If you’re working on a side hustle, you need to set up an LLC early. Otherwise, you’re leaving serious money on the table.
I’ve been starting businesses since I was in elementary school. Two of those companies eventually grew up and now reach millions of people per year (Skritter and CodeCombat).
When I was a kid, I never thought much about the advantages we give to people who start for-profit companies. I had started businesses in eBay reselling, lawn care, and photography before I even understood what "LLC" stood for.
It was at the ripe old age of 23 that I finally created my first limited liability company. Since then, I’ve created and owned 2 LLCs, 1 S-Corp, and 1 C-Corp. I’m not a corporate lawyer. I’m not a CPA. But I have learned a couple of things about corporate entities in my time in entrepreneur land.
If you are doing any sort of work with an honest intent to generate income, whether that’s starting a side hustle or going full time, you should set up an LLC immediately. It’s not difficult or expensive and it provides substantial benefits:
Benefit #1 of Setting Up and LLC Early: Tax Deductions
A simple corporate structure enables you to write off business losses. Even if you aren’t sure what your business will do, it’s worth it to setup an LLC. As you spend money figuring it out, you’ll get a discount according to your marginal tax rate.
If you are fortunate and your business eventually generates profit, you’ll be taxed on that financial gain. There’s no good reason not to get a small refund while you’re setting it up.
Benefit #2 of Setting Up and LLC Early: Limiting Personal Liability
A corporate entity that provides a firewall between yourself and any liabilities incurred by the business. Especially if you are building a business in a risky part of the economy (say, being a general contractor), the risk of you inadvertently causing damage to people or property is very real. It’s not completely foolproof, but a simple LLC provides a lot of protection. That protection could prevent you from having to file personal bankruptcy. And if you don’t go bankrupt, that means you continue to operate and learn from your mistakes.
This post is broken up into 4 parts:
Tax deductions. First, I’ll explain more about tax deductions. What are they and what are they not? I think the tax deductions are a great way to get a discount on the process of starting a company. They are great even if you don’t yet know what your company will do.
Why LLCs are best. In this section, I’ll explain why I think an LLC is the right corporate entity. I think they are better than S-Corps and C-Corps, but you should know what the tradeoffs are.
How to do it. This is where the rubber meets the road. I’ll give you a practical overview of some of the tools that can create your entity. I’ll provide a framework to decide whether you should it do it yourself or involve a CPA/lawyer to help.
Limiting liability. Finally, I’ll wrap things up by summarizing the benefits of a corporate entity in limiting your liability.
Let’s get into it.
Let me reiterate before I dive in here that I am not a CPA or a lawyer. You should absolutely seek the advice of those professions if you are serious about your side hustle. A good lawyer and CPA can save your business 6-7 figures of financial pain by avoiding common pitfalls. With that out of the way, let’s talk about everybody’s favorite vacation reading topic: tax deductions.
Are Tax Deductions Sleazy?
Many people think that tax deductions are barely-legal tricks used by the rich to avoid contributing to things like orphanages. And let’s be honest, there definitely is some of that black-hat behavior out there. But understanding tax deductions and using them to your benefit isn’t sleazy. It’s closer to understanding all the rules to a complicated board game than stealing from impoverished children.
I can hear some people screaming at this point that the tax laws themselves are unethical. They are written by the rich for the rich, after all. And I couldn’t agree more.
But most of the people I know who believe the tax code is unethical also believe in paying your taxes. And that puts those folks in a tough place. It’s hard to argue that you should understand enough to file your taxes, but not enough to benefit from that knowledge.
Even if you think the US tax code is fundamentally immoral, it doesn’t make you an immoral person to understand and abide by its rules. And that’s what I propose that all side hustlers do.
What is a Tax Deduction?
A lot of people – even money-savvy people – don’t understand what a tax deduction actually is. That’s why this scene from Schitt’s Creek is so darn funny. Go ahead and watch it. It’s 2 minutes of your life you can’t get back. But it’s a good way to spend 2 minutes.
