If you're a freelancer, you're probably wondering when you should set up a formal entity. "A formal entity" is a legally formed business, like an LLC or S-Corp.
You might know some small business owners who formed an entity before they earned their first dollar. You might also know someone who makes a damn good living, but is setup as a sole proprietor. So now you're like, "WTF?! Should I set up an entity or keep doing this sole proprietor/freelancer thing?"
Glad you asked! There are different factors to take into account when deciding to setup a formal entity. Here are three main factors and perspectives to focus on that will help you understand why (and when) you should form an entity:
- The legal perspective
- The tax/accounting perspective
- The big picture (goal) perspective
The Legal Perspective
Take a look at all the legal considerations first and foremost - sometimes there are legal requirements you must comply with, examine whether or not you have liability exposure and think about how you'll want to structure ownership.
Are you legally required to set up a formal entity in order to start doing business? If so, then that answers the question of whether or not you need to formally set up a business entity. If you're starting a creative business, there probably isn't a legal requirement for you to set up an entity. Examples of businesses that require an entity to be formed before business can commence are marijuana dispensaries in certain states, a medical practice or a law firm.
Even if you're starting a creative business, one big question you need to ask yourself is, "am I exposing myself to liability through my products and/or services?" When we say liability, what we mean is, can you get into legal trouble with one of your customers? Can a customer sue you for getting sick from a food product you sold to them? Is there a risk that a customer can get hurt while shopping at your store front (yes!) or at your event (yes!)?
If you speak to a lawyer, (you absolutely should) I'm sure they can convince you of all the ways in which you are exposing yourself to liability with your business model, so therefore you need to set up an entity right away. And if you're an American reading this, the other side of the same coin is that we live in a very litigious society, so yeah, you can probably be held liable for anything, so the safe and smart thing to do is set up an entity that limits your liability. And, yes there are costs associated with setting up and keeping a business entity up and running each year, but the cost may well be worth the limited liability shield that you get from an LLC or corporation.
Disclaimer: This isn't legal advice, because I'm no lawyer!
The type of entity you set up has its own set of laws and regulations that it must abide by, so if you're planning to structure ownership with partners or investors, there are legal considerations. For example, if you want you and your partners to receive different portions of the company’s profits or losses regardless of how much actual company you or they own, you need to understand the different entity types and whether or not you can structure that. Don't worry a good lawyer can help you with this.
The Tax/Accounting Perspective
If you don't need to set up an entity for legal reasons, the next factors to consider are the tax/accounting perspective and the big picture. Let's talk tax first.
As you do business, the goal amount of income you make grows as your business does. And when your income reaches a certain threshold, most accountants and CPA's agree that there are tax benefits that come along with a formal entity, therefore it's savvy to set one up.
Most CPA's and accountants will agree that if your business is earning $250k a year, you should have an entity set up. Some accountants will say that at $100k a year, you should have an entity set up. It depends on your specific, unique situation. You should ask your accountant what he or she says about your business. Your accountant will know your tax situation, which is totally different from anyone else's.
The reason accountants recommend you should be earning a certain amount of income is because there are tax benefits that come along with a formal entity at those income thresholds. And these benefits outweigh the cost of setting up and maintaining an entity.
Again, please reach out to your accountant to get their advice. Disclaimer: This isn't tax advice because I'm no accountant. I just get the privilege of hanging out with them on a regular basis.
The Big Picture
what's the goal?
You'll need to consider what your big picture goals are for your business. Are you looking to maintain a small business that you run for yourself and your family? Do you plan to scale and sell your business? Are you looking for investors? All of these factors will determine if and when you should be setting up a formal entity. If you're on the prowl for investment dollars now, you should probably look into formalizing your business sooner than later.
It's totally possible that you have small projects that provide you income, but won't ever need to be set up as a formal entity. It's possible that you have an idea that you want to turn into a business, but it needs to be a formal entity before you can even earn your first dollar. I learned this when I co-founded a non-profit organization.
Before you get stoked and start filing all the paperwork to get formal, talk to your industry peers about whether or not they have an entity set up and how they made the decision. Talk to accountants, talk to lawyers. And if you've been in business for a while and realize, "Oh shit, I needed to be setup like yesterday", don't freak out, a small business attorney and accountant can get you formalized if the process is too daunting for you.