When Should You Switch Your Side Hustle to a Business Entity Structure?

Starting a side hustle today is easier than ever. Between the numerous websites that act as marketplaces and project jobs that can be found on the internet, almost anyone can turn a skill or hobby into a money-making venture. Many people who do this are just looking to make a little extra money on the side. However, side hustles can turn into something bigger – and this is where tax and legal questions arise.

Sole Proprietorship

For someone just starting or looking to make a little extra on the side, there is nothing special to do when it comes to filing federal taxes. Simply complete an extra form — Schedule C —along with your personal tax return. This is referred to as doing business as a sole proprietorship.

But that is where the simplicity stops. While organizing your business, the default way as a sole proprietor takes the least effort and expense; however, there are risks associated with this path, particularly legal liability risks.

Legal Risks

The biggest problem is that the sole proprietorships form leaves both personal and business assets exposed to the risk of being sued. Lawyers will often recommend that the moment a business has paying clients, it should be converted to an LLC or corporation to provide legal protection by separating the business and personal assets.

While this legal advice is technically true, it fails to account for the cost benefit of the situation. The problem is that the costs of forming and running an LLC or corporation can easily exceed the money earned from a side hustle. Combine this with the probability of getting sued at all (in each individual situation) and for most side hustles, it’s simply not worth it to form an LLC or corporation. The key question, then, is when is it worth it to switch from a sole proprietorship to an LLC or a corporation?

When Side Hustle Grows Up

What about the taxation issue? Generally, tax savings aren’t a good reason to convert a sole proprietorship to an LLC or corporation. Making the move from a sole proprietorship to a single member LLC will not help for tax purposes and may even increase the chances of an audit. Moreover, operating as an LLC will cost more both for the initial filing and in ongoing annual expenses. Legal liability remains the main reason to convert the entity structure.

Hidden Tax Issues

All three pass-through entity types (sole proprietor, LLC and S-Corporations) calculate income in the exact same way under current laws. However, there is a hidden tax to consider: the self-employment tax. Self-employment taxes are paid on all sole proprietor earnings, but only on the salary portion of LLC or S-Corp earnings. Any profits over and above your salary are considered dividend payments and are not subject to self-employment taxes.

The income level required to change entity structures depends on each individual situation. That said, you will need the savings to at least cover the initial and long-term compliance costs of filings, fees and tax preparation costs. Let’s look at two examples to see how this works.

Imagine your business is earning $100,000 in net profit and from this you pay yourself $40,000 as salary and take the remaining $60,000 as dividends. At the current 15.3 percent self-employment tax rate, this translates into a savings of $7,650. Now imagine a side hustle that only earns $25,000 from which you take $15,000 as salary and the remaining $10,000 as dividends. This only translates into $1,530 in tax savings.

In the first case, you have not only generated enough tax savings to more than cover your tax preparation and filing costs, but you will end up with more money in your pocket and have stronger legal protection. In the second case, you will barely save enough to cover your costs – and you will create more work for yourself.

Conclusion

Your side hustle might be small right now, but tomorrow it could grow into the next big thing, so make sure your organizational structure makes sense now.

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