Visual artists are more than three times as likely than the general U.S. workforce to be entrepreneurs. Of all artists, whether visual, performing or musicians, 34% are self-employed, versus 10% of the general population. Fine artists, art directors, and animators are the most entrepreneurial, with 55% being self-employed. Photographers trail only slightly at 46%, while designers clock in at about 24%. Altogether, about 375,000 visual artists claim to be self-employed, yet a surprising number of them run their art businesses without a corporate structure that protects them from personal liability. Without this, creditors can force these artists to liquidate personal assets, such as their homes or cars. In some cases, they are also missing out on tax benefits. What is the best type of company for self-employed creators? Let’s take a look.
Structuring an Art Business
The are several types of business structures available in the United States, each with its own advantages and disadvantages. The most popular are:
- Sole Proprietorship
- Corporation (C-corp)
- Subchapter S (S-Corp)
- Limited Liability Company (LLC)
However, we can further divide the company structures into two camps: Corporations (C-Corp, S-Corp, and LLC) and Non-Corporations (Sole Proprietorships and Partnerships). The major difference between the two is that corporations protect owners from being personally responsible for things that the company does, assuming those actions are legal. When a corporation is formed, a new legal entity is created. It’s like having a business baby. A corporation is entitled to certain rights which are very close to many of the rights people enjoy. The corporation is given a legal name, and receives a Corporate Tax ID, which is like a social security number, and it can enter into contracts and be punished for doing things that are illegal.
The owners of the business, though, have limited liability, meaning that since the corporation is a “person”, it gets in trouble, the owner. If your company is sued over a contract dispute, you can use company money for lawyers, and if you lose, the winner can only get money from the company. If there isn’t enough, the winner can’t try to take your personal assets as compensation. The same is true if someone comes to your studio and falls, breaking their leg. They may sue for their injuries, but they can only sue the company. You are protected. The opposite is true if you are a non-corporation. In that case, hopefully, you have insurance.
That isn’t the only benefit of corporations, though for owners of an art business. There are hosts of benefits, such as lower taxes or being able to issue stock to investors. However, corporations are not all roses and kittens. These corporate structures also have their downsides. Which is better for you?
Sole Proprietorship is a type of business entity that is owned and run by one natural person and in which there is no legal distinction between the owner and the business. They are very popular due to their simplicity. In fact, the majority of people in solo businesses are sole proprietors primarily because you don’t have to take action to be a sole proprietor. If you open a business and don’t incorporate, then you are automatically a sole proprietor. You can have a real business name, a business bank account, and you can employ people, but the company is not a separate business entity. It does not have its own tax form. If you earn a profit, the money is added to any other income you have, such as your spouse’s income if you file a joint tax return.
The sole proprietorship doesn’t pay any payroll taxes on income, withhold income tax, file employment tax returns or pay state or federal unemployment taxes. Nor do you need to be covered by workers’ compensation insurance. But you do have to pay Medicare and Social Security taxes at the end of the year.
The downside is that the sole proprietorship, by virtue of the business not being a separate entity, cannot protect you from actions you took through the company. That means you have unlimited personal exposure for anything that might go wrong. If the business is sued, then your personal assets, such as a house or car, may be at risk. In some States, that risk may be mitigated, but only partially. For example, in Florida, the Homestead Act limits the ability for creditors to force you to liquidate your main home. However, in most cases, the risk is yours. Company assets and personal assets are the same, so company debt is personal debt.
Partnerships are similar to Sole Proprietorships in that the business is not a separate entity. In most cases, the default State regulations would treat each partner as a full owner, with the right to enter into contracts on behalf of the company, or even liquidate company assets without regard to the desires of the other partners. As well, partners are liable for business debts. Unfortunately, the default rules for partnerships in most States can be problematic, especially when the partners are having problems with each other. For example, let’s say one of two partners decides to leave the business and wants to liquidate the assets so he can take the cash? He can probably do that. If your partner decides to sell his half of the business to someone that you don’t like, he can probably do that too. If your partner is spending too much company money on things you don’t need, it may be impossible to stop it. It depends heavily on which State the Partnership is located.
To some extent, these issues can be mitigated through a Partnership Agreement, which sets the rules under which the business operates. The Partnership Agreement is just a contract between the partners. Be sure to work with an attorney on any Partnership Agreement as the attorney can guide you and recommend terms that you may never have considered.
