If you’ve been running a side business, like nearly one in three Americans, you might wonder when it’s time to make your business more “official” by creating more structure to support it. But what does that mean, and how do you do it?
Running a successful business—whether scaling up, tapping into the gig economy, or nurturing a creative project—often involves choosing how the government recognizes your business and selecting an appropriate tax strategy. Many entrepreneurs consider the transition from a sole proprietorship to an LLC.
We’ll explore the potential benefits of forming an LLC for your side hustle and what you should consider before making this change.
What is an LLC?
A Limited Liability Company (LLC) is a flexible business structure that offers significant advantages over a sole proprietorship, such as enhanced liability protection and various tax options, including pass-through or corporate taxation.
Understanding these benefits, whether your side gig involves freelancing, consulting, or real estate investment, is crucial.
Benefits of Forming an LLC for Your Side Hustle
Starting a side hustle is so easy—any hobby can potentially be turned into a business. This automatically sets you up as a sole proprietor, reflecting all financial activities on your tax return.
However, this simplicity comes with risks, notably the lack of protection for your personal assets. Forming an LLC can mitigate these risks by treating your business as a separate legal entity.
Limited Liability Protection
An LLC protects your personal assets from business liabilities. In other words, personal finances aren't at risk in the event of business debts or legal actions. This separation is crucial for peace of mind, allowing you to pursue business opportunities with less personal risk. An LLC protects your personal assets from business liabilities through what is known as the "corporate veil." This legal separation ensures that your personal finances are not at risk in the event of business debts or legal actions. Maintaining this corporate veil is critical, as it allows you to operate your business with significantly reduced personal risk.
Tax Benefits
All businesses in the United States, including LLCs, must file tax returns or information returns with the IRS. Additionally, if a business is expected to owe more than a threshold amount of taxes, the company will need to make quarterly tax payments.
While an LLC is legally recognized as a separate entity from its owners, it can be treated as a "disregarded entity for tax purposes." This means that the IRS views the LLC's financial activities as directly linked to its owner(s), similar to a sole proprietorship. In this common scenario, known as pass-through taxation, all income, expenses, and tax-deductible activities are reported directly on the owner’s tax return. If the owner is an individual, the income would be reported on a schedule of the owner’s personal income tax return. if the owner is another entity or trust, the income would be reported on that entity’s or trust’s return
However, an LLC has the flexibility to choose a different tax treatment. By filing IRS Form 8832, an LLC can opt to be taxed as a C-Corp. This election changes how taxes are calculated and may lead to benefits such as lower tax rates and the ability to claim certain business deductions not available under pass-through taxation. This C-Corp tax status often becomes more advantageous as your business's earnings increase and you invest the earnings back into the company.
Deciding on the best tax strategy for your LLC involves assessing your business’s specific financial circumstances and future projections. It's advisable to consult with a tax professional to understand which tax benefits will most effectively support your business's growth and financial health. This decision can significantly impact your yearly tax responsibilities and potential savings.
Credibility and Professionalism
Forming an LLC sets your business apart as a legitimate entity separate from your personal affairs. This formal structure enhances your business's credibility, signaling to customers, partners, and potential investors that your operation is stable and committed to meeting its obligations.
Establishing an LLC can significantly boost your business's image, making it appear more professional and reliable. This enhanced perception can help attract and retain clients, secure valuable partnerships, and access broader business opportunities. Additionally, the legitimacy conferred by an LLC can provide more leverage in negotiations, potentially offering advantages that are less accessible to informal business structures like sole proprietorships.
Flexibility in Management
LLCs offer significant flexibility in management compared to other business structures, such as corporations, which are bound by more rigid formalities. An LLC is not required to have a board of directors, nor is it legally required to hold regular formal management meetings or maintain extensive records. Holding meetings and keeping records can be useful in many ways, but the lack of a legal requirement to do so allows you to focus on other things when your time is limited. This flexibility makes LLCs more responsive and adaptable to changing business goals and market conditions.
Additionally, the structure of an LLC provides several operational advantages:
- Streamlined Decision-Making: With fewer formal requirements and typically fewer people involved in the decision-making process, LLCs can make decisions quickly without waiting for board approval. This can be especially beneficial in dynamic markets where a rapid response is crucial.
