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Business Formation - Partnerships
by Scott Krokoff
In my introductory blog on business formation issues for independent artists and bands, I discussed the need to choose an appropriate business vehicle for your music business activity, and in particular, summarized the pros and cons of being a sole proprietor (aka, the DBA model). Obviously, only individual artists may conduct business through a sole proprietorship. So what can a band do? A band can form a partnership.
What exactly is a partnership? A partnership, generally speaking, exists when two or more persons conduct business together. So all you need is evidence of two or more people operating a business. You do not need to draft a partnership agreement to have a partnership, although you should have an agreement in place to protect everyone’s interests. Each person who participates in the business is called a partner, and each partner is considered to own an equal share in the business unless specified to the contrary in the partnership agreement. Thus, in the case of a band, each band member would be a partner in the partnership.
Generally, there are two kinds of partnerships – general partnerships and limited partnerships. There are also variations of limited partnerships, such as limited liability partnerships (LLPs) and, believe it or not, limited liability limited partnerships (LLLPs), but I will not be discussing those in this article. A general partnership is the most basic kind of partnership, and is just like a sole proprietorship except here you have more than one owner. Unfortunately, the same risk of being of sole proprietor is present in a general partnership – that each partner is fully liable for the debts, obligations and actions of the partnership. In other words, just like a sole proprietor, a partner in a general partnership has unlimited personal liability. Moreover, a partner can also be liable for the actions not only taken by the partnership but by the other partners as well, and a party seeking to sue the partnership can go after the partners individually or as a group. This is called “joint and several” liability and can be a real killer. By contrast, a limited partnership exists where you have at least one partner serving as the general partner (and thereby bearing the brunt of the risk in the event of liability) and the other partners are “limited partners,” meaning that their risk is limited only to their own investment in the partnership. While this is more advantageous than the general partnership, bands cannot form limited partnerships because in order to be a limited partner you cannot be active in the business (and have no say in management or control), and bands by definition are active in the business. So limited partnerships are generally not available to bands, but they can be available to individual artists who need investors who are willing to serve as silent partners (and therefore qualify as limited partners).
Through the partnership, which is treated as a separate entity from the band for non-tax purposes, the band conducts its business (e.g., by entering into agreements with other parties, for example, with respect to booking gigs and licensing songs) and collects any income earned, offset by any losses or deductions. For tax purposes, however, the partnership is usually treated as a “flow-through” entity and what that basically means is that all tax items earned or incurred by the partnership flow through to the partners to be reported in the partners’ individual tax returns. In other words, the partnership is not treated as a separate entity for tax purposes (when we discuss corporations, you will see that certain corporations are treated as separate entities and must pay taxes). The partnership files an informational return with the IRS through Form 1065, but that is for informational purposes only. The partnership itself does not pay any taxes; only the partners do.
Come tax filing time, each band member receives what is called a Schedule K-1, summarizing his or her ratable share (also referred to as the “distributive share”) of partnership income and losses based on his or her ownership percentage. For example, assume you have 5 bandmates forming a partnership. Assuming each band member owns an equal percentage in the partnership, each member would own 20% and therefore be required to report for tax purposes 20% of the partnership’s income and losses in his or her own tax return. So if a partnership has $10,000 of net income, then each partner would be required to pay taxes on $2,000. This is a key concept. What you need to know is that a partner must pay taxes on his or her distributive share even if the partnership does not distribute that partner’s share of the partnership’s net income to the partner. Put another way, if you are a partner, you must pay taxes on your share even if you decide to leave that money invested in the partnership. Again, that is because the partners themselves, rather than the partnership, are required to pay taxes. So you want to make sure the partnership distributes to you sufficient money to cover your tax hit.
You do not need to do much to set up a general partnership. You may need to file some kind of certificate of formation, depending on where you live, and may need to pay a small filing fee. You should also draft a partnership agreement addressing such issues as the business purpose of the partnership, the partnership’s term in which it will exist, the terms and conditions of ownership (including what happens if someone dies or if new partners want to buy into the business), how the partnership will conduct business and how profits will be distributed. If you do not have an agreement, then the partnership will be governed by the law as stated in the Uniform Partnership Act. To avoid unintended consequences, it is highly recommended that you draft an agreement with the help of an attorney.
