It’s so easy to start a side hustle. In fact, it’s effortless.
Any hobby will do. Pick something you love. If you can make money off of it, all the better.
You don’t even need to file any special paperwork. Everything can fit onto Schedule C of your personal tax return. There’s already a line for it on your 1040.
Doing business this way is called a “sole proprietorship.”
It may be easy to start and simple to incorporate into your tax filings, but there is a very real danger with relying on this form of business entity.
“A Sole Proprietorship provides no legal protection and the owner personally and the business are considered one and the same,” says Dori Zavala, a business attorney at Zavala Law Offices, LLC in Scottsdale, Arizona. “This means that if the business is sued, the party suing can go after the owner’s personal assets including house, cars, etc. As soon as the business has even one paying client, the owner is open to liability and should create an LLC or corporation to provide legal protection. The LLC or corporation provides a separation between the business assets and the personal assets. With an LLC, generally speaking, if the business is sued the party suing can only go after the business assets and not the owner’s personal assets.”
While sound advice, there’s one problem with it. The legal and accounting costs of starting and operating an LLC or corporation can far exceed the revenues derived from a fun little side hustle. For all practical purposes, a little side hustle doesn’t generate enough business to make the possibility of getting sued very significant.
But what happens when “little” becomes “bigger”? At what point does the income generated by your side hustle justify the costs of switching from a sole proprietorship to an LLC or a corporation?
Tax professionals don’t necessarily consider tax savings as the primary reason to make the switch.
“From an income perspective, there really isn’t a difference as all three can be treated similarly for tax treatments,” says Lewis Rhodes, an attorney and President of 4S Professional Services in Arlington, Virginia. “The real issue is for liability.”
Aside from liability issues, there are also red flag issues. “Simply shifting from a sole proprietorship to a single member LLC will not help for tax purposes,” says Greg O’Brien, President of Greg O’Brien CPA PC in Boston. “We often caution against sole proprietorships because of the increased legal liability and increased audit rate per the latest statistics.”
Making the switch will increase the costs of doing business. Aside from the initial filing costs, you’ll generate ongoing annual expenses.
You may think switching is merely a question of “Can I afford it?” but there really is a potential savings you can derive by switching entities. It’s just not where you might expect it to be.
“Typically, the cost of preparing a business tax return will vary; however, a simply ‘side hustle’ business return should cost 500-750 dollars,” says Al Wagner, Founder & CEO of TruPayroll.com in Marco Island, Florida. “The annual state filing fees also differ; however, for the sake of a solid response, the average state fee for annual registration will be $150-200 per year. So, the average cost of owning a business structure will be about $1,000 per year.”
These pass-through entities (sole proprietor, LLC and S-Corporations) offer no difference in the calculation of your income tax. Yet, there’s a hidden tax you may be paying that can present a significant difference. It’s the self-employment tax. You pay it on your entire sole proprietor earnings. You only pay it on the salary portion of your LLC and S-Corp earnings.
Wagner says, “By using just the self-employment tax rate of 15.3% (Social Security and Medicare), we can see that reveals an income level of roughly $6,500 as the break-even point for the cost of taxes vs. a business structure. If a business is generating more than $6,500 per year net profit, it’s time to form a structure for tax advantages.”
This means the conversion pays for itself as long as your business generates $6,500 more than it pays you in salary. These excess profits over and above your salary are considered a dividend payment.
The IRS expects you to take a “fair” salary from your business, but that salary does not necessarily have to include all the profits. The remaining profits can be paid as a dividend to you. Unlike your salary, any dividend you receive is not subject to the 15.3% self-employment tax. It is this dividend portion that produces the savings that can pay for the additional costs associated with converting to an LLC or corporation.
What do these numbers translate to in terms of how much income your sole proprietor needs to make before it makes sense to switch to an LLC or corporation? It probably won’t surprise you to discover the correct answer is “it depends”.
“There’s no hard and fast rule,” says Keren de Zwart, a business attorney who runs Not Your Father’s Lawyer out of Irvine, California, “but if your business is netting at least $60K in profits, that’s usually a good time to formalize into an LLC or corporation because the tax benefits can really start to be utilized then. If you have high personal net worth and/or significant personal assets, it may make sense to form an entity earlier on to protect yourself.”
O’Brien says, “When a business is approaching six figures, it may make sense for your tax advisor to run projections and talk about restructuring your entity to a C corporation or an S Corporation (or potentially multiple entities).”
For side hustles that generate significant revenues, the self-employment tax savings can grow substantially.
When it comes to the proper income number high enough to trigger the switch, Steve Kenney, tax partner at Lutz CPA in Omaha, offers this caveat and example. He says, “There is no magic answer and it depends on the facts and circumstances and is not without risk, but I would suggest a minimum of $50,000 (the Social Security max wage base is now $137,700 for 2020). If you had a profit of $137,700 and paid yourself a salary of $50,000 it would save you 15.3% of the difference or approx. $13,400. You do have extra work and costs for setting up payroll and filing a separate tax return, and the annual costs are probably at least $1,500-$2,000. When does the S-Corp with a salary make sense? I would say earnings would need to be at least $100K.”
Different business entities offer different advantages. You should consider all of them and speak to your tax professional to determine which advantages can help you the most given your current circumstances. You may discover, over time, as your circumstances change, so, too, does your choice of preferred business entity.
“Owners could use all three as their company builds,” Rob Stephens, Founder of CFO Perspective in Spokane Valley, Washington. “They could start with a Sole Proprietorship as they start the business. At this point, they may not have much business risk and only need their own capital. They could then shift to an LLC to gain personal asset protection and add additional owners who can provide funding or technical expertise. The pass-through tax treatment of Sole Props and LLCs allow the losses in the early years of the company to flow directly to the owners’ personal tax returns. As the company matures, switching to a C-Corp can provide favorable tax treatment of fringe benefits and the ability to set up deferred compensation plans. C-Corps also have the strongest personal assets protection and the broadest range of equity options and classes.”
Your side hustle might be little today, but tomorrow it may be the next Amazon. Make sure your organizational structure’s shoes are big enough to fit it.