- Cost and Time Efficiency: The lack of formal meetings and minimal record-keeping reduces the time and financial costs associated with managing an LLC. This allows you to dedicate more resources to core business activities rather than administrative tasks.
- Customizable Operating Agreement: An LLC's operating agreement can be highly tailored to fit the business's and its owner's specific needs. This agreement sets forth the rules for ownership and operation of the business, providing clarity and structure while allowing for adjustments as the business evolves.
Considerations Before Starting an LLC
When considering starting an LLC, it's important to weigh key factors and potential drawbacks.
- Setup costs: Establishing an LLC involves some upfront expenses, such as state filing fees and potential legal fees. Depending on your state, these fees can range from $50 to $500.
- Ongoing compliance requirements: LLCs must adhere to state-specific compliance requirements, including filing annual reports, maintaining a registered agent, and, in some cases, licensing fees. These responsibilities add to the administrative burden but are essential for maintaining the legal status of your business.
- Record keeping: Accurate record-keeping and timely tax filings are crucial to avoid penalties and ensure the company remains in good standing. For LLCs with many owners and complex business models, this could involve a significant time commitment and may require dedicated resources or external assistance, but for most LLCs, staying in good standing is easy.
- Financial management: Keeping personal and business finances separate is important for both legal and tax purposes. This financial separation assists with financial management and ensures compliance with tax regulations.
State-Specific Requirements
The requirements and benefits of forming an LLC can vary significantly by state.
For example, in Delaware, known for its favorable business laws, LLCs benefit from a specialized court system, which enhances legal protections and business efficiency. On the other hand, California has stricter regulations and higher taxes for LLCs, including an annual minimum franchise tax, making compliance more expensive.
By researching and following state-specific rules governing LLC formation, taxation, reporting, and liability protections, you can maximize the advantages of an LLC and experience the benefits they offer while staying legally compliant.
10 Steps to Forming an LLC for Your Side Hustle
Step 1: Choose a Business Name
Register your LLC's name with the IRS and the Secretary of State’s office, and use it consistently for all legal and tax purposes.
Step 2: Appoint a Registered Agent
Every LLC must designate a registered agent to handle legal notices and important communications.
Step 3: File Articles of Organization
Submit the required documents (Articles of Organization, Certificate of Organization, etc.) with your state’s Secretary of State office to formally establish your LLC. Fees and requirements vary by state.
Step 4: Apply for an EIN
As of January 1, 2024, all LLCs need an Employer Identification Number (EIN) for tax reporting and banking purposes. You can obtain an EIN for free from the IRS.
Step 5: Create an Operating Agreement
Though not mandatory in all states, an Operating Agreement outlines how your LLC operates, member responsibilities, profit distribution, and dispute resolution.
Step 6: Submit Entity Classification Election Form
File IRS Form 8832 to choose how your LLC will be taxed. This election determines whether your LLC is treated as a sole proprietorship, C-corp, or S-corp for tax purposes.
Step 7: Open a Business Bank Account
Separate personal and business finances with a business bank accountto protect personal assets and maintain the LLC’s legal status.
Step 8: Obtain Necessary Licenses and Permits
Determine and obtain required licenses and permits based on your business activities and locations.
Step 9: Adhere to Hiring and Employment Laws
Follow federal, state, and local employment regulations if you hire employees.
Step 10: Maintain Good Standing
Regularly fulfill ongoing compliance requirements, such as annual filings and reporting, to keep your LLC in good standing.
Taking a deep dive into these steps and responsibilities tailored to your state’s regulations is crucial for successfully managing and growing your LLC.
Alternatives to an LLC
While there are many benefits to the limited liability corporation structure, it’s not your only avenue.
As we noted initially, most entrepreneurs with a side hustle simply start as sole proprietors out of simplicity. As long as you are comfortable risking your personal assets, you can continue to run your business as a sole proprietorship for as long as you wish or for the entirety of your business venture.
Another option if your side hustle involves more than just you is to operate as a partnership without forming a business entity. This is just as simple as a sole proprietorship; all you have to do is decide to go into business with another person, and you’re ready to open your business.
Like any business structure, there are pros and cons to both of these structures.
