Visual artists are more than three times as likely as the general U.S. workforce to be entrepreneurs and start an art business. A Statistical Report from the National Endowment of the Arts showed that more than 34% of artists and musicians are self-employed, versus 9% of the general population. Fine artists, art directors, and animators are the most entrepreneurial, with 55% being self-employed. Photographers trail only slightly at 46%, while designers clock in at about 24%. Altogether, about 375,000 visual artists claim to be self-employed, yet a surprising number of them run their art business without a corporate structure that protects them from personal liability.
Should an artist without a corporation have legal or financial issues related to their art business, creditors can force them to liquidate personal assets, such as their homes or cars, to pay debts, whereas, with a corporation, those personal assets would be protected. Basically, the idea is that since the corporation is deemed a “person,” it gets in trouble, but the owner doesn’t.
If your art business is sued over a contract dispute and you lose, the winner can only get money from the company’s assets, not yours. If someone comes to your studio and falls, breaking their leg, they may sue for their injuries, but they can only sue the company. You are protected.
Incorporating has a number of other benefits, such as lower taxes or being able to issue stock to investors. However, it is not all roses and kittens. These corporate structures also have their downsides. Let’s take a look at some of the most popular to see which corporate entity is right for your art business.
Structuring an Art Business
The are several types of business structures available in the United States, each with its own advantages and disadvantages. The most popular are:
- Sole Proprietorship
- Corporation (C-corp)
- Subchapter S (S-Corp)
- Limited Liability Company (LLC)
However, we can further divide the company structures into two camps: Corporations (C-Corp, S-Corp, and LLC) and Non-Corporations (Sole Proprietorships and Partnerships). The major difference between the two is that corporations protect owners from being personally responsible for things that the company does, assuming those actions are legal. When a corporation is formed for your art business, a new legal entity is created.
Sole Proprietorship is a type of business entity that is owned and run by one natural person and in which there is no legal distinction between the owner and the business. They are very popular due to their simplicity.
In fact, the majority of people with an art business are sole proprietors primarily because you don’t have to take any action to be a sole proprietor. If you open a business and don’t incorporate, then you are automatically a sole proprietor. You can have a real business name and a business bank account, and you can employ people, but the company is not a separate business entity. It does not have its own tax form. If you earn a profit, the money is added to any other income you have, such as your spouse’s income, if you file a joint tax return.
The sole proprietorship doesn’t pay any payroll taxes on income, withhold income tax, file employment tax returns, or pay state or federal unemployment taxes. Nor do you need to be covered by workers’ compensation insurance. But you do have to pay Medicare and Social Security taxes at the end of the year.
The downside is that the sole proprietorship, by virtue of the business not being a separate entity, cannot protect you from actions you took through the company. That means you have unlimited personal exposure to anything that might go wrong. If the business is sued, then your personal assets may be at risk. In some states, that risk may be mitigated, but only partially. For example, in Florida, the Homestead Act limits the ability of creditors to force you to liquidate your main home. However, in most cases, the risk is yours. Company assets and personal assets are the same, so company debt is personal debt.
Partnerships are similar to Sole Proprietorships in that your art business is not a separate entity. In most cases, the default state regulations treat each partner as a full owner, with the right to enter into contracts on behalf of the company or even liquidate company assets without regard to the desires of the other partners. As well, the partners are personally liable for business debts.
Partnerships can also be problematic when the partners are not getting along or have differing ideas on the future direction of the company since each partner has full control over company decisions. For example, let’s say one of two partners decides to leave the business and wants to liquidate assets, like camera equipment, so he or she can take the cash. The liquidation would be hard to stop. Similarly, if your partner is spending too much company money on things you don’t think you need, it may be impossible to stop them. If your partner decides to sell his or her half of the business to someone that you don’t like, you would likely end up with a partner that you dislike.
To some extent, these issues can be mitigated through a Partnership Agreement, which sets the rules under which the business operates. The Partnership Agreement is just a contract between the partners. If you want this type of corporate entity, be sure to work with an attorney on any Partnership Agreement, as the attorney can recommend terms that should be included that can make things easier should there be a problem.
Unfortunately, a partnership agreement cannot alleviate each partner’s risk to their personal assets. Just as in the sole proprietorship, all the partners would have unlimited liability for the actions of their art business. Plus, all the partners could be personally on the hook for the actions of a single partner. That risk can be too high for some people, which is why many businesses choose to incorporate it as a means of reducing their personal liability.
