Art Business Entities: Looking at the Types of Legal Forms You Can Use to Operate Your Art Business
Art businesses, like all businesses, must be conducted in a particular legal form. The features of each form have their pros and cons. This blogpost is aimed at giving you a feel for which business form might be best for you and offering some pointers as to how to set up your business in the chosen form.
1. Business Forms – the four key types:
· Sole Proprietorship
· Partnership
· Limited Liability Company
· Corporation
Sole Proprietorship: This is the simplest business form. “Proprietor” simply means “owner.” You are the sole owner. Legally you and your business are the same thing. A sole proprietorship arises automatically when you begin conducting business for profit. If your business borrows money, you are personally liable for the debt. If you hire an employee, you are personally responsible to the employee and to the state and federal government with respect to their wages and taxes. Even if you run your company under an assumed business name, you are personally considered to be the company for all matters arising under the law.
Partnership: A partnership necessarily involves two or more people who come together to do business. Art brand businesses operated jointly or in group form are typically going to be what’s called a “General Partnership.” A General Partnership arises automatically when two or more people begin conducting business together for profit. This kind of entity is like a sole proprietorship that has replicated itself. If one or more partners borrow money for the business, all partners are personally liable for the debt. If one or more partners hire an employee for the business, all are personally responsible to the employee and to the state and federal government with respect to their wages and taxes. Again, even if you run your company under an assumed business name, all partners are personally considered to be the company for all matters arising under the law.
Limited Liability Company. A limited liability company (LLC) is a legal entity separate from you. Unlike sole proprietorships and partnerships that arise automatically when you begin conducting business for profit, an LLC must be proactively formed by filling out and filing paperwork in the state in which you wish to create it. Because the LLC is considered to be an entity separate from you, it is the LLC and not you that is legally responsible for the business. If the LLC borrows money, only the LLC is liable for the debt. If the LLC hires an employee, only the LLC is responsible to the employee and to the state and federal government with respect to their wages and taxes.
Corporation. Like an LLC, a corporation is a legal entity separate from you. You form a corporation by filling out and filing paperwork in the state in which you wish to create it. Again, because the corporation is considered to be an entity separate from you, it is the corporation and not you that is legally responsible for the business. If the corporation borrows money, only the corporation is liable for the debt. If the corporation hires an employee, only the corporation is responsible to the employee and to the state and federal government with respect to their wages and taxes.
2. Personal Asset Protection
Operating a business poses all kinds of risks. Business may falter and you may not be able to pay back a loan. Perhaps you entered into a license agreement containing an indemnity clause for alleged copyright infringement and a frivolous lawsuit is filed against your licensee who invokes the clause to make you pay for their lawyer. Your shop assistant slips and falls and breaks his arm and says it’s because you didn’t put carpet in the fulfillment area.
A sole proprietor or partner is going to be personally liable for these matters. What does that mean in practical terms? It means that if money has to be paid from assets of “the business” in satisfaction of some claim, and you are legally considered identical with the business, all of what you consider your personal assets are included: Your home. Your car. All your money in the bank. The property you inherited from a relative. Your personal possessions. Any money that is owed to you. In many cases even the money in your retirement account such as an IRA.
On the other hand, if money has to be paid from assets of “the business” in satisfaction of some claim, and you are legally considered separate from the business, as when you’re operating as an LLC or corporation, anyone making a claim has to look only to the entity and its assets for satisfaction. This means your personal wealth is shielded from legal peril.
3. Why wouldn’t I want to operate as a separate legal entity?
Operating as a separate legal entity has some down sides, mainly in the form of formation expenses and, in some cases, fees charged by the state each year for the right to operate as an entity under its laws. For instance, in California the formation fee charged by the state is $70 and every year you have to pay $800 in “Franchise Tax,” even if your LLC didn’t make a dime or was not even active as a business. In addition, California charges you additional fees if your gross proceeds exceed $250,000. In contrast, Texas charges a formation fee of $300 but has no annual fees after that unless revenue exceeds $2.4 million. The story is similar as to corporations. In California the formation fee is $100 and the Franchise Tax is at least $800, plus more depending on your company’s revenue. In Texas the formation fee is $300 and there are no additional fees unless revenue exceeds $2.4 million.
The take away here is that every state is going to charge a formation fee and have some kind of approach to taxing the entity’s income. You will want to acquaint yourself with these costs in considering whether you want to operate as an entity.
4. Tax Benefits
a. Double versus Single Taxation
Beyond shielding your personal assets, operating as a separate entity can tax burden. To understand this, you need to know the difference between a “C” corporation and an “S” corporation.
To begin with, when you form a corporation by filling out and filing articles of incorporation, the state is typically going to assume what you’re creating is a “general stock corporation,” meaning a generic corporation that issues stock as representation of ownership. When you file your articles of incorporation, you’re not likely to be asked whether you’re forming a C corporation or an S corporation. This is because a general stock corporation is presumed to be a C Corporation.
