Two. Let’s Talk Business
In this chapter we’ll discuss the various types of business entities and how they’ll impact you, both personally and professionally. Make no mistake: as we discussed in the previous chapter, it takes more to be a professional photographer than just buying a camera.
What business type is best for you? A sole proprietorship, a partnership, an S-Corp, a C-Corp, or maybe an LLC? We’ll dive into each of the various types and break them down into an easy-to-understand decision tree that’s right for you.
These are things you have to consider sooner rather than later. These are decisions that will impact your income, taxes, business, and ultimately your liability. Don’t underestimate the importance of getting your business entity set up and running correctly right out of the gate.
It is without a doubt one of the most important decisions you’ll make for your business.
Make It Real
Everyone gets excited when they get that shiny new camera and they start taking pictures for the first time. Trust me, I know how it starts. First, maybe you are taking pictures of your family and friends. Then someone in your life makes the statement, “Hey, you should charge money” or better yet, “I need a photographer for my wedding. Can you do it?” And suddenly, your hobby has become a job.
But are you ready? What was once a fun hobby has now become a mission-critical task with responsibilities tied to it. Don’t get me wrong. I’m not trying to scare you away from being a professional, but if you’re going to do it, you have to adjust your way of thinking. You have to start thinking like a business. Now, where money is involved, there are risks and exposure for you both on a personal and a professional level. How are you going to mitigate that risk? Now is the time. Make it real and protect your business, your family, and your future.
Let’s explore the various types of businesses and how they are applicable to your potential new business. It’s very important that you make the right business type selection. Though it can be changed, that change is not without significant cost.
Types of Business Entities
There is a never-ending list of business types to consider. This can be truly overwhelming. Hopefully, I can shed some light here and break it down in a way that’s easy to understand.
Most people don’t realize that under most circumstances their business entity is managed and incorporated at the state level. Though the federal government does have some classifications, in most cases, these are banks and other financial institutions that are incorporated at the national level. For our purposes, we’ll focus on the state level and the various business types offered at that level.
Keep in mind, this is meant as a general guide for you. Use it to help inform your decision process and to help you understand your options. (And be sure to check out your options online with great resources like entrepreneur.com and business.usa.gov.) No matter what you decide, I highly encourage you to consult with your accountant to better understand how your setup will impact your business and personal finances. Also, each state has its own rules for creating each of these entities, so be sure to check with your state for more information.
Here are the business designations we’ll explore:
• Sole Proprietorship
• DBA
• Partnerships: General Partnership, Limited Partnership, LLC
• Corporations: S Corporation and C Corporation
Sole Proprietorship
Definition
The sole proprietorship is the simplest business form under which you can operate a business. The sole proprietorship isn’t a legal entity. It simply refers to a person who owns the business and is personally responsible for its debts. A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name, such as Salvatore Cincotta Photography (see the DBA section a bit later). The fictitious name is a trade name; it doesn’t create a legal entity separate from the sole proprietor owner.
The sole proprietorship is a popular business form due to its simplicity, ease of setup, and nominal cost. A sole proprietor need only register his or her name and secure local licenses, and the sole proprietor is ready for business. A distinct disadvantage, however, is that the owner of a sole proprietorship remains personally liable for all the business’s debts. So, if a sole proprietor business runs into financial trouble, creditors can bring lawsuits against the business owner. If such suits are successful, the owner will have to pay the business debts with his or her own money.
The owner of a sole proprietorship typically signs contracts in his or her own name, because the sole proprietorship has no separate identity under the law. The sole proprietor owner will typically have customers write checks in the owner’s name, even if the business uses a fictitious name. Sole proprietor owners can, and often do, commingle personal and business property and funds, something that partnerships, LLCs, and corporations cannot do. Sole proprietorships often have their bank accounts in the name of the owner. Sole proprietors need not observe formalities such as voting and meetings associated with the more complex business forms. Sole proprietorships can bring lawsuits (and can be sued) using the name of the sole proprietor owner. Many businesses begin as sole proprietorships and graduate to more complex business forms as the business develops.
