Here are some financial and other real-world reasons why your new creative arts venture should operate through a separate business entity.
So you’ve just formed a new creative arts team with a small band of talented, inventive souls, and you have a magical project in mind that you’re certain has marketplace potential. You’re now looking to monetize your work by selling your services and content, likely in the entertainment sector.
What’s next? Should you form your own business entity, and perhaps make it a limited liability company? Should you form a company jointly owned by the various members of your team? Is that really necessary?
While opinions among lawyers and accountants may vary, from our perspective, the answer to those questions is a resounding “yes.”
As with most business decisions, there’s a balancing act. We’ve found that, regardless of industry, there are five primary reasons why someone may consider forming a separate entity:
- 1. Limitation of liability
- 2. Tax optimization
- 3. Perception of legitimacy
- 4. Joint ventures and collaborative projects
- 5. Separation of operational control and financing
Each of these factors into the decision-making relating to creative ventures and, in particular, into collaborative creative ventures. While it may seem like an unnecessary complication, we think that each creative should have their own personal loanout company (let’s refer to it, ever-so-creatively, as “Loanout LLC”), and then each collaborative venture would benefit from having an additional business entity specific to that project or group of collaborators (let’s call it “Project LLC”). The caveat here is that the formation and maintenance costs for a limited liability company vary from state to state, and so the benefits we talk about here have to be weighed against the very real out-of-pocket expenses that could accompany this sort of structuring. But, on the whole, we think it’ll make sense to take this approach. Here’s why:
Limitation of Liability
We’ll actually start with the lowest impact of the reasons for starting a company at the early phases of a collaborative project – limitation of liability. This aspect receives the most attention, but in reality, it’s probably the least relevant with respect to Loanout LLC. In most instances, even when someone is being paid through Loanout LLC or even Project LLC, all of the contractual obligations for services will include an inducement provision, through which the owners of the company agree to be personally liable for the obligations of the company. Similarly, when it comes to a thorny issue such as copyright infringement, there are ways to get around the limited liability for closely held companies pretty easily.
At the same time, limited liability becomes extremely important for production companies that are filming and interacting with the environment, where accidents can happen. Limitation of liability can help in those instances, but it probably won’t mean much for individual creatives.
Tax optimization is the most important reason to go down this path of a separate business entity and, more specifically, why each contributor should have their own Loanout LLC. (To cover ourselves here, we do want to be clear that we are not CPAs, nor are we licensed financial advisors/financial planners, nor are we “tax attorneys.” We do happen to be, however, not only corporate attorneys who regularly have to factor tax implications into what we do, but also business owners ourselves, including with respect to creative projects. We’ve become informed enough over the years about these issues to feel comfortable writing a blog like this.)
With that thoroughly lawyered disclaimer, we firmly believe that any one person or team of individuals who participate in creative projects for money would benefit from launching Loanout LLC.
As a general rule, the benefit of an LLC (as opposed to some other entity type) is its flexibility – not just in its ease of management, but also in the tax election. Think of Loanout LLC as a “tax filter.” A single-owner LLC would be a disregarded entity for tax purposes by default, but then you could make an election to have it taxed as an S corporation (or even a C corporation), if it ever made sense to do so. The shift in tax election would not affect the simplified corporate formalities that would have to be followed with an LLC, as opposed to with a corporation.
A disregarded entity would make sense in the early stages, before there was a lot of money flowing in, and maybe even when your operation was running at a net loss. As the name suggests, with a disregarded entity, it’s as if there was no company for tax purposes. Even though an LLC exists, the IRS treats it as a sole proprietorship. Sole proprietors are responsible not only for typical income taxes, but also for self-employment taxes. If the company isn’t making “very much money,” however, there aren’t really any significant income or self-employment taxes to pay. If the company runs at a loss in the early phases, the sole owners of an LLC being operated as a disregarded entity would be able to use those losses to offset their respective outside incomes (better known as “day jobs”) in the same exact year as those losses were incurred. If a creative has a spouse who makes money while the creative pursues a career in the entertainment industry, net losses from the creative venture can be used to offset the spouse’s income. This is a major benefit to be able to take advantage of as your creative venture gets off the ground.
Conversely, once you start realizing net incomes of $30,000 – $40,000 per year (according to feedback from some CPAs that we trust), you might start seeing a benefit to electing to have Loanout LLC taxed as an S corporation. Doing so would maintain all of the operational flexibility of the LLC, while creating this “tax filter” that we keep talking about.
With an S corporation, you have to pay yourself a “reasonable salary,” but the salary doesn’t have to be 100% of your net income. Instead, a portion of your net income will be allocated as “salary,” which would be taxed at the applicable tax bracket, while the remainder could be distributed as a “dividend,” which is taxed at the long-term capital gains rate (“LTCGR”).
