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.

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Next topic:  Partnerships


Bio:
Scott Krokoff is an independent singer-songwriter from Queens, New York.  Previously, he practiced as a tax attorney before recently taking the bold step to pursue his lifelong dream to be a musician.  For more details, and to download his debut CD, A Better Life, for free, check out his official web page at http://www.scottkrokoff.com.