Tax Implications
Because a sole proprietorship is indistinguishable from its owner, sole proprietorship taxation is quite simple. The income earned by a sole proprietorship is income earned by its owner. A sole proprietor reports the sole proprietorship income and/or losses and expenses by filling out and filing a Schedule C, along with the standard Form 1040. The “bottom-line amount” from Schedule C is transferred to your personal tax return. This aspect is attractive because business losses you suffer may offset income earned from other sources.
Again, consult with your accountant to fully understand the tax implications of this form of business.
Legal Implications
Sole proprietors are personally liable for all debts of a sole proprietorship business. This potential liability can and should be alarming to you. Assume that a sole proprietor borrows money to operate but the business loses its major customer, goes out of business, and is unable to repay the loan. The sole proprietor is liable for the amount of the loan, which can potentially consume all personal assets.
Imagine an even worse scenario: the sole proprietor (or even one of your employees) is involved in a business-related accident in which someone is injured or killed. The resulting negligence case can be brought against the sole proprietor owner and against their personal assets, such as their bank account, retirement accounts, and even their home.
To make it even more real, think about an event you might be working and the real possibility of someone injuring themselves by doing something as simple as tripping over your lightstand. You’re now personally responsible and liable.
Pros
• Owners can establish a sole proprietorship instantly, easily, and inexpensively.
• Sole proprietorships carry little, if any, ongoing formalities.
• A sole proprietor need not pay unemployment tax on himself or herself.
• Owners may freely mix business or personal assets.
• Owners maintain control of all decision making.
• No special tax forms are required for your business.
Cons
• Owners are subject to unlimited personal liability for the debts, losses, and liabilities of the business.
• Owners cannot raise capital by selling an interest in the business.
• Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value.
• Sole proprietorships provide less of a professional appearance than other types of businesses.
• You could have difficulty in raising financing or capital for ongoing business operations or growth. This is due to the fact that the business has little or no assets.
My Thoughts
While on the surface this may appear to be the easiest and simplest form of business entity there is to set up, it’s not without significant risk.
In most cases, you can be set up and running in no time at all. However, the liability concerns here are almost impossible to ignore. For us, when we started our business, I was concerned about something I felt was a reality. Is it possible for someone to trip over my gear bag at an event? I think that’s a realistic possibility. And as such, I don’t want to risk my personal assets and that of my family’s future. My home, my retirement, future earnings, etc.—all this would be put at risk.
For us, the ease of setup and tax reporting wasn’t enough to offset the huge personal risk we’d have to absorb. And it’s because of this that we didn’t opt for a sole proprietorship for our business.
Doing Business As (DBA)
Definition
This is the operating name of your company, which differs from the legal name. Certain states require a filing of the fictitious name to protect consumers conducting business with this entity. If you’re starting a sole proprietorship or a partnership, you have the option of choosing a business name or DBA (“doing business as”) for your business. If you want to operate your business under a name other than your own (for instance, Sal Cincotta doing business as “Salvatore Cincotta Photography”), you may be required by the county, city, or state to register your fictitious name. (Note: No fictitious business name may include the words “corporation,” “Inc.,” “incorporation,” or “Corp.” unless it’s a corporation registered with the Secretary of State.)
The processes of filing for a fictitious name vary among states. In many states, all you have to do is go to the county offices and pay a registration fee to the county clerk. In other states, you also have to place a fictitious name ad in a local newspaper for a certain amount of time. The cost of filing a fictitious name notice varies so be sure to check with your local papers—generally, this is inexpensive. Your local bank may also require a fictitious name certificate to open a business account for you. In most states, corporations don’t have to file fictitious business names unless the corporations do business under names other than their own. Incorporation documents have the same effect for corporate businesses as fictitious name filings do for sole proprietorships and partnerships.
Tax Implications
The tax implications are the same as the business legal type. So, if you’re a sole proprietor you’d have the same tax implications. The same would be true if you were a corporation DBA “fictitious name.”
My Thoughts
This type can be best if you’re creating multiple studios or lines of business. For example, let’s say you are a family or senior portrait photographer who also wants to explore boudoir photography. This would be a great way to keep the same legal formation of your company but create a distinctive name for your new venture that is separate from your main business focused on families. If my main business name is Salvatore Cincotta Photography, I could create legal paperwork with Salvatore Cincotta Photography DBA (doing business as) Upscale Boudoir. Doing so allows me to open a checking account and other items under that new business’s pseudo name.