Finally, just as in the sole proprietorship, all the partners have unlimited liability. The Partners are responsible for the company’s actions and its debt so you may be personally on the hook for something that you partner did. That risk can be too high for some people, which is why many businesses choose to incorporate as a means of reducing their personal liability.
Most of the big name companies you know are C-corps (also known as Inc.): Coke, Boeing, Walmart, Verizon, and Apple, to name a few. As we discussed earlier, the big advantage of C-Corps is the personal liability protection. Starting a company can be a risky proposition. Most startups fail due to any number of reasons in or outside of the company. For many would-be entrepreneurs, the risk is just too high, especially if any losses might affect their families, such as losing a house should the business fail. However, entrepreneurship is important to a growing economy, especially one that is so focused on innovation. To spur entrepreneurship, the government had to find a way to mitigate some of the risk associated with forming a new business, so the corporation was born.
As discussed earlier, Corporations are distinct entities with the power to make agreements, sign contracts and even commit crimes. Owners can’t be blamed for the corporation’s actions, despite the fact that they might be the ones who determine the actions. Corporate principals have no personal liability for corporate debts, breaches of contract or personal injuries to third parties caused by the corporation, employees or agents. Creditors can only target corporate assets so cannot make any claims or seizure for personal assets.
However, liability protection is only available to those who follow the rules. When rules are flaunted, creditors might be able to pierce “the corporate veil” and target the responsible shareholders. For example, commingling personal funds with corporate funds, such as using the company bank account as your personal bank account or if a shareholder committed fraud on behalf of the company would likely pierce the corporate veil. So, if you are a corporate officer, always be sure to talk with an accountant to ensure that you don’t inadvertently do something that allows the corporate veil to be pierced.
A C-Corp has the added advantage of being able to issue stock. Almost all public companies on the myriad of stock exchanges are C-corps since the shares are all publicly traded. Also, C-Corp is not limited to a single type of stock but can issue different classes of stock, each with their unique rules. Common and Preferred are the two main stock types. Common stock is what most people normally think of when buying stock on stock exchanges. Common stock represents ownership in a company and holders can receive a portion of the company profits as a dividend although the amount can vary wildly if they are distributed at all. Shareholders get one vote per share to elect the members of the Board of Directors, who oversee the major decisions made by management. Preferred stock, on the other hand, also represents some degree of ownership in a company but usually doesn’t have the same voting rights. However, shareholders are usually guaranteed a fixed dividend forever. Also, if the company goes out of business and liquidates its assets to pay off creditors, Preferred shareholders are paid off before the Common shareholder.
On the downside, C-corps are much more difficult to manage from a legal and tax perspective, than any of the other models, so for small entities with limited resources, C-corps are not the preferred entity type. Ownership control and voting rights are strictly based on the class and the amount of stock a person owns. Corporations must also pay quarterly taxes, which may require that they pay taxes on profits in a quarter even though they have a loss the next quarter. They won’t see the refund until the final years filing, which can hurt a company’s cash flow. There are many other procedural requirements, as well, such as holding shareholder meetings where Officers are elected. Meeting minutes must be recorded, and an Annual Report and fee must be filed with the State.
Additionally, a major downside of the C-Corp model is double-taxation. Here is how it works. Assume that you are a designer, and you generate $50,000 in gross revenue. You pay any company expenses and take the rest as salary, leaving no money in the company. The company then pays no tax, because it has no profit. The owner / shareholder pays income tax on their salary as personal income. However, if the owner decides to leave money in the company for any number of reasons, such as future growth and development or to have cash on hand to mitigate slow months or clients late paying bills, the remaining capital is considered income and the company must pay taxes on it. Now assume that the retained money, after taxes, isn’t used for anything, and the owner later takes it as a bonus, then the owner pays taxes on the bonus as personal income. So the revenue was taxed twice, once as corporate profit and once as personal income.
As you can imagine, for a small business with only a handful of people, or even a single owner, the requirements of a C-Corp can be too burdensome. These companies still want the liability protection afforded a C-Corp to mitigate the risk of starting a new business. So, governments created hybrid corporate forms, such as the Subchapter S and Limited Liability Corporations (LLC).
