If you've been successful as a freelancer and you enjoy independence, you may want to establish your own small design firm. Usually this does not happen suddenly—it involves a gradual shift away from subcontracting and toward direct business relationships. If you currently hold a full-time staff position in someone else's studio, you may want to negotiate a gradual cutback in scheduled hours. You will want to be careful about issues of competition and conflict of interest. It may take a while for you to establish the legal structure of your new company, create an identity for it, print up your first batch of stationery and land your first paying client. The transition can happen much more quickly, of course, if you're lucky enough to have an actual client already waiting to work with you.
As you make the transition from being an independent contractor to being a company, it's important to seek out good advice. The process of launching a small business will be new to you and you'll be faced with a series of first-time challenges. You don't want to reinvent the wheel. Good advice can help you to avoid problems. Start by talking with designers who've been through this process before. Discuss your plans with peers who've started their own companies and ask for their honest feedback. Then, seek guidance from the following professional advisers:
- An attorney to help you in setting up the company and to provide you with ongoing guidance on intellectual property questions
- A certified public accountant (CPA) who has other design firms as clients, to help in setting up your financial systems and to provide you with ongoing guidance on tax issues
- A banker with a focus on small business clients, to provide advice and assistance with a range of banking and financing needs
- A business insurance agent who is an independent broker, to make sure that your business is adequately protected against common risks
- An industry consultant with particular expertise in your creative discipline, to serve as a strategic adviser
Choosing a Legal Structure
Every business has a legal format that defines its ownership structure and how its profits will be taxed. Here's a brief comparison of the formats typically used by creative firms. In order to choose the most appropriate format for your business, you'll have to carefully weigh a number of important trade-offs: the ease or difficulty of set-up, the level of business taxation and the extent of your personal liability for business debts and obligations.
When you first start working on your own, your business is, by default, a sole proprietorship. You don't need to do anything special to set up an unincorporated business that's owned and managed by one person. No legal formation documents need be filed with any governmental agency (although some local registration and permit requirements may apply—more about this below). For tax purposes, the Internal Revenue Service (IRS) considers a sole proprietor and his or her business to be one entity. Business profits are not taxed separately. They are reported and taxed on your personal tax return, using your Social Security number. (As you already know from your freelance career, you need to estimate the amount of tax you owe and make quarterly prepayments to the IRS.) This single level of taxation is the major benefit of a sole proprietorship. The major disadvantage is that you have unlimited personal liability for all business debts and obligations. If something goes wrong, you're on the hook and you could lose personal assets such as your savings, house or car.
A partnership can be easy to establish as well. A partnership is defined as a voluntary association of two or more people to carry on a business as co-owners for profit. They don't necessarily need to file any formal paperwork to do this. There are two basic types of partnerships—general partnerships (also known as ordinary partnerships) and limited partnerships. If you don't file any paperwork, you've automatically formed a general partnership. Over the years, these have been quite common among creative professionals. It's a logical move to launch a business that you co-own with a friend or fellow grad who has a complementary skill set. This is especially true in advertising, where many agencies are co-founded by an art director and a copywriter. In a general partnership, all partners participate to some extent in the day-to-day management of the business. All partners also have a duty of loyalty—a legal obligation not to act adversely to the interests of the partnership, such as usurping opportunities.
For taxation purposes, the company is not considered separate from its general partners. This means that the business itself does not pay taxes on profits. Instead, the partnership “passes through” the profits or losses to each partner (based on percentage of ownership), who then reports his or her share on an individual tax return. (Again, you'll need to make quarterly estimated tax prepayments to the IRS.) At the end of the year, the partnership must file an informational tax return with the IRS (Form 1065) and distribute a schedule to the business owners (Schedule K-1) that lists each owner's share of the business income or loss. This single taxation is one of the benefits of selecting a general partnership as your legal format.
General partnerships have a downside, however. Because a general partnership is inseparable from its owners from a legal standpoint, the partners are jointly liable for the entire amount of any business-related contracts, debts or other obligations. This means that you are legally bound to any business transactions made by any of your partners. If one of them takes out a loan on behalf of the partnership, you can be held personally responsible for the debt. Creditors can come after your personal assets to make sure that partnership debts get paid. Because a general partner's actions can legally bind the entire business, you need to be cautious when considering potential partners. They must be people you respect and trust. You should also negotiate a detailed partnership agreement before launching the company. A formal partnership agreement is not required by law (if you don't create a written agreement, the partnership laws of your state will govern the relationships), but it's a very good idea to prepare one. The drafting process gives you and your partners a chance to discuss your expectations of each other and to define how each of you will participate in the business. It will help you to work out any issues that could lead to disagreements or problems later on, including such things as capital contributions, division of profits and losses, salaries, management duties, limitations (if any) on authority and an agreed-upon process for the admission or withdrawal of partners from the firm. It's important to consider what will happen to the company if one partner wants to leave, reaches retirement age or dies. Your agreement should include a buyout provision (sometimes called a “buy-sell” provision) to spell out in advance how you will handle the sale or buyback of an ownership interest. The agreement can control who can buy the departing partner's share of the business. For example, it may limit the purchase to existing partners. You might not want to share control of the company with an outsider you have not selected. Without a buyout provision, if one partner decides to leave, the partnership might be dissolved by law. This would force you to divide all assets and profits among the partners and then start the business over.