The S and C designations are in fact made under the Internal Revenue Code. The laws known as the Internal Revenue Code are collected at Title 26 of the United States Code, the US Code being the collection of all federal laws. Subchapter C of the Internal Revenue Code, relating to C Corporations, is found at 26 U.S. Code §§ 301–385 and Subchapter S, relating to S Corporations, is found at 26 U.S. Code §§ 1361–1379.
A key difference between the two chapters is how profits are taxed.
The profits from a C corporation are effectively taxed twice, once when the company makes a profit and files its corporate tax return, and then again when, after paying its corporate tax, the company distributes after-tax income to its shareholders. Under the terms of Subchapter C, the distribution is treated as income to the shareholder. To be clear, the corporation does not pay the 2nd round of tax, the shareholder does by way of their personal tax return on a Form 1040.
On the other hand, Subchapter S provides that the shareholder only pays once. This is because an S-Corporation is treated as a “pass-through entity.” What this means is that the corporation declares its net profit and then, instead of paying the first round of taxation the way a C-corporation does, it “passes through” the profit to the shareholder who declares the profit as income on the shareholder’s personal income tax filing.
As noted above, your corporation is presumed to be a C Corporation unless you “elect” to be an S Corporation. You do this by filing IRS Form 2553. You must file the form within 2 months and 15 days after the beginning of the tax year the election is to take effect, or any time in the year before the year it is to take effect. In other words, if you want to go S Corp in the current year, you have to do it by March 15th. After that you can file the form, but it won’t take effect until the next year. If you miss the deadline, you can also file a form explaining why you missed the deadline and the IRS will usually approve the election.
b. Reducing self-employment tax
What is self-employment tax? Self-employment tax is the mechanism by which self-employed business people are taxed to pay for social security and medicare. If you are an employee of a company, you will see on your pay records 6.2% withheld for social security and 1.45% withheld for medicare. That comes directly out of your pay. But in truth, the employer pays an equal amount, i.e., 6.2% for social security and 1.45% for medicare, relating to your employment that you never are told about. When you work for yourself, you have to pay both the employer share and the worker share. Thus, as a wage-earning employee, 7.65% of your wages are withheld for social security and medicare. As a self-employed sole proprietor or partner, you have to pay twice that, 15.3% of your income.
Here's where the S-Corp comes in handy. An S-Corp does not pay self-employment tax on distributions of company income to the S Corp’s shareholder as a shareholder.
This is a little tricky, but there’s an IRS rule that says an S Corp shareholder who works in the business must receive a “reasonable” salary on which social security and medicare taxes are paid. That’s because in receiving a salary, they’re treated as an employee of the company, and money received as wages is subject to both employer and employee social security and medicare taxes. But beyond the reasonable salary, the artist wears another hat, as corporate shareholder. Money paid to the S-Corp shareholder is treated as a distribution instead of wages. Distributions are what the owners of stock get, for example, when Apple Inc. pays out some of its income to people who own Apple stock. Corporate distributions, including S-Corp distributions, are not subject to social security and medicare taxes at all.
Example scenario:
Imagine your art business brings in $120,000 in revenue. Your expenses such as studio rental, web hosting, shop maintenance, etc., come to $10,000. In addition, you pay yourself as an employee a salary of $50,000 which you deem “reasonable” since many people are paid that amount of money for doing your type of work. In other words, as owner of the company, you could hire someone for $50,000 to do the work you do.
But since you’re both employee and owner, you get the owner’s piece of the pie too. You distribute the remaining $60,000 to yourself as the owner of the S corporation. While this amount is subject to ordinary income tax, it is NOT taxed at all for social security or medicare. That saves you $9,180.
Why does the IRS allow this?
Because you paid yourself a “reasonable salary” of $50,000 as an employee of the company. That $50,000 is called W-2 wages (after the form W-2 given to employees at the end of the year summarizing their earning and deductions). W-2 wages have withheld from them sums for social security and medicare. The IRS wants to be sure you pay some reasonable amount to fund social security and medicare, they just don’t demand that every dollar coming out of your S-Corp be treated as subject to the self employment tax.
5. Limited Liability Companies as S Corporations
Though the IRS acknowledges there are Limited Liability Companies, it does not recognize LLCs as a distinct type of entity for taxation purposes. All LLCs are taxed either as a sole proprietor (for single-member LLCs) or a partnership (for multiple-member LLCs) or as an S Corp. To be treated as an S Corp you have to file an S Corp election form, the same form discussed above for C Corps that want to convert to S Corp status. If you don’t file the Form 2553, the IRS will treat your LLC as being a sole proprietorship or partnership subject to self-employment tax. In other words, you have to opt in to S Corp status.