Partnerships
Definition
Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, whereas the limited partners serve as investors only; they have no control over the company and aren’t subject to the same liabilities as the general partners. Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.
Tax Implications
At tax time, the partnership must file a tax return that reports its income and losses to the IRS. In addition, each partner reports his or her share of income and losses on Schedule K-1 of Form 1065.
Legal Implications
Personal liability is a major concern if you use a general partnership to structure your business. Like sole proprietors, general partners are personally liable for the partnership’s obligations and debts. Each general partner can act on behalf of the partnership, take out loans, and make decisions that will affect and could be binding on all the partners. Keep in mind that partnerships are also more expensive to establish than sole proprietorships because they require more legal and accounting services.
Pros
• Partners share the cost of startup.
• Partners share the responsibilities.
• Partners share the risk.
• One of the major advantages of a partnership is the tax structure. A partnership does not pay tax on its income but “passes through” any profits or losses to the individual partners.
Cons
• Partners share the profits.
• The lack of total control of the business or assets can lead to internal disputes about the direction of the company and ultimately end in the dissolution of the business.
• Like sole proprietors, general partners are personally liable for the partnership’s obligations and debts.
• Partnerships are more expensive to establish.
• A risk of dissolution of the company exists with the loss or removal of a partner.
My Thoughts
I like to control my own destiny, so the thought of a partnership isn’t one that’s appealing to me, especially when it comes to a photography business. These types of businesses are typically tied to a single person’s vision, and I wouldn’t want someone else to be able to control that vision or share in the success of my vision unless they were bringing something very powerful to the table that I couldn’t live without.
If you decide on this route for your new venture, be sure you draft a partnership agreement that details how business decisions are made, how disputes are resolved, and how you’d handle a buyout.
Limited Liability Companies (LLC)
Definition
A modern corporation’s heavy administrative burden is a remnant of the more traditional and formal legal system under which corporate law was cultivated. The LLC changed all that.
Limited liability companies (LLCs) have been around since 1977, but their popularity among small-business owners is a relatively recent phenomenon. The LLC offers the liability protection benefits of the corporation without the corporation’s burdensome formalities. This simplicity has made the LLC an instantly popular business form for smaller companies.
LLCs are the favorite choice for small businesses with between one and three working owners who don’t plan to grow the business significantly and don’t expect to raise significant amounts of cash. But as the number of owners grows, the corporation often becomes a more attractive choice as a business form.
An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations. LLCs were created to provide business owners with the liability protection that corporations enjoy without the double taxation. Earnings and losses pass through to the owners and are included on their personal tax returns.
This sounds similar to an S corporation—discussed in a moment—except an LLC offers small-business owners even more attractions than an S corporation. For example, there’s no limitation on the number of shareholders an LLC can have, unlike an S corporation, which has a limit of 75. In addition, any member or owner of the LLC is allowed a full participatory role in the business’s operation; in a limited partnership, on the other hand, partners aren’t permitted any say in the operation.
Unlike corporations (and like partnerships), LLCs don’t have perpetual life. Some state statutes stipulate that the company must dissolve after 30 or 40 years. Technically, the company dissolves when a member dies, quits, or retires.
Pros
• The members enjoy limited liability, which means they’re personally protected from any liability of the LLC and successful judgments, as well as from the LLC itself.
• The members’ share of the bottom-line profit of an LLC isn’t considered earned income, and therefore isn’t subject to self-employment tax.
• As a member, you can contribute capital or other assets to the LLC, or loan the LLC money to put dollars or value into the business. You can take dollars out by taking a repayment of your loan (plus interest), a distribution of profit, or a guaranteed payment.
Cons
• Each member’s pro-rata share of profits represents taxable income—whether or not a member’s share of profits is distributed to him or her.
• The managing member’s share of the bottom-line profit of the LLC is considered earned income, and therefore is subject to self-employment tax.
• For companies that wish to pursue venture capital, accumulate a large number of shareholders, and/or eventually pursue an initial public offering, the LLC isn’t an appropriate alternative to a corporation.
