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How do I know when it's time to make my craft business into a legal entity?

by Bettie Newell

sell more art in a recessionThis article orginally appeared on Hello Craft in their Ask a Lawyer feature column.

Question: How do I know when it's time to make my craft business into a legal entity?

Answer: This is one of the most common questions I get from small business owners and I always give the same answer: If you are making and selling products, you want to be sure, from the outset, that you are running your business in accordance with your state's laws.

The follow up (and more important) question is really: what is the correct legal entity for your business? Choosing which form is right for your business involves an understanding of your options and consideration of a number of factors. Depending on what state you live in, there are generally four types of business structures you can choose from: sole proprietorships, limited liability companies (LLCs), corporations, and partnerships. The most common forms I see small craft businesses take are sole proprietorships and LLCs.

A sole proprietorship is a very attractive option for the new small craft business owner. It is the simplest form your business can take and it is the least expensive to set up. By definition, it can only have one owner. A sole proprietorship doesn't have to be registered with the state and it is not a separate legal entity. If your business is a sole proprietorship it is really just an extension of you for tax purposes (you'll report income and expenses on your personal return) and you won't get any liability protection under your state's laws.

One common mistake made by sole proprietors is failing to register an assumed business name. If you are using a business name that is something other than your real and true legal name (for example, you are selling ceramic bowls under the name "Jenny's Lovely Creations") most states require that you make a filing (and pay a fee) to register that name with your state.

An LLC is more complex and costly to set up than a sole proprietorship and requires more vigilance on an ongoing basis. It is a separate legal entity from the individual owner and, if done correctly and run in accordance with state laws, can provide the owner with some personal protection against the business's debts and liabilities. An LLC might be an attractive option for business owners with significant personal assets that they would like to protect from the business's creditors.

An LLC can have one owner or multiple owners (called "members").To get the "limited liability" that having an LLC affords, it is very important that you, as the business owner (the member of the LLC), treat your business as being a separate entity. For example, you should have separate bank accounts and proper accounting of funds. If you choose the LLC structure, it is the LLC, not you personally, that should be conducting all the business. It is also very important to take note of any annual state filings your business may be required to make.

If you determine that your business will be a sole proprietorship, there are a few things you can do to "legitimize" your business and set yourself up for success:

  • Make sure that your business name is available to use, not just on sites like Etsy, but in your home state. Most states have an online business name availability lookup on the Secretary of State's website. There's nothing worse than setting up shop, ordering business cards and invoices, and building a website and a brand, only to discover that someone else is already using your business name.
  • Register that name as an assumed business name, trade name or DBA (depending on your state) and pay the required fee. Don't forget to renew your registration in accordance with your state's requirements!
  • Get an Employee Identification Number (EIN) from the IRS. It isn't required for your sole proprietorship, but if you don't get one, you are going to have to use your social security number as an identification for your business. You can apply for an EIN online here, and it only takes a few minutes.
  • Open up a separate bank account for the business and keep track of all of your expenses. This will make tax time much less stressful.
  • Check to see if your city or county requires you to have a business license.
  • Make an appointment with your insurance broker to determine if you need additional business insurance.
  • Make an appointment early on with your CPA or Licensed Tax Consultant. If you aren't currently working with an accountant, get recommendations from your crafty friends.
Choosing your business form is an important decision and should be undertaken after consulting with an attorney and a tax professional. Taking the time to get things right from the beginning can help avoid costly mistakes down the road. And finally, note that choosing a structure today doesn't mean that you can't convert your business into another form as your business grows and circumstances change.

Note! The preceding provides general information. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact an attorney.

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C. Sharp ArtBettie Newell offers general information on legal matters every other month via Hello Craft's Ask a Lawyer feature column. See what else she is up to at her site, Little Paper Cities.

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