Although many people dream of starting their own business or side hustle, few people actually do. Maybe they think everything has to be “just so” in order to start. Actually, there are fewer barriers to entry than ever before. It took a pandemic for people to learn that they can work from home. Or maybe they were part of the displaced workforce who decided to start a YouTube channel, a blog, or a podcast. Whatever the case, it is important to have the right business model for the chosen venture. Here is a primer for beginners.

Sole Proprietorship

The sole proprietorship is the simplest of all businesses to form. In fact, it’s not actually an entity. There is no need to register with government agencies or authorities in many states, and the owner pays ordinary income tax on profit. There is not legal differentiation between an individual and a sole proprietorship.

The drawback to forming a sole proprietorship is unlimited liability. Because there is no distinguishing between the individual and the proprietor, he or she assumes 100% of the liability.

Let’s say Biff starts a business reconditioning automobiles. Over time, he develops a great reputation. People start to bring him their very expensive automobiles to recondition. One day, his 3-year old starts swinging toys in the garage and accidentally damages (very badly) one of these super expensive cars that Daddy is reconditioning. Biff is personally liable for the damages as the sole proprietor.

A simple partnership is another business structure that is kind of like a proprietorship, but it is among multiple individuals, but most opt for a multi-member LLC or LLP. (See below.)

Limited Liability Company (LLC)

As businesses grow, many proprietors restructure into a limited liability company, or an LLC. The LLC is a separate entity from it member(s). An LLC can be a single-member LLC or a multi-member LLC. Family LLCs have even been created for estate planning and distribution of assets to heirs. With LLCs, the member(s) income “flows through” and is taxed as ordinary income similar to the proprietor, but they have legal protections against unlimited liability as long as they meet the requirement of establishing an LLC.

While LLCs share some of the limited liability characteristics of a corporation, there are considerations. Restructuring into an LLC means that finances must now be kept separately. Co-mingling of funds is not legal. Also, members must establish articles of organization and have an annual meeting with minutes. Failure to do these things can result in the “corporate veil” being pierced. Bye bye limited liability protection.

The LLC is the newest entity. Most states established laws in the late 70s and early 80s. Different states have different rules surrounding the formation and “ongoingness” of LLCs.

Also an LLC does not have to be formed in the state where it conducts business. Many real estate LLCs are formed in Wyoming for its strong protection against charging orders in the event of a lawsuit. (Corporations are often formed in the states with the most favorable tax laws.)

Most states will also require LLC members to retain a registered agent to handle lawsuit paperwork. Many attorneys will charge a fee for serving as registered agents.

Corporations

Corporations require the most paperwork to form. A corporation is essentially a file folder full of paperwork. Although there are many corporate entities, the S corporation is most popular for small business entrepreneurs. An LLC is an entity while an S corporations is a tax classification. As such, the LLC must be formed first. Then the tax classification can be applied. Profit to owners “flows through” the entity as with the LLC and is claimed on personal income taxes.

C corporations are typically large (even multi-national) companies. Maybe think NYC skyscrapers. Double taxation is the chief drawback of the C corp. That is, the company pays taxes on income. Then the owners pay tax on distributions (i.e., dividends). Say you own stock in XYZ Company, Inc. XYZ Co. pays corporate taxes on profits. Then as a shareholder, you also pay taxes on your dividends.

However, owning stock does not subject the owner to liability that comes about because of the actions of the corporation. For example, ABC Co., Inc creates an adhesive that keeps a bandage adhered to a person’s body. Later it is discovered that the adhesive causes nail fungus. Owners of ABC may lose their initial investments, but they will not be sude by any individuals who have suffered adverse events. The most a stock investor has at risk is the amount invested in the stock. So from the owners’ standpoints, a corporation is a best.

Those are some very basics. Two of my favorite resources about these topics are Investopedia and Garrett Sutton at Corporate Direct.

Other Entities

Although there are many other entities, these are the most common for a small business. Most of us do not have to have anything more complicated to get started on our side hustles. If a change ends up being a necessity, then we will hopefully have the ability to hire an expert attorney.

As Always…

Thanks for reading! I hope this information provides food for thought. Remember that I am not a certified financial planner, a certified public accountant, a licensed real estate agent, etc. My content is for educational purposes. I am a math educator who happens to have a finance degree. Like they say, never take financial advice from a math teacher! (Do they really say that?)

But you should spend less than you earn, invest the difference, and stay out of debt!

I would so appreciate your sharing my content with anyone you feel could benefit. And if you would like a free exploratory conversation or just want to shoot the breeze about personal finances, call me and leave a message or send a text to 570-731-0425.