The other basic type of partnership is a limited partnership. It's a bit more complex and expensive to set up than a general partnership because a limited partnership becomes a separate legal entity from the partners themselves. It's comprised of one or more general partners and one or more limited partners. The general partners control the company's day-to-day operations and are personally liable for the partnership's debts and obligations. This is in contrast to the limited partners, who are passive investors. They contribute capital and they share in profits, but they cannot be involved in the management of the company. They have no right to bind the partnership to contracts or other obligations. Because of this, the personal liability of a limited partner is capped at the amount of his or her investment.
Limited partnerships enjoy single taxation. At the end of the year, the company files an informational return with the IRS but the income and expenses are reported on the personal income tax returns of the partners. Limited partnerships are not common in the design profession. It's a format that's used more often by companies making investments in other firms or in real estate. Federal and state securities laws often apply to the sale of limited partnership interests so, if you're interested in creating this type of business, you need to consult an attorney who has experience setting them up in your state.
For businesses, forming a corporation is the next step up the evolutionary ladder. There are several different types of corporations. The most common is a C corporation, meaning that it meets the requirements of Subchapter C of the Internal Revenue Code. A corporation is legally defined as having a separate existence from that of its founders or owners. As a separate legal entity, the corporation can conduct business, open bank accounts and own property under its own name. Each corporation is formed under the laws of a specific state. Because the details of state laws vary, large corporations generally choose to incorporate in the state with laws most favorable to their internal operations. One popular state for large corporations is Delaware. However, for the sake of convenience, smaller corporations tend to choose the state where they will be doing most of their business. The owners of a corporation are referred to as shareholders. If just one shareholder or a very small group of shareholders owns the company, it's called a close (or closely held) corporation. Corporations are complex to set up and maintain so it's best to use an attorney. Your incorporation papers will identify the initial shareholders and specify the number and type of shares being issued (C corporations can issue different classes of stock). Once you receive a certificate of incorporation, you must comply with a wide variety of rules.
On an annual basis, the shareholders elect directors who are responsible for making major business decisions, particularly those that legally bind the corporation (such as borrowing money, leasing an office or buying real estate). Corporate resolutions must be prepared in connection with important decisions and all board decisions must be entered in a book of corporate minutes (usually maintained by your attorney). The corporate directors appoint officers to run the day-to-day operations of the company. In a small design firm, though, it's common for the owners to be directors, officers and employees simultaneously. Because the corporation has an independent existence, it's possible for it to remain in operation perpetually. The purchase, sale and gifting of stock make it possible for individual shareholders to come and go without causing major disruptions in the corporation's ability to conduct business.
The main advantage of a forming a corporation is that its shareholders are not personally liable for the company's debts and obligations. This protection is sometimes referred to as the corporate shield or corporate veil. If the corporation cannot pay its debts and is forced into bankruptcy, the assets of the company will be liquidated but the stockholders, directors or officers will not be required to pay any shortfall with their own money. Because of this, when a lender is approached by a small corporation (particularly one that is newly formed) the lender may require personal guarantees from the corporate officers as a condition of supplying credit. Obviously, signing a personal guarantee negates the limitation of liability. In certain instances, a court might also impose personal liability on officers and directors for damages caused by the corporation under their control. This is referred to as “piercing the veil” and it can happen if the individuals have intentionally acted in an illegal way or if their actions have exceeded the authority given to them by the company's articles of incorporation.
The biggest disadvantage of a C corporation is that it's subject to what is often called “double taxation.” Business profits are taxed first at the company level, then again at the individual level if they are distributed to shareholders. Profits distributed as dividends become taxable personal income to those who receive them.
To avoid this double taxation, corporations can make a special election to be taxed as a “pass-through” entity under Subchapter S of the Internal Revenue Code. S corporations are most appropriate for small business owners and entrepreneurs who want to be taxed as if they were sole proprietors or partners. The corporate profits pass through to the owners, who then pay taxes on the profits at their individual tax rates. At the end of the year, the company files an informational tax return to show each shareholder's portion of the corporate income.