6. Banking Matters - Federal Employer Identification Number
In most cases you’re going to need to get a Federal Employer Identification Number (FEIN or EIN for short). An EIN functions like a social security number for your business. Unless you’re operating as a sole proprietor under your own name, a bank will almost certainly need an EIN for you to open a business bank account. EINs are easy to apply for on the IRS’s website. An EIN can be handy even for a sole proprietor operating under their own name, as it provides an alternative to your personal social security number for payments from clients, e.g., when they need to issue you a 1099 at the end of the year.
7. Ease of Use – Corporation versus LLC – Veil Piercing
Returning to the theme of liability risk reduction, there is a concept called “veil piercing.” When a corporation is sued, and the corporation has little money, the plaintiff may try to reach the corporate shareholders’ personal assets to satisfy a legal judgment against corporation. To do so successfully, the plaintiff must convince a judge to disregard the distinction between the corporation and its shareholders and order the shareholders to be liable. If the plaintiff is successful, they will have, in legal parlance, “pierced the corporate veil.”
What will the judge look for in deciding whether to pierce the veil and make the shareholders personally liable? In a word, “separation.” Has the corporation been treated like a truly separate thing from the shareholders? Here, since we’ve been looking primarily at art businesses with one owner, I will now speak of a single shareholder.
The plaintiff will try to prove that the shareholder didn’t actually treat the corporation as a separate thing. A major piece of evidence supporting veil piercing is where the shareholder did not separate the business’s money from the shareholder’s money. For instance, if the shareholder used the corporation’s account to pay for non-business things like groceries, family vacations, back-to-school clothing for the kids, basically anything that doesn’t look like a true expense of operating the corporation’s business. This is a kind of seriousness or “solemnity” test. Are you acting in your day-to-day as if this business is a serious thing or is it more like your private cash pinata funding whatever comes to mind?
Another key piece of evidence in support of veil piercing is where the shareholder failed to observe “corporate formalities.” Corporate formalities are procedures that state corporation law requires in order for a corporation to exist. These procedures include having a board of directors that elects a president. Having regular board meetings. Notifying shareholders of upcoming meetings. Selecting a board secretary to take minutes of corporate meetings. Communicating board meeting minutes to absent shareholders. Keeping a book of shareholder stock holdings.
Corporate formalities make sense for a big corporation, especially publicly-traded corporations with lots of employees and shareholders, but for a one-person corporation it can seem pretty theatrical. Since you’re the CEO, the board, and the entire staff all in one, sending notice of a meeting, conducting a meeting, and keeping records of the meeting, all required by law, are arguably a waste of time. And yet, if you have set up your business as a corporation, and then elected S Corp status, if you haven’t observed corporate formalities, a plaintiff might use that as evidence you weren’t really operating as a corporation and should now be deemed personally liable for the corporation’s debt. Kind of ridiculous, right?
This issue of needing to observe corporate formalities in order to maintain the legal separateness of you and your S corporation is why many small businesses elect to operate as a limited liability company. A limited liability company doesn’t issue stock, it has “membership interests,” and it doesn’t have “shareholders,” it has a member or members. There are no requirements to have a board of directors or to hold regular meetings. In short, with an LLC you don’t have to follow “corporate formalities” the way you do with a corporation. And because you can elect to be taxed as an S Corp, you can get the tax benefits discussed above that flow from operating as an S Corp.
So, just to round this out, if you want to operate as a legal entity separate from yourself, you can choose to be either a C-Corporation or a limited liability company. Then, once formed, you can make an S-Corp election with the IRS and be taxed as a pass-through entity, potentially shielding some of your business income from 15.3% in self-employment tax.
8. I’ve made my business-form decision, what now?
If you are operating as a sole proprietor, your main concerns will be:
· Getting a Federal Employer Identification Number
· Setting up your business bank account
· Obtaining a business license (from your city/county)
· Obtaining a doing-business-as license (from your city/county)
If you’re operating as a partnership, you’re going to want all those things AND a partnership agreement. A big concern with operating as a partnership is that the moment you begin operating a business in tandem with another person or persons, you are suddenly subject to a whole bunch of state laws pertaining to the operation of a partnership under what’s called “The Revised Uniform Partnership Act” which every state has adopted in whole or part. For instance, under most states’ laws any one partner can bind the business to a contract without the permission of the other partner or partners. So, your partner could go get a loan for business funds and you would suddenly be liable for the debt as well. And it’s not 50% of the debt, it’s “joint and several” liability, meaning each one of you is 100% liable for the whole debt.