Pros and Cons of Sole Proprietorships
| Pros | Cons |
|---|---|
| Minimal paperwork and low startup costs The owner has full decision-making authority over all business aspects Simple tax process since business income is reported on the owner's personal income tax return Easy to shut down if the business is not successful or if the owner wants to close it | The owner bears personal liability for all business debts and legal obligations May be more challenging to secure financing and attract investors The owner bears the full burden of management and decision-making The business will close if the owner can’t work or decides to stop operating it |
Pros and Cons of Partnerships
| Pros | Cons |
|---|---|
| Business partners share management and decision-making duties Pooled resources and skills can help offset start-up costs and growing pains Relatively simple and inexpensive to establish compared to corporations Pass-through taxation benefits mean avoiding double taxation on business income | General partners are personally liable for business debts and obligations Disagreements between partners could negatively affect business operations Profit sharing among business partners might create disputes Unless provisions are made in the partnership agreement, the company could dissolve if one partner leaves or passes away |
While the sole proprietor and partnership options might offer some flexibility, neither will provide the protections or structure for security and growth that an LLC can.
Real-Life Examples
Meet Brenna
Brenna loved making jewelry, often crafting pieces inspired by semi-precious stones or meaningful messages. Her friends and family soon noticed and began requesting unique pieces, which Brenna happily created as a hobby to unwind after work. As more orders poured in, Brenna was running a thriving small business. She converted a room in her home into a showroom, creating an intimate retail space for her creations. Brenna realized she needed to train a junior employee to meet growing demand. At this point, she recognized the limitations of operating as a sole proprietorship. Forming an LLC provided the personal liability protection, tax benefits, and risk mitigation needed to handle high-value assets and continue growing her business confidently.
Meet Rakesh
When Rakesh started baking cakes for his kids’ birthdays, neighborhood parents took notice and began requesting cakes for their own children's celebrations. What started as a creative side gig soon grew as he took on more complex orders, such as anniversaries, graduation, and wedding cakes. Initially, Rakesh managed by accepting cash and tracking expenses informally.
However, as referrals increased and corporate inquiries emerged, Rakesh realized he needed a more professional setup. Corporate clients often hesitated to work with him because he was a one-person operation. Wanting to expand, Rakesh found securing credit and loans as a sole proprietor challenging.
By converting his business into an LLC, Rakesh gained access to better banking and loan options, improving his brand’s credibility. This transition allowed him to invest in professional equipment, rent a commercial kitchen, and confidently pursue corporate contracts.
Meet Mo
When the advertising agency where Mo worked started to seem unstable, they began looking for side gigs as a backup. Initially, Mo took on small projects, creating logos and refreshing websites. As an experienced graphic designer, Mo was well-versed in how large companies built their brands. Along the way, Mo discovered a digitally-native community of business builders who lacked this expertise and needed affordable services.
Realizing the opportunity, Mo decided to target this group. Already part of the digital nomad and remote worker communities, Mo learned how to create profitable digital courses and workshops while still working full-time. Unexpectedly, Mo's on-demand courses scaled quickly, leading to five-figure revenue from the side hustle.
This success prompted Mo to transition from a sole proprietorship to an LLC for tax benefits, personal liability protection, and the ability to create an Operating Agreement. This separation clarified Mo’s dual roles and facilitated transparent discussions with their manager and HR, ensuring no conflicts of interest in pursuing both work opportunities.
Is Transitioning to an LLC Right for You?
Transitioning your side hustle from a sole proprietorship to an LLC offers significant benefits, including liability protection, tax flexibility, enhanced credibility, and operational flexibility. An LLC separates your personal and business assets, safeguarding your finances. Due to its professional image and tax advantages, an LLC can attract more clients and business opportunities.
While these can be beneficial, it’s also important to consider the setup costs, ongoing compliance, and administrative responsibilities necessary with an LLC. Whether forming an LLC is right depends on your circumstances and goals. Evaluate your business needs, financial situation, and long-term objectives to make an informed decision.
With careful planning and professional advice, you can choose the best path to support and grow your side hustle. LLC Attorney is here to help.
AUTHOR
Jonathan Feniak, Esq., MBA
Jonathan is admitted to practice law in Colorado and Wyoming. In this position, he helps business owners at nearly every level and in nearly every industry with asset protection, estate planning, and business formation. Beyond business owners, Jonathan also helps activists of all political persuasions to legally protect themselves.