To qualify as an S corporation, a number of IRS rules must be met. The company must be a profit-making enterprise and can only issue a single class of stock. The company must have no more than 75 stockholders, all of them natural persons (or estates or certain trusts) residing in the United States. Partnerships and other corporations cannot be shareholders. Once Subchapter S status has been granted, it's possible to lose it if the company receives a large percentage of its income from passive sources (such as royalties, rents and investments) for several consecutive years.
Limited Liability Company
The limited liability company, or LLC, is the most recent business format to be offered and there are different versions in different states. Its popularity has grown very quickly because it represents a great combination of benefits: it's less complicated to set up than a corporation, it offers protection from personal liability for business debts and claims, and business profits are taxed only at the personal level. For these reasons, it's now the preferred business structure for design entrepreneurs. The owners of an LLC are called members and typically there must be two or more. In general, to form an LLC you must file formal articles of organization with your state's LLC filing office (usually the secretary of state or department of corporations). Depending on your location, you may need to comply with additional filing requirements. For example, some states require you to publish a notice of your intention to form an LLC in a local newspaper. In some states there's a separate version of the LLC that can be used only for licensed professionals such as lawyers, doctors, accountants and architects.
You should also prepare a detailed operating agreement. It's not required in all states, but it's very important to clarify the rights and responsibilities of the members. In a design firm, it's common for all members to work in the company and play an active role in managing it. It's important to note that if you plan to sell memberships to passive members, the set-up process will become more complicated. If you're sharing ownership with people who will not be actively working in the business, you may be subject to federal and state securities laws.
Cooperatives and Collectives
Occasionally, a group of designers will describe themselves to potential clients as a cooperative or a collective. Casual use of these two terms can create confusion because one is, in fact, a formal legal structure while the other is not.
In some states, a cooperative (also co-operative or co-op) is a distinct business format, usually as a type of corporation. In a co-op, several individuals (or businesses) voluntarily join together to provide services to members. As a legal entity, it's owned and democratically controlled by its members. To qualify as a co-op, it's usually required that there be no passive shareholders, no political activities, and a limited return on any invested capital. For this last reason, many are established as nonprofits. In those that are organized as for-profit enterprises, profits are often shared based upon the production, capital or effort of each individual member. The members of a co-op are protected from personal liability for business debts and claims.
It's not likely that your creative firm will be structured as a co-op, but many design firms and advertising agencies work with clients that are. They can be organized with several different objectives in mind. There are producer co-ops where farmers, ranchers or manufacturers work together in promoting and distributing specific commodities, occasionally under a single brand name such as Land O'Lakes, Ocean Spray or Sunkist. There are retailer co-ops that use economies of scale to get discounts from manufacturers or to conduct joint marketing activities. This is common for locally owned grocery stores, hardware stores and pharmacies. This kind of shared marketing is often done by franchisees of major chains (such as fast-food restaurants) in order to produce regional advertising. The co-op collects dues from its members (usually calculated as a percentage of gross sales) and hires a regional advertising agency. The regional agency must then coordinate its campaigns with the national franchisor's agency of record in order to ensure uniformity. There are also consumer co-ops such as food-buying co-ops or credit unions, where individuals join together to obtain price advantages from volume purchasing. Members get discounts compared with non-member customers. A well-known example of this in the U.S. is the REI chain (Recreational Equipment Incorporated).
A collective is not a type of legal entity. Your business must be organized in one of the formats discussed above in order to identify its tax status and to be capable of suing (and being sued) in a court of law. In contrast, the term collective describes an overall philosophy of interaction and decision-making. It can be used to describe any group of like-minded individuals brought together in an organized manner to accomplish a shared goal. Members of a collective tend to have an egalitarian or non-hierarchical way of relating to each other. Decisions are reached using a consensus process. In the design world, when several creative professionals describe themselves to a potential client as a collective, most often the reality is that they collaborate on projects but each is a separate business entity. One of them signs a formal contract with the client, then brings the others in as independent contractors. The client might not be aware that the various team members are not part of a single company. Disagreements can crop up between collaborators, so it's important to negotiate and document the terms of the project very carefully with all of the various subcontractors. You need to have signed agreements in place to spell out how each will be compensated, to explain how any final profit or loss will be shared, and to clarify the ownership of any intellectual property that is created.
State Tax Issues
We've been discussing the process of selecting a legal structure for your company, but there are other challenges for new businesses as well, including two different types of state tax that you should be aware of.
State Business Income Tax
In most states, companies are required to file an informational return with the state government at the end of the year. Depending on your legal structure, you may have to pay a state business income tax.