A well drafted partnership agreement can address issues like:
· Defining what roles each partner plays
· How to deal with deadlock if the partners disagree
· Procedures for handling business expenses and capital expenditures
· Dealing with what happens if one partner dies or is incapacitated
If you’re operating as a Corporation (S-Corp election)
Your first step is to form the legal entity. This is done by filing articles of incorporation (or some variation on that title) with one of the 50 states. Usually, you’re going to want to file in the state you live and work in, but sometimes people will elect to form their corporation in another state, generally because some states laws are more “business friendly,” meaning less costly. But know that in general, the state you live in will want you to register, and pay fees, even if you set up your LLC in another state, so you’ll likely end up paying more in fees rather than less. (Wherever you file, the initial formation document is pretty simple. It usually includes:
· Corporate name
· Business purpose (sometimes a general statement)
· Principal address
· Registered agent name and address
· Number and type of authorized shares
· Incorporator(s) name(s) and signature(s)
· Sometimes the initial directors
As with most business filings, you can do this initial filing yourself or pay someone to do it for you (typically a lawyer). To be clear, you can figure out the issues on your own. Nolo Press offers law guidance books for laypeople that explain the various issues you’ll need to address. Chat GPT can offer insights as well, though, based on my own (fairly extensive) experience with Chat GPT and its hallucinations, I’d be wary of relying on it.
One big piece of setting yourself up as a corporation is knowing how to “follow the formalities” like having board meetings and keeping track of shares. Again, this is something you’d find addressed in a Nolo how-to-form-a-corporation book. In a nutshell, these are the key pieces:
Articles of Incorporation
This is a required document, filed with the Secretary of State to legally create the corporation.
Corporate Bylaws
These are the company’s written internal rules for governance (how directors are elected, meetings conducted, etc.). To be clear, you’re not required by law to have corporate bylaws, but without them you are subject to state laws applying a bunch of default rules about how the corporation is operated. You may or may not want to follow those state rules to govern your business. This is typically an area where you would confer with a business attorney to decide what you want your corporate bylaws to contain. Corporate bylaws are not filed with the state but they can be critical for governance, especially if there are disputes, and for dealing with third parties, like banks, who may want to see the bylaws as a condition to opening a business account.
Initial Board Resolutions (a.k.a. Organizational Meeting Minutes)
In order to legally get the corporation up an running, the board needs to meet and pass key resolutions, typically:
Bylaws
Appointment of officers
Bank account authorization
Stock issuance terms
Stock Certificates and Stock Ledger
A corporation must issue stock to represent ownership. The board of directors authorizes the corporation to issue stock certificates to shareholders and to maintain a stock ledger to record ownership. Both pieces are especially important if you ever sell the company or want to raise capital.
Shareholder Agreement
A shareholder agreement is not legally required. If you are the sole owner of all the shares, then matters usually addressed by such an agreement, e.g., rules about transfer of shares, buyouts, rights of first refusal, will not be an issue. But if you transfer or sell shares to other people, then you’re going to need to set some rules, because by transferring shares you are giving up some of your governing control. Again, issues around agreements among multiple shareholders in a small corporation are generally handles by a business lawyer who can tailor such an agreement to the parties’ needs.
If you’re operating as a Limited Liability Company (S-Corp election)
Your first step is to form the legal entity. This is done by filing articles of organization (or some variation on that title) with one of the 50 states. As with a corporation, usually you’re going to want to file in the state you live and work in for all the same reasons cited above. Wherever you file, the initial formation document is pretty simple. It usually includes:
· LLC name
· Business purpose (sometimes a general statement)
· Principal office address
· Registered agent name and address
· Name and signature of organizer
The main document governing operation of a limited liability company is called an “operating agreement.” An operating agreement is signed by the LLC’s member or members and spells out key things about the LLC such as ownership structure and membership details; management and voting; capital contributions and distributions; meetings and record keeping; exit and dissolution Provisions. Most states do not require an LLC to have an operating agreement. If you’re forming a single-member LLC, then a simple agreement should suffice. If you’re forming a multi-member LLC, you’re going to want a more complex form because the moment you add another person into the mix you create the potential for conflict. Some banks will want to see the operating agreement when you apply for a bank account. And at a minimum, even if you’ve got a single member LLC, you want the operating agreement to spell out what happens if you’re incapacitated. Having an operating agreement also lends credence to your argument that you’re truly operating as a separate entity.
9. What Makes the Most Sense?
If your business is a “going concern,” meaning it’s bringing in enough money to pay you a salary and put savings away, the benefits of operating as an LLC that has elected S Corporation status are hard to argue with: Asset protection with far fewer operating requirements than a corporation; tax benefits exceeding those available to sole proprietors and most partnerships; flexibility in operations while clearly separating your home life from your business life.
10. Conclusion
Choosing the business form for your art business will of course involve a lot of considerations special to your way of showing up to do business. Hopefully this overview of some of the many matters you want to consider will help you think about the matter. Talking to your tax advisor, CPA, and legal counsel, is always advisable before embarking upon a new path or changing the one you’re on.