Jonathan M. Gardey, MBA, CFA®, CFP®
President and Chief Executive Officer
Have you turned your hobby into a side hustle? Or perhaps grown your side hustle into a full-time gig? If so, you’re not alone.
The pandemic drastically changed the way the world works and operates. In fact, according to U.S. Census data, U.S. business formations increased by almost 42% in 2020 and that trend is still going strong. Almost two years in, some folks are still working from home. With more time on their hands and less cash in their pockets due to rising inflation, side hustles are becoming very mainstream and very lucrative.
Most side hustles take on the shape of a sole proprietorship first. No formal filing of paperwork is required at the state or federal level. Maybe you create a logo, Facebook page, or even a website. Perhaps you spread the news through word of mouth. At this juncture, you’re mostly organized, so you keep track of your income and expenses, then, when tax time comes, you simply pay self employment taxes and report the side hustle income and expenses on your personal tax return. This setup makes the most sense because it’s easy and free!
But if your business is becoming more profitable and/or you’re looking for some protection of your personal assets, it may be time to consider changing your business entity structure. Let’s break down when changing your business entity structure makes the most sense.
When to Convert to an LLC
Most side businesses start at the limited liability company (LLC) level because they want the legal protections that come with it. A sole proprietorship, after all, provides absolutely no legal protection. If someone sues your business, your personal assets (such as your home, vehicle, and bank accounts) are also at risk for seizure. Converting to an LLC helps protect your personal assets in the event of legal action. It also helps you to separate your personal and business assets.
LLCs typically are easy to set up. There are annual expenses that occur to keep the LLC operating. Between annual reports, state filing fees, business taxes, and the expense of hiring an accountant to help you prepare your taxes, you’ll likely incur an average annual carrying cost of about $1,000 per year. These annual LLC expenses will vary from business to business and state to state, but they can be added to the business expenses on your tax return. So just weigh the annual LLC expenses with the peace of mind of the protection an LLC provides, because from a tax perspective, nothing changes from a sole proprietorship to an LLC. You will still pay self-employment taxes and report the business income and expenses on your personal tax return.
When to Convert to a S-Corporation
Taxes and trying to keep more of your hard-earned money are likely going to be the biggest deciding factors that will determine when you decide to make the move from an LLC to an S-Corporation business entity structure. The threshold of earnings can be different for different people. Some CPAs will tell you $60,000 net income, some will tell you $40,000, but it could even be as low as $20,000. It really comes down to when the self-employment tax you pay with an LLC exceeds the tax you would pay if you converted your business to a S-Corporation.
With an LLC, you must pay self-employment taxes, which are Social Security and Medicare, on any income the LLC generates. For example, let’s say your side hustle is cutting hair and you earn $100,000. Your LLC would then owe $36,000 in taxes.
But with an S-Corporation, you will be paid a salary and then the company pays the payroll taxes, which are Social Security and Medicare. Those payroll taxes can then be deducted as a business expense from the company’s taxable income. Plus, any leftover profits after you are paid your salary can be distributed as dividends, which have a lower tax rate than regular income. Your same $100,000 income would only owe $21,000 in taxes as an S-Corporation.
When Is Change Necessary?
Your side business might be small now, but if it keeps growing then the time will come when there will both be a cause for celebration (because who doesn’t like making more money?) and a cause for considering adjusting your business entity structure. After all, no one wants to pay more taxes than necessary and protecting what you’ve built should always be top of mind.
If you aren’t sure about when or how to switch, seek out the help of a trained professional. You’ll want the best advice possible when looking at your business entity structure so you can spot and reduce any potential liabilities—tax, legal, and otherwise.
If you are in need of a financial ally who is well-versed in guiding business owners and their families, we encourage you to visit our site, learn more about our services, and see if Gardey Financial Advisors could be a good match. We best serve clients looking for exceptional client service, who value a long-term partnership, and have a minimum of $500,000 in investable assets.