As David’s father explains, a write-off or tax deduction is a business expense that reduces your taxable income. Let’s walk through a simple example to demonstrate how this might actually work in practice.
A Simple Tax Deduction Example
Let’s assume that you earned $90,000 in 2022 and filed your taxes as a single earner in Texas. Being located in Texas keeps things simple because there are no state or local income taxes to include. Your $90,000 income would put you in the 24% Federal income tax bracket. The tax bill for 2022 would be calculated as follows:
This calculation assumes you have made no deductions. Deductions allow people to reduce the income that will be taxed.
If you claim a deduction of $1,000 for a qualifying expense, that would reduce your taxable income from $90,000 to $89,000. The 24% tax bracket for 2022/2023 starts at ~$89,000. That means you would otherwise have had to pay 24% for that $1,000 of income. But because you can claim a deduction of $1,000, you were able to reduce your tax overhead by 1,000 * .24 = $240.
If you itemized that $1,000 as an owned business loss, you would have save $240 on your $1,000 of spending. Put another way, tax deductions are a "discount" on business losses equal to your marginal (highest) tax rate.
Let’s say you work at an extremely lucrative job in finance. You made $600,000 per year, so your marginal tax rate would be 37%. That means you would get a 37% discount on the spending required to set up a business. That’s more than a third off of a business expense you would otherwise have spent money on!
Of course, everyone’s tax returns are more complicated than I’ve outlined above. You probably live in a state that does have state and local income tax. You probably have other deductions to claim. And to itemize in the first place, you must keep records to provide to the IRS in case you are audited. But the above example illustrates the concept.
How Do Business Expenses Become Deductions?
In the title of this post, I claimed that if you are starting a side hustle, you should set up an LLC early. I then provided an example of how a tax deduction works. But I haven’t tied the two together. So you may now be wondering how the money that you spend on a side hustle becomes a tax deduction.
The simple answer is that business losses (not expenses!) are usually tax deductible. Hopefully your side hustle will generate profit eventually, but most businesses start out deeply unprofitable. And the IRS will let you claim losses on a business for 3 out of 5 tax years. So during that unprofitable setup time, you can reduce how much tax you pay. People who start businesses full time learn about this quickly. In this case, a CPA can help you carry the loss to reduce your income when your business starts generating profit. But people working on side hustles frequently forget this step.
Business Expense to Tax Deduction Example
Let’s say that you decide to build a new iOS app. You pay a software engineer $40,000 to build it. It takes them 6 months to build, QA, and polish the app. You incur another $15,000 in marketing costs to launch the app. During the first 6 months in the app store, it generates $20,000 in revenue. For that year, you spent $55,000 and you made $20,000. The business can report a loss of $35,000.
Let’s say you’re the person from the $90k/yr example above. You would have to report an additional $20,000 in earnings because your app did so well in the app store. But you can also claim $35,000 in tax-deductible losses. So your gross income would be $110,000, but your taxable income would only be $75,000. You just received a tax break for doing what you would have done anyways: spending money to build your business.
Of course, a lot of businesses never make any significant revenue. If you got it wrong and only make $5,000 in revenue the first year, you could claim $50,000 in losses. That would further depress your taxable income and save you money.
Why Setting Up an LLC Early is Best for Side Hustles
There are 3 major ways to "wrap" a small business: LLCs, S-Corps, and C-Corps. Here’s a very brief summary of the differences between the three:
There are other entity types (nonprofits, sole proprietorships, etc), but LLCs, S-Corps, and C-Corps are the most common.
If you are going to set up up a legal wrapper, you should at least get the following:
Personal liability protection
No additional tax overhead
Minimal paperwork/maintenance requirements
Here’s how I would score the entities based on these requirements:
S-Corps don’t provide protection for personal assets, so that status isn’t worth considering. C-Corps have serious tax disadvantages – namely that corporate profits are double-taxed.