Most of the big-name companies you know are C-corps (also known as an “Inc.”). Artrepreneur, Boeing, Walmart, Verizon, and Apple, are all C-Corps. The big advantage of C-Corps is personal liability protection.
Starting a company can be a risky proposition. Most startups fail due to any number of reasons in or outside of the company. For many would-be entrepreneurs, the personal exposure that might affect their families, such as losing a house should the business fail, is just too risky.
However, entrepreneurship is extremely important to a growing economy, especially one that is so focused on innovation, like the United States. To spur entrepreneurship, the U. S. government had to find a way to mitigate some of the financial danger associated with forming a new business. So, the corporation was born.
As discussed earlier, Corporations are distinct entities with the power to make agreements, sign contracts, and even commit crimes. Owners can’t be blamed for the corporation’s actions, despite the fact that they might be the ones who determine the actions. Corporate principals have no personal liability for corporate debts, breaches of contract, or personal injuries to third parties caused by the corporation, employees, or agents. Creditors can only target corporate assets.
However, liability protection is only available to those who follow the rules. When rules are flaunted, creditors might be able to pierce “the corporate veil” and target the responsible shareholders. For example, commingling personal funds with your art business funds, such as using the company bank account as your personal bank account, would likely pierce the corporate veil, allowing creditors to grab your personal assets. Committing illegal acts, such as fraud, also negates any personal protection. So, if you are a corporate officer, always be sure to talk with an accountant to ensure that you don’t inadvertently do something that allows the corporate veil to be pierced.
Additionally, a C-Corp has the added advantage of being able to issue stock. Almost all public companies on the myriad of stock exchanges are C-corps since the shares are all publicly traded. Also, C-Corp is not limited to a single type of stock but can issue different classes of stock, each with its unique rules.
Common and Preferred are the two main stock types. Common stock is what most people normally think of when buying stock on stock exchanges. Common stock represents ownership in a company with the stock value increasing with the company’s success. Shareholders can also receive a portion of the company’s profits as a dividend.
Preferred stock shareholders, on the other hand, are usually guaranteed a fixed dividend forever. Also, if the company goes out of business and liquidates its assets to pay off creditors, Preferred shareholders are paid off before the common stock shareholder.
On the downside, C-corps are much more difficult to manage from a legal and tax perspective than any of the other models, so for small entities with limited resources, C-corps are not the preferred entity type. Ownership control is based on the class and the amount of stock a person owns, which means that if a lot of stock is outstanding, the company owner who may have the most individual shares could find that another shareholder can accumulate enough shares to gain control over the company.
Corporations must also pay quarterly taxes, so can’t keep those taxes in the bank and use them to minimize the impact of losses in the next quarter. For an art business, where sales can fluctuate dramatically each quarter, paying quarterly tax payments can really hurt.
C-Corps also have a number of time-consuming procedural requirements, such as holding shareholder meetings where officers are elected, recording meeting minutes, and preparing an annual report that must be filed with the state.
The most problematic aspect of a C-Corp, however, is the potential for double taxation. Here is how it works.
In one scenario, assume that you are a designer and your art business generates $50,000 in gross revenue. At the end of the year, all company expenses are paid, and the remainder is taken as salary by the owners, leaving no money in the company. The company then pays no income tax because it has no profit. Taxes are instead paid by the owners/shareholders as income tax on their salary.
However, if the owners decide to leave money in the company for any number of reasons, such as future growth and development or to have cash on hand to mitigate slow months or clients late paying bills, the remaining capital is considered income and the company pays taxes on it. Now assume that the money retained in the company after the taxes are paid, isn’t ultimately used for any expenses so the owners take it as a bonus at the end of the next year. The owners will pay taxes on the bonus as personal income but the company already paid taxes on it in the prior year. So the money was effectively taxed twice, once as corporate profit and once as personal income.
As you can imagine, for a small art business with only a handful of people, or even a single owner, the requirements of a C-Corp can be too burdensome. So, the Federal and State governments created hybrid corporate forms, such as the Subchapter S and Limited Liability Corporations (LLC), that make it easier for small businesses to manage and still receive personal liability protection
Subchapter S Corporation
An S-Corp provides many of the same benefits as a C-Corp without double taxation. S-Corps allow the shareholders to “Pass-through” the corporate income as profit and loss on their individual tax returns rather than a corporate tax return. That also means no quarterly taxes, as in the C-Corp. And just like the C-Corp, the company can attract investors through the sale of shares of stock. Think of an S-Corp as C-Corp lite. In fact, when the business initially files for corporation status, it is classified as a C-Corp. Once completed, you can file for S-Corp status if you meet the additional requirements, namely, that you have fewer than 100 shareholders, that you maintain only one class of stock, and that the owners are U.S. citizens or resident aliens. For a small art business, these are fairly easy requirements to fulfill.