Partnerships can be advantageous for a few reasons. They are usually easier and cheaper to set up than corporations, for example. They also require less formality (i.e., no need for a board of directors, annual meetings or corporate minutes). Most importantly, they permit a high degree of flexibility in setting up the economic arrangement between the partners. Ownership does not have to be equal amongst the partners, and profits (or losses) do not always have to be distributed in accordance with ownership percentages. The tax rules addressing these issues are very complex and can be very tricky, so please make sure you consult an accountant or tax lawyer when setting up your partnership.
As stated above, the biggest disadvantage in setting up a general partnership is the unlimited personal liability risk (including joint and several liability). While this risk can be mitigated by purchasing the proper insurance, conducting a general partnership is not recommended. There are other types of business vehicles available, such as limited liability companies (LLCs), S corporations and C corporations, which will be discussed in subsequent blogs. In particular, LLCs and S corporations are very popular alternatives, but it was important here to begin the discussion of partnerships since these issues will come up when discussing other business vehicles. In addition, despite the obvious risks, some bands may still opt for conducting business as a general partnership due to the relative ease and low expense of setting it up.
Next topic: C Corporations
Business Formation Issues for Indie Musicians - Part I (Sole Proprietorships)
In order for an indie artist to have a legitimate chance of being successful in the long term, it is crucial for that artist to treat his or her music career as a business. The same holds true for bands. Thinking like a businessperson, however, does not come naturally for most musicians as they are more attuned to and focused on their creative side. Nevertheless, the music industry is a business, just like any other industry, and one of the first things an aspiring artist or band should think about is determining the most appropriate business structure out of which that artist or band’s business will be conducted.
As a preliminary matter, many artists and bands may wonder whether it is even necessary to choose a business structure. They may ask themselves, “Why can’t I just go out and perform?” The short answer to this is that you can, but if you do not take care of the formality of establishing your business – such as by choosing a business structure, opening a business bank account, setting up an accounting system, and preparing and filing tax returns – then your music activity may be treated as a hobby and not as a business for tax purposes. The IRS significantly limits your ability to deduct expenses if all you are doing is pursuing a hobby. Moreover, the IRS still taxes income from a hobby so you will have to report the income anyway even if you want to dispense with the hassle of setting up your business, and by doing so you will also lose the ability to take additional deductions. Also, if you want to attract investors or borrow money, you need to have a business plan that shows your business will be profitable in the long term, and as a prerequisite to that you will need to have chosen a suitable business structure. Furthermore, certain business structures limit your personal liability exposure, so you may be exposing yourself to unnecessary liability risks by refraining to adopt a business structure that fits your needs. To sum it up, if all you want to do is play a few gigs a year for fun as a hobby on the side, then you do not have to choose a business structure and this article is not for you. If, on the other hand, you want to have a career and make a living as a musician, then read on.
Each business structure not only has corporate ramifications but also tax consequences, so the pros and cons of each must be carefully considered before choosing a specific structure. This article will be the first in a series of articles that collectively will summarize the main corporate and US federal tax consequences to be taken into account by US artists and bands when forming a business entity. Please keep in mind throughout this discussion that this is just an overview and provides general information on legal issues commonly encountered. This is not to be construed as legal advice, and you should consult an attorney or CPA when setting up your business structure.
There are primarily 5 business structures to consider:
1) Sole Proprietorship (i.e., the “DBA” model)
2) Partnership
3) “C” Corporation
4) Limited Liability Company
5) “S” Corporation
This blog will discuss the pros and cons of setting up a sole proprietorship. Subsequent blog columns will address the other types of structures available.
