same dividends. In other words, the same money is taxed twice.
Most small design offices will pay out profits in the form of salaries and bonuses to avoid this challenge, however careful planning and caution are required to avoid cash flow issues at the end of the year. For example, if a client pays a large invoice on December 31st after it’s too late to run a payroll, you will be taxed for that payment as profit without the deduction of the following payroll cycle or bonuses for that year.
4. S Corporations
The main difference between an S corp and a corporation, as mentioned above, is how it is taxed. S corps are a great option for designers who want their company to receive all of the advantages of a corporation as well as pass-through taxation (explained in benefits below). As long as your state recognizes S Corps, not all states do, it is good option to those who prefer pass-through taxation.
An S corp is a pass-through entity for federal and most state income taxes. Meaning that income and many tax deductions are passed through to the owners instead of being taxed at the corporate level. This helps you avoid the potential issue of “double-taxation” that is present with corporations.
2. Asset Protection.
Like all corporations, S Corps provide the owners limited liability protection. Meaning, your personal belongings are shielded from any creditors and litigation.
3. Salary Payments.
As an S-corporation owner, you are required to pay yourself “reasonable compensation” in the form of a salary. This is because, net profits of an S-corporation are not considered “earned income” and therefore not subject to the self-employment tax. As a way to save on these Self employment taxes, many taxpayers would pay themselves a modest salary and receive the bulk of the S-corp profits in the form of distributions of the earnings. The IRS has tightened this loop hole a bit, but has not gone so far as to give a pure definition of reasonable compensation. Therefore, you should pay yourself a salary at least equal to what you would need to hire an outside person with the same qualifications to do your work, or what is standard in the industry for the job at hand.
Unlike an LLC (read more about LLCs below), there are corporate formalities that you will need to adhere to.
5. Stricter profit and loss allocation rules.
Like a corporation, an S corp must allocate profits and losses among owners based on percentage of ownership or shares held rather than whatever proportions the owner desires. Allocation of profits must match stock percentage but distributions must also match. An LLC or a partnership is more flexible if you need to disproportionately share profits and distributions.
6. Stricter Qualification Requirements.
S corps must meet requirements regarding the number and type of shareholders and types of shares. An LLC is not subject to these restrictions.
5. Limited Liability Company LLC
The Limited Liability Company (LLC) is a form of business entity that combines the benefits of a corporation and of a partnership. An LLC is like a corporation in that it provides limited liability for the owners. However, for federal income tax purposes, it is treated as a partnership so that its income is taxed only once. An important distinction to note is that although an LLC is by default a partnership or a sole proprietor, it can elect to be taxed as a Corporation or as an S Corp. Therefore the advantages and disadvantages may vary depending on how you’ve chosen to be taxed.
Like S Corps, LLCs are not “double-taxed” meaning that you will not have to pay taxes on profits at the personal and corporate level (Assuming no C-corp election was made).
As the name implies, LLCs offer protection for the owners against possible litigation and creditors.
The main disadvantage is that all members of the LLC must pay taxes on the LLC’s profits, even if they do not share in the distribution (Again, assuming there is no C-corp election).
Members of an LLC are not officially allowed to take a wage, instead they must take distributions if they need it for income. Note: If taxed as a partnership, they can also take guaranteed payments or if a C-corp or S-corp they can of course, take a salary.
Self-employment tax still applies to LLCs and any profits earned are considered earned income (Once again, assuming no C-corp election).
Chapter 3 Conclusion
If you are starting out as a freelancer, a sole proprietorship is likely a good way to go in the beginning. Most small design firms will find that either an S corporation, an LLC, structure will accommodate their needs very nicely, but it’s important to remember that some states do not recognize LLC’s at all. Those states that do recognize these forms of corporate structures may have very different rules regarding how these structures are taxed and treated.
Now that you are equipped with some basic knowledge of the various legal structures that you can choose from, you can get a rough idea of which framework will work best for you and set up a meeting with your lawyer, accountant, insurance agent and banker to get their input.
You might be tempted to rush through the process so that you can officially start your business, but make sure that you put the necessary time and consideration into choosing your business structure.
This chapter was written with the help of Raymond Pinglora, CPA and principal at Van Duyne, Bruno & Co., P.A. If you are a mid size to enterprise level design company and looking for professional accounting service, give them a shout. They have been focused on helping creative professional and the top of their industries manage their finances for over 20 years.