As well, since an S-Corp is a corporation, it provides liability protection for the shareholders. S-Corps have an additional advantage when it comes to paying Social Security and Medicare taxes. An S-Corp does not have to pay Social Security and Medicare taxes on distributions (dividends), only on normal salaried income. The larger the distribution, the fewer Social Security and Medicare taxes you’ll end up paying. The S-Corp is the only business entity type that allows this. However, not all corporate revenue can be a corporate distribution. A shareholder/employee must be paid for his or her services with a reasonable salary, which is subject to Social Security and Medicare taxes.
On the other hand, while you may reduce Social Security and Medicare taxes, there are additional expenses associated with an S-Corp, such as workers’ compensation and unemployment insurance coverage, depending upon the State. Some states also require minimum annual state taxes, no matter how much money the company earns. For example, California requires an $800 annual minimum tax. So the tax savings may not be enough to offset the additional expenses.
One other point on distributions, they are allocated based on the number of shares outstanding (remember, there is only one type of stock). So if the company is distributing $1000 and you have 500 of the 1000 shares issued, then you get $500. If there are ten other people with 50 shares each, they each get $50.
The Limited Liability Company (LLC)
To wrap up the different corporation types, we come to the LLC. LLCs combine the personal liability protections of a C-Corp or S-Corp with the simplified tax structure and filing requirements of a partnership or sole proprietorship. An LLC is identical to an S-Corp in so far as a company’s profits and losses flow through to the shareholders’ personal tax returns. No corporate tax return is required, which also means that you can avoid double taxation. Also, unlike the S-Corp, there is no residency requirement. Owners need not be U.S. citizens or permanent residents. And like any other corporate form, there is limited liability for business debts and obligations. Finally, the administrative requirements are minimal as compared to a C-Corp.
The main difference between an LLC to the other corporate forms is that LLCs do not issue stock. There are no shareholders nor shareholder meetings or required elections. There is no Board of Directors that oversee the policy and direction of the company. Instead, LLCs have Members and Managers. Unlike Common stock shareholders, Members of an LLC participate in the management of the company unless the members agree to select a manager-managed LLC, where one person makes the decisions. Typically, however, LLC members actively participate, making decisions and offering input on the company’s direction. However, member decisions are decided by a majority.
Additionally, most states do not restrict ownership, and so members may include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members. However, being a fairly new type of entity structure, there is a wider variety of regulations among the various states. For example, not all states permit “single member” LLCs, those having only one owner.
From a tax perspective, an LLC with at least two members is classified as a partnership for federal income tax purposes unless it affirmatively elects to be treated as a corporation. And an LLC with only one member is treated as a sole proprietorship unless it affirmatively elects to be treated as a corporation.
On the other hand, like with a Partnership Agreement, much of the default operating procedures can be determined by the owners and memorialized in the Articles of Incorporation or Operating Agreement. There are no state requirements as to their content. For example, since control among the owners isn’t based on the stock, the voting rights and responsibilities for each manager, member, or member type are written into the Operating Agreement. Even the distribution allocations are determined by the terms of the Operating Agreement. So it is critical to think through how you want the company to run and what happens if members want to leave or the company fails. One thing to note, if you do intend on receiving investment from traditional investment groups, most will want stock, so forming an LLC is probably not the best approach. However, if you do have an LLC and then want to change to a C-Corp later, there are myriad ways to make that happen.
For those in the arts, especially self-employed or a solo art business, the hybrid structures, S-Corps, and LLCs should be considered seriously, but given the variations among states, one may be preferable to the other depending upon location. As well, your business needs might have particular aspects that would be better served by a C-Corp or a partnership. Also, you don’t have to open your corporation in the State in which you live. You can take advantage of the laws of other States, such as Delaware, which is very pro-corporation. However, and I can’t stress this point enough, do not try to for the corporation yourself. While there are lots of sites that allow you to form companies online that may be inexpensive and seemingly easy to use, the myriad of rules and regulations need the consultation of an expert. Make corporate formation a high priority. You don’t want to find yourself in a situation from which you and the business cannot recover.
What corporate structure works best for your art business? Let us know in the comments below.