The more money you make, the bigger the difference is between the LTCGR and the marginal tax bracket rate. As an example, with seller’s discretionary earnings (“SDE,” the net income after permissible deductions, but not counting payments to the owner) of $100,000, the total taxes paid would be significantly lower if only $55,000 of that income were “salary” (with taxes paid at the applicable graduated tax rates). The remaining $45,000 of SDE could be distributed to the owner as a dividend and taxed at the 15% LTCGR (as opposed to at the 22% – 24% brackets for various portions of that income). Using the S corp election would also help eliminate some of the self-employment tax that would be paid by you if you had a disregarded entity or if you operated as a sole proprietor without any entity. Loanout LLC, wearing its S corporation tax hat, would still have to pay analogous employment taxes, but only with respect to the salary portion. The portion that had been distributed as a dividend would not be subject to self-employment tax. So, at a relatively low threshold of income, you start to come out on top due to the flexibility of having a Loanout LLC.
You can also explore the potential of tax optimization through some sort of a retirement plan, set up through Loanout LLC. Small businesses have a variety of retirement plan structures at their disposal, each of which has certain benefits and drawbacks. But one thing is constant – each type of plan allows for contributions from business income into the retirement plans pre-tax. In effect, this allows for taxable portions of your income to be lowered while still retaining the benefit of the money earned that was contributed to the retirement plan. When companies with retirement plans have multiple owners, those owners have to be aligned about what kind of retirement plan the company has and, often, even about how much money each owner can contribute to the plan. By having separate Loanout LLCs, however, each creative can have the type of plan that makes the most sense for their personal tax situation, keeping in mind that spouses’ incomes can significantly impact personal tax situations.
The bottom line regarding tax optimization is that, with a Loanout LLC, each collaborator will have the flexibility to take advantage of losses while simultaneously being in a primed position to save on taxes as incomes rise.
Perception of Legitimacy
Even in the hard business world of dollars and cents, perception can be reality. So this reason isn’t really a legal consideration, but it is a business consideration. Employers might perceive those working through a Loanout LLC as more serious, more committed and a more successful entity. (Also, if you’re selling your work to the entertainment world in California, working through Loanout LLC can provide a bit more flexibility in the employee vs. independent contractor classification in that state’s employment laws. This, in turn, could make you more attractive to hire.)
Joint Ventures and Collaborative Projects
Loanout LLCs would hold each collaborator’s respective interests in various ventures, which can differ in ownership from one project to another. In other words, it’s probably unlikely that your current team will operate as a team on every single project. It’s probable that you all have individual interests that may involve some combination of you, but not all of you all the time. And that’s where Project LLC comes into play.
Using Project LLC will help differentiate your collaborative project from whatever else the various partners may be working on, whether individually or in some other combination of contributors.
Project LLC is the company that actually handles the creation of the project. It contracts with all service providers. It pools all the assets and contributions for the single project, without touching on your other projects. Your respective interests in Project LLC will be owned by your respective Loanout LLCs. (Your interests could also be owned directly by you without a personal LLC, but then you’d be losing the tax filter of Loanout LLC that we discussed above.)
For tax purposes, Project LLC would be a partnership, meaning that all net profits/losses would flow up to the owners in some agreed-upon proportion. All the “tax filtering” would occur at the owner level in your Loanout LLCs.
Separation of Control and Financing
Particularly in the creative space, there’s an expectation that investors will stay out of the creative process. So, while it’s true that they have a financial interest in the project, the operational control will remain with a limited set of people driving the project (e.g., the producers). The division between content control and financial interest is much easier to achieve through an LLC, and so that’s what Project LLC becomes as a project develops. You might have any number of passive investors in Project LLC that have a financial interest, but that do not have any significant voting rights or other substantive say in the decision-making. That is much harder to achieve without a separate entity created specifically for the purpose of commercializing the project.
The way of achieving this sort of separation of control and financing is through Project LLC’s operating agreement. As the name suggests, an operating agreement governs how the LLC operates. This includes provisions relating to capital contributions, monetary distributions, and management rights. As part of securing their financial stake in your project, investors agree to the terms of the operating agreement, which grants all of the substantive managerial rights to you and your co-producers (because by the time you’re raising money for a project, that’s what you are – a producer).
At the same time, the operating agreement of Project LLC can also govern the dynamics among the creative collaborators. When you’re just starting out, it’s often hard to see disputes arising among people who want to launch and build a creative arts entity together as a team and are enthusiastic about the project. But that thinking is rather naive. Disputes happen. People’s commitments and enthusiasm can wane over time. And so, independent of any investors, it’s beneficial to have an operating agreement among creative team members to allay the potential of disagreements over finances, employment, intellectual property ownership, union membership, or other matters.
For the reasons above, we think that corporate structuring involving Loanout LLCs for all contributors and a Project LLC for the joint venture is worth the investment. While company formation may involve expenses and complications that may seem like a nuisance, we believe that the benefits outweigh the downsides, and so we recommend this sort of structure to all creatives who are serious about their careers in the entertainment industry.