Subchapter S Corporation
An S-Corp provides many of the same benefits as a C-Corp without the double taxation. S-Corps allow the shareholders to “Pass-through” the corporate income as profit and loss on their individual tax returns, rather than a corporate tax return. That also means no quarterly taxes, as in the C-Corp. And just like the C-Corp, the company can attract investors through the sale of shares of stock. Think of an S-Corp as C-Corp lite. In fact, when the business initially files for corporation status, it is classified as a C-Corp. Once completed, you can file for S-Corp status if you meet the additional requirements, namely, that you have fewer than 100 shareholders, that you maintain only one class of stock, and that the owners are U.S. citizens or resident aliens. For the small art-based business, these are fairly easy requirements to fulfill.
As well, since an S-Corp is a corporation, it provides liability protection for the shareholders. S-Corps have an additional advantage when it comes to paying Social Security and Medicare taxes. An S-Corp does not have to pay Social Security and Medicare taxes on distributions (dividends), only on normal salaried income. The larger the distribution, the less Social Security and Medicare taxes you’ll end up paying. The S-Corp is the only business entity type that allows this. However, not all corporate revenue can be a corporate distribution. A shareholder/employee must be paid for his or her services with a reasonable salary, which is subject to Social Security and Medicare taxes.
On the other hand, while you may reduce Social Security and Medicare taxes, there are additional expenses associated with an S-Corp, such as workers’ compensation and unemployment insurance coverage, depending upon the State. Some states also require minimum annual state taxes, no matter how much money the company earns. For example, California requires an $800 annual minimum tax. So the tax savings may not be enough to offset the additional expenses.
One other point on distributions, they are allocated based on the number of shares outstanding (remember there is only one type of stock). So if the company is distributing $1000 and you have 500 of the 1000 shares issued, then you get $500. If there are ten other people with 50 shares each, they each get $50.
The Limited Liability Company (LLC)
To wrap up the different corporation types, we come to the LLC. LLC’s combine the personal liability protections of a C-Corp or S-Corp with the simplified tax structure and filing requirements of a partnership or sole proprietorship. An LLC is identical to an S-Corp in so far as a company’s profits and losses flow through to the shareholders’ personal tax returns. No corporate tax return is required, which also means that you can avoid double taxation. Also, unlike the S-Corp, there is no residency requirement. Owners need not be U.S. citizens or permanent residents. And like any other corporate form, there is limited liability for business debts and obligations. Finally, the administrative requirements are minimal as compared to a C-Corp.
The main difference of an LLC to the other corporate forms is that LLCs do not issue stock. There are no shareholders nor shareholder meetings or required elections. There is no Board of Directors that oversee the policy and direction of the company. Instead, LLCs have Members and Managers. Unlike Common stock shareholders, Members of an LLC participate in the management of the company, unless the members agree to select a manager-managed LLC, where one person makes the decisions. Typically, however, LLC members actively participate, making decisions and offering input on the company’s direction. However, member decisions are decided by a majority.
Additionally, most states do not restrict ownership, and so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. However, being a fairly new type of entity structure, there is a wider variation as to the regulations among the various States. For example, not all states permit “single member” LLCs, those having only one owner.
From a tax perspective, an LLC with at least two members is classified as a partnership for federal income tax purposes unless it affirmatively elects to be treated as a corporation. And an LLC with only one member is treated as a sole proprietorship unless it affirmatively elects to be treated as a corporation.
On the other hand, like with a Partnership Agreement, much of the default operating procedures, can be determined by the owners and memorialized in the Articles of Incorporation or Operating Agreement. There are no state requirements as to their content. For example, since control among the owners isn’t based on the stock, the voting rights and responsibilities for each manager, member, or member type is written into the Operating Agreement. Even the distribution allocations are determined by the terms of the Operating Agreement. So it is critical to think through how you want the company to run, and what happens if members want to leave, or the company fails. One thing to note, if you do intend on receiving investment from traditional investment groups, most will want stock, so forming an LLC is probably not the best approach. However, if you do have an LLC and then want to change to a C-Corp later, there are a myriad of ways to make that happen.
For those in the arts, especially self-employed or solo businesses, the hybrid structures, S-Corps and LLCs should be considered seriously, but given the variations among states, one may be preferable to the other depending upon location. As well, your business needs might have particular aspects that would be better served by a C-Corp or a partnership. Also, you don’t have to open your corporation in the State in which you live. You can take advantage of laws for other States, such as Delaware, which is very pro-corporation. However, and I can’t stress this point enough, do not try to for the corporation yourself. While there are lots of sites that allow you to form companies online that may be inexpensive and seemingly easy to use, the myriad of rules and regulations need the consultation of an expert. Make corporate formation a high priority. You don’t want to find yourself in a situation from which you and the business cannot recover.