When you start a side hustle, one of the initial critical decisions you must make is about the legal structure your business will take. Given the simplicity and low overhead, it can be tempting to continue as a sole proprietor. However, as your business grows, it might be worth considering more formal structures, such as forming a Limited Liability Company or LLC.
Forming an LLC can offer numerous benefits, such as limiting your personal liability, offering tax advantages, enhancing your professional image, and potentially giving you better access to business credit and loans. However, forming an LLC also comes with its own costs and complexities. This article will delve into these points in more detail to help you determine whether starting an LLC for your side hustle is the right move.
Advantages Of Forming An LLC
Liability Protection
One of the primary advantages of forming an LLC is the protection it offers to the owner's personal assets. In a sole proprietorship or a general partnership, there is no legal distinction between the owner(s) and the business. If the business were to be sued or incur substantial debts, the owner's personal assets (like their home, personal bank accounts, or car) could potentially be at risk.
Conversely, an LLC stands as a unique legal entity that is independent of its owners. This independence establishes a safeguard, frequently referred to as the “corporate veil,” which differentiates between the owner's personal assets and those of the business. In scenarios where your LLC faces a lawsuit or has an outstanding debt, only the assets under the business's name would usually be susceptible to risk. This can provide peace of mind, especially in industries where litigation or business debt is a significant risk.
However, it's crucial to note that this protection isn't absolute. There are circumstances, such as fraudulent or illegal activities or not adequately maintaining the separation between personal and business finances, where owners may still be personally liable (a concept called “piercing the corporate veil”). So, it's not just about forming an LLC but also about how you operate it.
Access To Business Credit And Loans
As a legally distinct entity, an LLC can build its own credit history separate from the owner's personal credit. This separation can help the business access more business credit or larger loans than the owner could access based on their personal credit alone.
Over time, having access to larger lines of credit or loans can help your business grow and expand. It could enable you to make significant investments in equipment, inventory, or marketing that can take your side hustle to the next level. It can also be helpful in weathering periods of low cash flow or other financial challenges.
However, especially for new LLCs, lenders often still require a personal guarantee from the owners. This requirement means that if the business defaults on the loan, the owners are personally responsible for repaying the debt. Over time, as the business builds its credit history and financial stability, it may be possible to obtain loans without a personal guarantee.
Registered Agents
If you've decided to form an LLC for your side hustle, another important question arises that you need to ask yourself: should I be my own registered agent for an LLC?
A registered agent is an individual or a business entity appointed to receive crucial tax and legal documents for your LLC. This role encompasses the receipt of legal notifications, such as lawsuit notices (service of process), governmental correspondences including annual report reminders, and communications from the IRS.
As the owner of an LLC, you have the option to serve as your own registered agent. However, before you decide to take on this role, it's essential to understand what it involves and consider the pros and cons. The registered agent needs to be available during standard business hours at a physical address (not a P.O. box) in the state where your LLC is registered. This requirement can be challenging if you travel frequently or work irregular hours.
Tax Flexibility
Tax treatment is another area where LLCs offer considerable advantages. By default, the Internal Revenue Service (IRS) treats an LLC as a “pass-through” entity for tax purposes. This treatment means that the business itself does not pay any income taxes. Instead, the profits and losses of the business “pass-through” to the owners, who report this income or loss on their individual tax returns.
The pass-through taxation structure offered by an LLC can streamline your tax filing procedures and circumvent the problem of “double taxation” commonly experienced by corporations. In the case of corporations, profits are initially taxed at the business level, and subsequently, when these profits are shared as dividends, they are taxed again on the shareholders' individual tax returns. The pass-through structure of an LLC helps to avoid this double layer of taxation.
However, an LLC also offers flexibility in how it's taxed. If it's beneficial, an LLC can choose to be taxed as a corporation. Corporate taxation can lead to a lower overall tax burden in certain situations, especially with high-earning businesses. This complex area depends heavily on your specific circumstances, and you should consult with a tax professional to understand the potential benefits and drawbacks.
Professional Image
Creating an LLC can enhance your side hustle's credibility and professional image. It demonstrates your commitment to your business, which can inspire trust and confidence in your clients or customers. This can be particularly valuable in industries where there's a lot of competition, as it could make your business stand out.
Adding the “LLC” suffix to your business name can also create a perception of size and stability. This perception can give you an edge when negotiating contracts, attracting high-value clients, or even when pitching your products or services to large corporations.
Administrative Costs And Complexities
Initial And Ongoing Costs
While forming an LLC offers many benefits, it also comes with costs. There are usually fees associated with filing the necessary paperwork to form an LLC. These fees vary by state. There may also be additional costs for related tasks like creating an operating agreement or obtaining a business license or permit.
In addition to the initial costs, there are also ongoing costs to consider. Many states require LLCs to file annual reports and pay a filing fee or franchise tax. The cost of these requirements varies widely by state, but they can add up to several hundred dollars per year.
It's also essential to consider the potential cost of hiring professionals to help set up and maintain your LLC. For example, you might want to hire a lawyer to help with creating your operating agreement or a tax professional to advise on your tax structure. While these professionals can add to your costs, they can also save you time and help you avoid potential legal or financial problems down the road.
Paperwork And Recordkeeping
Running an LLC involves more paperwork and administrative tasks than a sole proprietorship or partnership. For example, to form an LLC, you typically need to file articles of organization with your state and create an operating agreement that outlines how your business will be run. You also need to obtain an Employer Identification Number (EIN) from the IRS, even if you don't have employees.
Once your LLC is formed, there are ongoing administrative tasks to manage. These tasks can include filing annual reports with your state, maintaining detailed financial records, and separating your personal and business finances. Depending on your business's complexity, you may also need to manage payroll, sales taxes, and other regulatory requirements.
While these tasks can be time-consuming, there are resources and tools available that can help. For example, many states offer online filing for annual reports, and numerous software tools are available for managing your financial records.
Complexity
Finally, it's crucial to consider the complexity of managing an LLC. The legal and tax aspects of running an LLC are typically more complex than a sole proprietorship or partnership. For example, you'll need to make sure you're following all state requirements for maintaining your LLC, such as filing annual reports and keeping your business finances separate from your personal finances.
You'll also need to navigate the complexities of your chosen tax structure. If you choose the default pass-through taxation, you must understand how to report your business income on your personal tax return. If you opt to be taxed as a corporation, you'll need to understand corporate tax laws and potentially manage more complex tasks like issuing stock or paying dividends.
You might need to hire professionals such as lawyers or accountants to manage these complexities. These professionals can ensure you comply with all legal and tax requirements and help you make informed decisions about your business. However, hiring professionals can add to your business costs, and it's important to factor these costs into your decision about whether to form an LLC.
Takeaway
Starting an LLC for your side hustle can offer many benefits, including liability protection, tax flexibility, a professional image, and access to business credit and loans. However, it also comes with costs and complexities that shouldn't be overlooked.
Your decision should be based on carefully considering your circumstances and future plans. It's important to consider your business's potential risks, financial situation, and ability to manage administrative tasks or hire professionals to assist.
While this article offers a broad overview of the considerations involved in forming an LLC, consulting with a lawyer or a business advisor is also beneficial. They can offer personalized advice based on your unique circumstances and help you navigate the process of starting your LLC. No matter what you decide, taking the time to think through these considerations will help you make an informed decision supporting your side hustle's long-term success.
