As your side hustle starts to grow, it is important understand how the structure of your business affects you personally. It’s not just about the bonus income — it’s about how you pay taxes and whether you are personally liable for anything that goes wrong. There are benefits and drawbacks to each type of entity, so let’s talk about them.
There are four basic types of business structures:
Sole proprietorship
Partnership
Limited Liability
Corporation
A sole proprietorship is the default setting. If you start selling scarves that you knit out of your home, then you have a sole proprietorship — even if your business doesn’t have a name. The income from your sales should be reported on your income tax return, and the costs of doing business (for example, the cost of the yarn and needles) are deducted. This is as simple as it gets. You don’t even need to register with the State of Washington. But — and this is a big drawback — you are personally liable if something goes wrong. If someone decides to sue you, your loss is not limited to the income and expensive of your scarves. Rather, everything you own — your house, your car, your bank accounts, even if joint with your spouse — are all available to satisfy the person you have wronged.
Partnerships are very similar — two or more people (usually not married to each other — the only person who can co-own a sole proprietorship is a married couple) agree to contribute money, skills, or labor to a business, and each partner shares the profits, loss, and management of the business. Like a sole proprietor, however, each partner is personally liable for any debts. There is also no requirement to file with the Washington State Secretary of State.
There is a partnership variant called a Limited Partnership, where the agreement between the partners also limits their liability to the value of their investment. This kind of partnership must register with the Washington State Secretary of State.
Limited Liability organizations can include Limited Liability Partnerships (LLP) and Limited Liability Companies (LLC). For businesses requiring licensing, such as doctors and lawyers, the Professional Limited Liability Company/Partnership is required (PLLC, for example). These entities protect the investors from neglience on the part of their partners, and additionally limit liability to the value of their investment. All of them must file with the Washington State Secretary of State. Partnerships will always require at least two owners, but an LLC can be owned by one or more people, which makes it an ideal alternative to sole proprietorships — so long as the business is not banking or insurance (which cannot be LLCs). Limited Liability Companies may elect whether to be taxed as a pass-through entity (like a sole proprietor) or like a corporation (and you should talk to your accountant about which tax structure you want, as it depends on your current and projected revenue and expenses).
Corporations are complex business structures. Legally, they exist separate from the people who own them, and they are run by a board of directors on behalf of the owners (who are called shareholders). Corporations file their own taxes, separate from the individuals who own the corporation, and the owners are almost never held responsible for the liabilities and debts of the corporation. You must file with the Washington State Secretary of State to form a corporation.
Nonprofit corporations are just that — corporations. The first step in seeking exempt status is to form a corporation with a nonprofit purpose (as opposed to a for-profit purpose). They are structured in the same way: a board of directors runs the organization on behalf of the… well, public (or membership). Nonprofits are not owned by shareholders, but are considered to be “owned” either by the public or by members of the organization.