• Members of an LLC aren’t allowed to pay themselves wages.
My Thoughts
Potentially, I like the LLC as an option. The only concern I’d have is the life span of the company if one of the members quits, retires, or dies. And the fact that you wouldn’t be able to pay yourself wages does have significant tax implications. For the weekend warrior, I don’t think this is a good fit. It’s too complicated a structure to set up and maintain, and it hinders your ability to grow and profit from your company. There are better options out there, which we’ll discuss next.
Corporations
Definition
A corporation is created under the laws of the state as a separate legal entity that has privileges and liabilities that are separate from those of its members. There are many different types and forms of corporations; for our purposes we’ll explore one of the most popular among small business owners, an S corporation.
An important feature of a corporation is limited liability. If a corporation fails, shareholders may lose their investments and employees may lose their jobs, but neither will be liable for debts to the corporation’s creditors.
Despite not being natural persons, corporations are recognized by the law to have rights and responsibilities like natural persons (“people”). Corporations can exercise human rights against real individuals and the state, and they can themselves be responsible for human rights violations. Corporations are conceptually immortal, but they can “die” when they’re dissolved either by statutory operation, order of court, or voluntary action on the part of shareholders.
The S corporation is often more attractive to small business owners than a standard (or C) corporation. That’s because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there’s just one level of federal tax to pay versus a C corporation, where the business is taxed along with the distributions to its shareholders.
A corporation must meet certain conditions to be eligible for a subchapter S election. First, the corporation must have no more than 75 shareholders. In calculating the 75-shareholder limit, a husband and wife count as one shareholder. Also, only the following entities may be shareholders: individuals, estates, certain trusts, certain partnerships, tax-exempt charitable organizations, and other S corporations (but only if the other S corporation is the sole shareholder).
Pros
• Income from the profits or losses of the company are passed to the shareholders, who in turn allocate those figures on their personal income tax returns.
• The corporate entity generally shields shareholders and directors from the debts and obligations of the company.
• S corporations can be used to own property such as real estate or other assets due to S corporation tax advantages and for protection from liability.
• If an owner dies or sells his interest, the corporation continues to exist and do business unless formally dissolved. This is one of the S corporation benefits over sole proprietorships and most partnerships, which dissolve upon the death or sale of an owner, limiting the salability of these types of businesses.
• Tax advantages can be realized through distributing money from the S corporation to shareholders-employees as profits rather than as salary. It stems from the fact that profits aren’t subject to the over 15 percent in Social Security and Medicare taxes that salaries are.
Cons
• S corporations are subject to many of the same requirements corporations must follow, and that means higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions.
• The legal and accounting costs of setting up an S corporation are also similar to those for a standard corporation. And S corporations can only issue common stock, which can hamper capital-raising efforts.
• Each shareholder must be a U.S. citizen or resident.
• S corporations can never have more than 75 shareholders.
• Profits or losses must be distributed in direct proportion to ownership interest.
My Thoughts
This is the best of both worlds. You get to limit your personal liability via the corporate mechanism and still enjoy the profit and losses on your personal tax returns, allowing for a lower tax rate. For these reasons, we chose this type of entity for Salvatore Cincotta Photography. Not to mention, if we ever wanted to sell our business, we can do that without dissolving the business. This is key, and it matched with our overall business plan for the business.
Just to give you perspective, when we first opened the doors of our studio, we were set up as a sole proprietor, but we quickly realized that our personal assets were highly exposed. Within the first six months we made the investment to become an S-Corp. Trust me when I tell you, it only takes one mistake to run the risk of losing everything. For the $600–$1,000 it takes to become an S-Corp, there’s no reason not to.
In the beginning it was just Taylor and me as the principals and employees. Today, we have four employees within the Salvatore Cincotta Photography company: Taylor and myself along with two full-time employees. We anticipate that number will grow over the next 12 months; being an S-Corp, we are well poised for growth.
Whatever you decide, be sure to talk to a tax and legal professional. They’ll help you balance your vision with the long-term financial and legal implications. In the next chapter, we’ll explore your overall business plan, and that might influence your decision on which business type is right for you.