That leaves only LLCs as a good fit for a lightweight entity. LLCs offer personal liability protection, don’t cost more in tax overhead, and don’t require mountains of paperwork.
How to Set Up an LLC Early
There are 3 ways to actually create an LLC:
Do it yourself.
Use a service like ZenBusiness.
Pay a CPA or small business lawyer.
Each one has its own pros and cons. Read on to see which seems like the right fit for you.
Set Up the LLC Yourself
I know it probably seems daunting to file the paperwork for a new business yourself. That’s could be especially true if you’ve never done it before. But trust me, it’s actually quite manageable.
Every state has a somewhat different process for creating an LLC. If you want to do it yourself, I would start with a Google search like "how to start LLC in [state name]." You might read that you should create an LLC in Delaware rather than your home state. You can go down a rabbit hole on this one. My personal take is that it makes sense to set up C-Corps in Delaware, but not LLCs. My reason is that you start C-Corps with the goal of building a big company. If you do that, Delaware corporate law gives you a substantial advantage. But for smaller companies, I just don’t think it’s a big deal. Plus, if you incorporate in your home state, you will pay taxes in your own community and doing the paperwork might be a bit easier.
I would budget 3-5 hrs to do the foundational research about how LLC incorporate works in your state. You’ll need to know where to file your entity creation request, what fees are involved, how long it takes them to process requests, and what documents you get back. For a high-level summary, LLC University has a handy table that lists all of the filing and annual fees.
Generally, it costs $1-200 to do the initial filing and then another $100ish in yearly fees to keep the corporation in good standing with the state.
I did the paperwork myself for my first company. I got parts of it incorrect, it’s not rocket science to make corrections.
Pay a Service to Set Up the LLC
Services like ZenBusiness and LegalZoom charge a couple hundred (plus state fees) to file on your behalf. Their process is easier, doesn’t require as much sleuthing around state websites, and helps you avoid obvious mistakes.
If the prospect of filing a form incorrectly or having to field an annoying call from a state bureaucrat is unpleasant to you, I think these services offer a reasonable value.
For instance, typically the creation of the entity is separate from the process to request an EIN (Employer Identification Number). You want an EIN because it enables the business to exist as a separate taxable entity. If you don’t have an EIN, you’ll have to use your personal SSN on some paperwork. That means that you won’t be able to work with certain commercial vendors. When we were doing drop-shipping for my first company, for instance, the drop-shipping company required an EIN to create an account. A personal SSN wouldn’t cut it.
If you do the paperwork yourself, it’s easy to omit steps like this. For the example of the EIN, it’s not the end of the world if you file later. But a service like ZenBusiness will help you catch those sorts of things up front.
Pay a CPA or Lawyer to Setup the LLC For You
By far the most expensive option is to pay an accountant or lawyer to create the entity on your behalf. If you go this route, look for professionals that specialize in small business and avoid huge firms. Really big firms charge a lot more and won’t give you 1:1 attention.
Leveraging the expertise of a CPA or lawyer is fairly easy for you because someone else does the work! You will, however, still have to shop around to find the CPA or lawyer. That process alone can take longer than just filing the paperwork yourself. But if you find a CPA or lawyer you work well with, that relationship will pay dividends later on. In addition, you will be able to ask questions and ensure that the entity you get exactly meets your needs.
Of course, this option costs substantially more than either of the first two. If you are on a tight budget or think you’ll be setting up more entities in the future, I would put in the elbow grease and do it myself.
Which is Best for Setting Up an LLC?
Here’s a side-by-side comparison of the different options:
I’ve tried all three options. The last time I created an LLC was just last year, 2022. I chose to pay a family CPA. I did that because I could afford the cost and needed to find a CPA for other reasons. It cost about $900.