State Sales Tax
In many states, you may need to register for a sales tax license (also called a seller's permit). This usually applies to businesses involved in selling or leasing tangible property. However, in some states it applies to services as well. The license lets you collect any applicable sales tax from your customers and pass it on to the state. Currently, there are five states that do not impose a general sales tax: Alaska, Delaware, Montana, New Hampshire and Oregon. However, individual cities and counties in those states may have the authority to impose local sales taxes, so you'll have to check with your local government.
Name of Firm
Choosing a name for your company is a very important part of the setup process and a key component in developing an overall brand identity for your firm. Your business may already have a legal name by default. If you're a sole proprietor, then the legal name of the company is the same as your personal name. The legal name of a general partnership usually consists of the last names of the owners. However, for limited partnerships, LLCs, and corporations, the legal name of the business will be whatever name you registered with the state filing office. When selecting a name, follow the advice that you give to your clients—the name should be short, distinctive, easy to remember and easy to find on the Internet. Start the process by brainstorming a list of potential names. The next step is to carefully check each one for state, national, web, and local availability. Your business name should not be the same as any existing entity—particularly within the same category of services—and it cannot include a term such as “Inc.” or “LLC” unless that is in fact your legal structure. If you find that your preferred name (or a very similar one) is already taken at any of the following levels, you'll have to think of another.
If you're establishing a limited partnership, corporation or LLC, check for name availability with your state government.
On a national level, you'll want to check whether the name is available as a trademark. This means conducting a name and trademark search with the U.S. Patent and Trademark Office to make sure that no one else is using the name you want (or something very close to it) to identify their services in the marketplace. (For more information about trademark searches, see the earlier article about intellectual property).
You'll want the name of your company to be the name of your Web site as well, so you need to check for Internet domain name availability. To conduct a search of top level domain (TLD) names, go to the site of a domain name registrar. Registrars are accredited internationally by the nonprofit Internet Corporation for Assigned Names and Numbers (ICANN). For a full listing, visit the accredited registrar directory at www.internic.net/regist.html. As you'll see, there are a lot of them. Register.com and Network Solutions are among the largest. Finding an available name can be a frustrating process because millions of names are already taken (more than 30 million have been registered with the .com extension alone).
Finally, you need to register your business with your local government. If you're a sole proprietor or a partnership, you may want your company to operate under a name that's different from its legal name (such as Mary Smith wanting to conduct business as Impact Design). The registration process will include filing a fictitious business name statement. A fictitious business name (FBN) is also referred to as an assumed business name or a DBA (“doing business as”). You'll check the name's availability by searching the local government database, which is usually maintained by the county clerk's office. The registration process will include publishing an FBN notice in the local paper.
Other Local Licenses and Permits
Your company may also need to receive local business licenses or permits in order to operate. You'll have to do some research to make sure that you understand city and county rules. Often the requirements and fees vary based on the nature of the business, and the paperwork must be completed before you actually start conducting business. Start by asking city and county officials about license and permit requirements. The office of the assessor or treasurer can tell you about any local taxes on property, fixtures and equipment, or gross receipts.
When you register your business with the local government, your address will be checked to determine whether it's zoned for your type of business. This also applies to businesses operating from a residence. Be sure that you look into this before you sign any lease. Zoning is public regulation of the use of land. It involves the adoption of ordinances that divide a community into various zones or districts. Each district allows certain uses of land, such as residential, commercial, industrial or mixed. Your local government is concerned about how business activities might impact the neighborhood (for example, by creating traffic or noise). In some communities, you must have a zoning compliance permit before you can start your business in a given location. Local ordinances control such construction issues as neighborhood density, building height, bulk, setbacks and parking. Zoning laws often regulate the size, construction and placement of signs as well. Many design firms prefer to be located in historic buildings. Often these structures are centrally located and have interesting architectural details. Historic district locations may have additional restrictions, such as the need for city approval before a building's exterior can be modified or painted a different color.
Becoming an Employer
If your newly established design firm is going to hire employees, you'll need to apply for a Federal Employer Identification Number (EIN) from the IRS and a State Employer Identification Number from your state government. Both of these are necessary for payroll processing. (They're not needed if you're a sole proprietor with no employees, because you'll be using your own Social Security number.) For more information about payroll, please see the earlier article on bookkeeping basics. Lastly, your business may also be subject to state requirements for workers compensation insurance. Much more information about workers comp can be found in the recent article about insurance basics.
As you can see, new businesses need to jump through a lot of hoops. If you've never launched a company before, you won't be familiar with the process and requirements. That's why it's so important to seek out expert advisers. In particular, you'll need guidance on legal and tax issues from an attorney and a CPA. Discuss the details of your own particular situation with them. You'll be very glad that you did.