Sole Proprietorship
A sole proprietorship is the simplest way to conduct your business and the easiest and likely cheapest to set up as well, although this vehicle is only available to an individual artist as opposed to a band or group. Typically, to set it up, the only thing an artist needs to do is to file a “doing business as” certificate, or DBA for short. You do not have to draft any formation documents or operating agreements prior to conducting business. When completing the DBA certificate the artist selects a fictitious business name through which the artist will be conducting business (e.g., Soleman Records). Understand that you may feel free to officially do business in your own name. The choice is up to you. Most people, however, choose a fictitious name instead. If you choose a fictitious name, you will likely have to file the certificate with your local or county clerk’s office and pay a small filing fee as well, although the specific requirements may differ depending on where you reside. Accordingly, please check your state and local requirements for filing. For example, in New York, the DBA is called an Assumed Name Certificate, which is filed with the county clerk in the county in which the business is conducted.
As a sole proprietor, you are the sole owner of your business. You are not operating it through a separate entity such as a corporation. As such, for tax purposes, you will be accounting for all income, deductions, gains and losses in your own federal tax return (i.e., IRS Form 1040). This is done by filing a Schedule C which is a part of your Form 1040. All items associated with your business will be summarized here. Keep in mind, though, that you will still need to keep track of your income and expenses for accounting purposes in your books and records, most likely in consultation with your accountant.
So what happens to the artist I referred to above in the introduction that just “went out and performed” at venues without ever choosing a business structure? If such activity was purely for fun so that it appeared to be nothing more than a hobby, then any income earned would be taxable as hobby-related income. If, however, such activity was conducted with the goal of making a profit so that it would be more indicative of a business, then the IRS would likely treat the artist as a sole proprietor. Be aware that the IRS generally takes into account all facts and circumstances in determining whether or not you are operating a business as opposed to a hobby.
You may be wondering at this point why an artist would decide not to conduct his or her business as a sole proprietor if it is generally the easiest and cheapest way to go. The biggest reason to choose an alternative option has to do with personal liability. A sole proprietor is personally liable for any claims against his or her business. That means that if a claimant successfully brings a lawsuit against the sole proprietor, all of the sole proprietor’s assets, both personal and business, are vulnerable. If the owner’s business assets are not sufficient to settle the claim, then the claimant may go after the owner’s personal assets (such as a car, home and personal bank account) to satisfy the amount of damages awarded. In other words, there is no line drawn protecting an owner’s personal assets from a claim against the owner’s business assets. That can be a very high price to pay as a sole proprietor.
A sole proprietor can (and should) purchase insurance to address the lack of liability protection in the event of a lawsuit. However, the cost of insurance premiums will become another cost of doing business, which may be too much to bear for an indie artist at the outset, and even if the artist can afford an insurance policy the insurance may still be insufficient to fully protect the business owner.
A significant tax reason to avoid conducting business as a sole proprietor is due to the self-employment (SE) tax. If you are an employee and you earn wages, your employer is required to withhold not only income tax but also social security (currently 6.2%) and Medicare taxes (currently 1.45%, for a total of 7.65% in social security and Medicare taxes). Your employer will also match that by paying the same amount of social security and Medicare taxes to the government. However, as a self-employed business owner, you are required to pay an SE tax comprised of both components – i.e., the “employee” share and “employer” matching contribution – resulting in 15.3% of SE tax paid to the federal government by the same individual. This is in addition to paying income tax. While you are entitled to deduct one-half of your SE tax as an adjustment to your gross income in computing your income tax, which somewhat mitigates the harshness of paying the SE tax, you are still in a worse position tax-wise than you would have been as an employee working for someone else.
For many artists, the sole proprietorship can be a solid business choice simply because it is so easy to set up and maintain. An artist can also mitigate the risk of personal liability by purchasing insurance. However, due to the lack of liability protection from business debts (absent insurance) and having to bear full responsibility for the SE tax, other options should be examined and often tend to be preferable to the sole proprietorship structure.
Next topic: Partnerships
Check out my article on Partnerships, courtesy of @ArtistsHouse! http://ow.ly/wDxA
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