If I didn’t need to find a CPA, I probably would have paid a service to file on my behalf. The paperwork isn’t tough, but I have a lot of other things to do that are higher value. If I had gone that route, I would probably use ZenBusiness. It’s a bit cheaper and I’ve had trouble with LegalZoom in the past.
What About Clerky and Stripe Atlas?
There is a small ecosystem of tools out there that automate the creation of a different business entity for startups: C-Corps. I used Clerky to incorporate my second startup back in 2013. The services in this space are (in my opinion) generally easier to use, more comprehensive, and offer better support. But they all focus on creating C-Corps rather than LLCs.
You might be wondering why that’s the case, and the reason is a bit interesting. C-Corps have bigger cap tables. With an LLC you can only have a couple of people that own parts of the company. That’s just fine if you’re side hustlin’ and just want liability protection plus an entity to write losses against. But if you’re a startup, you often need to raise money from venture capitalists, angel investors, and sometimes non-accredited investors. If your startup succeeds, a lot of people and funds will own small parts of your company. That will require you to have a corporate entity that can accommodate a complex cap table. C-Corps are just that entity.
So if someone recommends Clerky or Atlas, just tell them you aren’t planning to raise money soon and get back to building.
Before I wrap up, I wanted to explain a bit why it’s useful to have personal liability protection. The idea of "limiting personal liability exposure" probably sounds extremely technical and daunting for most folks. It turns out to be pretty easy to understand, and it’s very important to your health, happiness, and financial success. The best way to understand the value of limiting your liability is to provide a short example.
Let’s say that you decide to start a car wash to earn some extra cash. You don’t spend much time thinking about the business entity. You just go to a nearby gas station and pitch the owner on letting you run the business in their parking lot. The owner gives you informal permission and you get right down to washing cars.
Later that day, a Ferrari drives up and the owner asks you to hand-wash his vehicle. But during the wash, you accidentally scrape some of the paint off the hood of the vehicle. Oops.
On a normal car, that wouldn’t be a huge problem, but Ferraris aren’t normal cars. It can cost tens of thousands of dollars to fix the paint on an exotic vehicle. The owner furiously asks you to give him a check for $15,000 so that he can have the car repainted. You don’t have that money. You just started your car washing business earlier that day after all! So you say you can’t afford to do that. He takes down your information and threatens to sue you for damages.
In this example, because you didn’t set up a business entity, you are personally liable for the damage that you inadvertently caused. The owner of the car can sue you directly and take your personal assets to cover the cost of paint repair. Things like money in a checking account can be seized, as well as certain types of real property. In extreme cases, the court can garnish your wages (take money from your paychecks) to make a creditor whole.
If, however, you had established an LLC ahead of time, the Ferrari owner would have a hard time seizing your personal assets. That’s what the limited liability part of "limited liability company" means. An LLC can’t protect against every possible legal challenge. With that said, it is a strong deterrent to anyone seeking to sue you for legitimate damages. It also helps to deter people from filing spurious lawsuits against you so that you settle out of court.
We all like to think that we won’t make mistakes. And that if we do make a mistake, it won’t create huge amounts of damage. And even if we do accidentally do a lot of damage, that our customers will exercise forbearance and not sue. But why take the risk? It only costs a couple hours of time and a few hundred bucks to ensure you are almost completely protected.
Will You Set Up and LLC Early or Take the Risk?
LLCs are pretty easy to set up. They offer you invaluable peace of mind in the form of limited liability. They also enable you to save money on your taxes just for doing what you would have done anyways. Whether you choose to set up the entity yourself or find a CPA to do it for you, it’s a complete no-brainer to set it up early if you are starting a side huslte.
What do you think? Am I overly-paranoid about the risks? Am I over-stating the value of the tax deductions?
I used Stripe Atlas to streamline my LLC registration, so you can use it for things besides C-Corps. That being said, it is a bit overpriced for that, even with a coupon, but it was worth it just so I didn’t have to deal with the mental overhead.