Whether you’re planning to start a new business in music, or make money as an artist, it’s helpful to know how you’re going to structure your company for both tax and liability purposes. If you don’t plan accordingly, you may end up accruing unnecessary costs that are otherwise relatively easy to avoid. In this article, I’ll show you the major pros and cons of each possible legal structure for your business to give you a better idea of which one might suit you best.
Sole Proprietorships are essentially one-owner businesses that have not filed the papers to become a corporation or limited liability company (more on those later). The only requirement to set up your business as a sole proprietorship is to declare yourself as such when filling out the normal business registration requirements with your state, city, county, etc. While this type of legal structure is typically easy to set up and doesn’t require any fees on top of minimal taxes, you are personally liable for any debts your business can’t pay. Sole proprietorships also have “pass-through taxation,” which means that all business-related taxes “pass through” the business itself, making the owner solely responsible for paying and reporting them on his/her individual tax return.
Partnerships are the same as sole proprietorships, only there is more than one owner. Liability in partnerships may vary depending on how you and your partners choose to set it up, but in general partnerships (the default type of partnership), each partner is fully personally liable for all business debts. Alternatively, partnerships can choose to have “limited partners” who are freed of the personal liability, but have little control over business decisions and operations. This is possible as long as there is at least one general partner.
Limited Liability Companies or (LLCs) are separate entities formed by the business owner(s) that offer the pass-through taxation capabilities of sole proprietorships and partnerships, but relieve the owner(s) of most personal liability. The only instances when owners are personally liable are for personal guarantees on loans, unpaid federal and state tax debts, intentional or negligent acts, fraud or other illegal behavior, and failure to treat the LLC as a separate entity from its owners (essentially not opening a separate checking account, getting a separate tax ID number, etc.). While LLCs do offer pass-through taxation, owners can choose to have them taxed separately like a corporation. This is typically done when the company starts making enough profit for the owners to keep some of it in the business, since corporations are taxed at lower starting rate than individuals. To form an LLC, you need to file an Articles of Organization with your Secretary of State or other LLC filing office, and execute an operating agreement, which governs your LLC’s internal operations. You may also need to pay hefty filing fees and/or annual dues depending on which state your company is based out of.
Corporations relieve owners of the same level of personal liability as LLCs do, and additionally have the capabilities of issuing public or private stock. C Corporations are taxed separately from their owners or shareholders, while S Corporations are pass-through entities like partnership-classified LLCs. It’s also worth noting that S Corporations are subject to various regulations in ownership, profit/loss allocation, corporate meetings and recordkeeping, and tax treatment of debt, that do not apply to LLCs. For this reason, relatively few businesses are organized as such nowadays. Forming a corporation is a very similar process to forming an LLC, only you additionally need to take specific corporate actions such as adopting bylaws, issuing stock, and maintaining records of director and shareholder meetings.
So how do you know which type of legal structure is best for you?
As a musician or small business, you want to take a look at what types of activities you’re engaging in. Musicians who earn a living playing small local restaurants typically don’t have to worry about incurring any financially catastrophic expenses, and probably don’t have the funds to afford forming a separate entity anyway. On the other hand, if you regularly tour and play mid-sized venues, you’re engaging in riskier activity, as audience members can sue if they’re seriously injured at one of your performances. In that case, you may want to consider forming an LLC to protect yourself from such costly lawsuits (and purchasing liability insurance as well, but that’s for another article). In fact, artists will sometimes have two separate entities—one for touring and one for all other activity—so as to keep any touring-related lawsuits from dipping into royalties and other income streams.
While some artists do form corporations, it is generally only necessary if you want corporate stock structure. That goes for small businesses too. An additional thing to keep in mind is that corporations who issue stock publicly play a whole different ballgame as far as taxes and regulations go, and since most startups don’t go public for quite a while, those rules won’t be addressed here.
For a more in-depth look at company legal structures, check out Peri H. Pakroo’s The Small Business Startup Kit, as well as the recommended readings inside.
The purpose of this article is to foster an open dialogue and not to establish firm policies or best practices. Needless to say, this is not a substitute for legal advice. In any particular case, you should consult with lawyers experienced in the field you are in and licensed within your state. Depending on your specific situation, answers other than those outlined in this blog may be appropriate.