Minki: Hey WINers! Welcome to Episode#5 of WINii's Money Bites. We have quite a number of members who are entrepreneurs or have side gigs, either as a hobby or to supplement their income. Well, there comes a point when you ask yourself: to incorporate or not? That is the question! Lucky for us, we have a special lady today who will give you the run down from an accountant's perspective.
Hi Elisa! Thanks for coming on Money Bites. We just had some amazing mandoo and potbingsoo (Amazing Korean dumplings and dessert).
Elisa: So good.
Minki: So good, so good. Unfortunately you don't have a really big sweet tooth.
Minki: I should have ordered more mandoo. I'm sorry about that.
Elisa: No, no. If you had, we wouldn't go out to eat after. Then I would not be able to enjoy something else.
Minki: That's fair. All right. So Elisa, you want to start off with a short intro of yourself?
Elisa: Sure. Hi, I'm Elisa. I'm a CPA in the state of California, I work for a small accounting firm and I'm also an accounting professor at a university.
Minki: There's a lot of confusion on when is a good time to start thinking about establishing a legal entity for yourself.
Elisa: Before you start selling anything.
Minki: Before you start selling anything?
Elisa: Yes. While you are in pre-selling stage, you're not making any revenue. There's no real liability or risk coming from you just talking to people about something that is coming down the line.
But once it gets to a point where you now have something that you're going to sell, it's important to have that separate legal entity because you don't want your livelihood to be affected by what happens with this product. It's hard to project what is going to happen, what liability, what risks are out there. You can do your best to come up with all possible scenarios but something might happen. I don't want your house, your car, whatever things you own, your bank account to be compromised just because something that you didn't predict happened. By putting that product under a legal entity, it protects you as a person beyond the company itself. I think that's important so for me it's more of a risk issue. I don't want everything I've worked hard to earn being drained as a result of something that goes wrong.
Elisa: Probably the next question is going to be which entity do I choose considering how many entity types there are.
Minki: You took the words right out of my mouth.
Elisa: In general, it depends on the company. So we do work with some startups and VCs. And as you have investors, a lot of them want to make sure that you have a C corporation - separate from you, does not get recorded necessarily on your tax return, a completely separate entity. That's common once you start to get to a point where people are looking to invest or you're looking for seed funding, things like that. I'd say that would be the best idea, to just start there if that is the route that you're planning on going.
Now if it's just your entity, I think an S corporation is probably better than an LLC. The reason why is for an LLC, if you are a single member LLC, it gets treated like it's part of your individual tax return anyways so there's no real benefit other than the liability aspect.
Now an S corporation though does file its own tax return so it's like having a separate entity even though any of the income or any of the loss does get passed through to your tax return as a single line - kind of like you were distributed or allocated this amount of income or loss that then you would put on your tax return. So it's a little bit different in how the reporting is and it's a lot cleaner in some senses if you have an S corporation instead of an LLC.
To me, there's no real benefit or disadvantage necessarily between an S corporation and an LLC but it is easier to convert an S corporation to a C corporation if you are going to go for funding than an LLC which usually we'd have to dissolve completely and then start up a new C corporation. So administratively it might be a little bit easier that way.
Minki: Are there different establishing costs associated with an LLC, a S corp or a C corp? Is one more expensive than the other?
Elisa: So the LLC does have less administrative requirements. For example a C or a S corporation would need to have shareholder meetings and documented board meetings, etc. Those type of administrative entity level items are a bit more restrictive as it relates to a S or a C corporation so it might be slightly more expensive. Because as an LLC, the reason why an LLC was set up was so that you could have a company that was legally separate but didn't have the same requirements for just all of the paperwork. Setup-wise, there shouldn't be a significant difference because especially if you're starting up there's not a lot of documentation that will be different across them but I would say that it does depend on the state that you're incorporating in. Some states might have more filing requirements than other states. That might be the only time when there could potentially be a difference in price for the setup costs.
Minki: What about for our users who aren't necessarily in what we think of the startup world but are more doing side gigs like tutoring or waitressing, etc? Once they start earning a secondary income, is there a point where they should seriously consider incorporating?
Elisa: I think from a tax perspective, if the income is getting to (or the gross receipts side) a point where it's quite large, which we see as say upwards of $100,000 or more, then we're starting to say maybe this is a time to start up a legal entity. Reason being, even if all you're doing is tutoring or some sort of other kind of freelance gig, there could be things that might come up from that. Once your income is starting to get significantly larger then it's about time to consider what liability risk do I have that's going out there that might come to bite me later.
Minki: So rather than tax benefits this really does come down to risk adjustments.
Elisa: Definitely. That would be the main driver as to whether you should start an entity or keep it as yourself.
Minki: And for our users who are thinking of managing their risks but are not thinking of taking in outside investors? For our consultants, bakery shop owners and members who sell on Etsy for example, would an LLC be sufficient?
Elisa: I think for those who are not thinking about going super far with their company, an LLC should be more than enough at that level. Although if they have an establishment like you were saying, a bakery owner or something like that, I would actually go to an S corporation beyond just the LLC because there are now lease agreements and other contracts that are being involved so I think that that would be an important step to take rather than just having an LLC for someone who has a brick and mortar something because as you start making your entities and as you are filing your tax return, most of these companies will require a tax return and it's much cleaner and probably something you don't want to disclose is your personal finances. As an LLC, if you are filing a tax return combined with your individual one you may end up disclosing more things than you want to.
Minki: That's a really good point. Once you establish a entity, would you recommend getting a new bank account and a separate credit card for your entity?
Elisa: Yes. Absolutely yes because we should not be mixing our personal and our company finances.
Minki: Just keep it clean.
Elisa: Yes. Now, it's hard to do and many people do not do that. I would say that early on it's something that is frowned upon but you're not going to go to prison for it. But at the same time it's something that we should all be striving to keep separate and make sure that we're putting the right expenses and the right financial concerns in the correct buckets. We have to think about - is this a business thing? Then we should put that in the business bucket. This is me going shopping? I should probably put that in the personal bucket.
Minki: Right. One of the first steps we do at WINii's Challenges is, as painful as it might be, coming to face with your numbers. How much is coming in? How much is going out? I think that's also important for a business owner just coming to terms with your numbers so that you can make a good decision on whether this is working or this is not working.
Elisa: That's a good point because once we start mixing those things, say we didn't have enough cash in the business account so we paid something out of our personal account, are we really evaluating our business expenses appropriate to our business income? Or are we basically covering for ourself which we shouldn't be doing if we want to track, "Okay, is my business making money?"
Minki: Very true.
Join us in the next episode to hear Elisa's personal money story and her unique philosophy on money - her anti-retirement retirement plan. Hope to see you soon!
Our theme music was played and produced by Luna Lee.