I know that when I graduated from college, I had no grasp on the differences between a LLP and a LLC. I wasn’t aware that a difference even existed between a S-Corp and a C-Corp. Then again, I was a social science major, and most technical/professional programs require at least one business class. However, knowing what this alphabet soup means and knowing which business structure is best for what you’re trying to do are very different things. Below are some of the traits of sole proprietorships, partnerships, and LLCs and how they can benefit and/or hurt your work in the game development area. Later, I’ll discuss Corporations, S-Corps, LLPs, and more.
- A note on "pass-through"—for tax purposes, pass-through means that you aren’t being taxed twice for profits earned by your business. Pass-through taxation is when your business profits pass through the business and are taxed on your personal income tax. I say this now because it comes up several times in this discussion and it’s an important point when you’re picking your business.
If you’re just starting out and you’re working out of your apartment, you are probably a sole proprietorship. A sole proprietor is someone who owns an unincorporated business by himself or herself. There is no liability shield and for tax purposes your business profits pass-through to you, the owner. As a sole proprietor, you’ll have a DBA (Doing Business As) that can be your name, your game handle, or something you made up. To register with your state/municipality as a sole proprietorship, you can visit your state’s Secretary of State website. Many states put the forms for most of the business types you need on the website as a service to you.
A sole proprietorship is useful when you are simply selling your services as an independent contractor. If you’re a freelance programmer or designer, you work independently and you don’t need anything more complicated than that. If you actually start selling a product you will probably want to convert to another organization type– being personally liable for products is a bit of a scary-dangerous business for tort reasons.
Why bother organizing as a sole proprietorship? First, it enables you to deduct business expenses in the same manner as corporations, partnerships, and LLCs. You can deduct things like operating expenses, marketing costs, travel expenses, and some of the notable "write offs" like business lunches. You can also deduct some of your start-up costs and some of your computer/equipment expenditures connected to making your business profitable. Second, it makes you look more professional when you have a DBA. Third, it can protect you in other ways, too.
Let’s look at an example. Say Duke’s is a freelance contractor /DBA/ Duke Nukem, Sole Proprietorship. He’s offered work by a small development firm. There is no written contract in place, just an oral agreement that he will do the work for a certain amount of cash. Duke writes unique programming code for the benefit of the development firm.
Who owns the copyright to the code? If Duke is an independent contractor, he does. If he is an employee (I will go into MUCH greater detail on this in another post), the developer does. Duke really, REALLY wants to be an independent contractor in this scenario because he wants to be able to use and sell the code in the future. Being a sole proprietorship and having a /DBA/ supports Duke’s contention that he is, in fact, an independent contractor. Otherwise the developer would have a stronger argument supporting the contention that Duke was an employee at the time he wrote the program code.
Having a sole proprietorship has its benefits if you’re working on your own, your risk for personal liability as it relates to your business is low, and you’re not making enough to justify the expense of incorporating. It’s usually worth registering if you’re an independent contract or a freelancer.
You typically don’t need to do much to have a general partnership, but failing to have a partnership agreement can put you at risk. If there are two or more people doing business together and no contract is in place, it’s assumed to be a general partnership. General partners share in all profits AND losses of the partnership. General partners are also personally liable for debts and claims arising from the business. Individual partners are taxed through pass-through taxation based on an equal distribution of profits and losses, unless an agreement is in place that splits the liability/profits otherwise.
A good example is when two or three good friends come up with a game. They design it, program it, and come up with a demo. They do this without any understanding of who owns what, assuming that they’ll all benefit equally when they sell the product. That’s a general partnership.
A lot of people advise against general partnerships. I’m not one of those people. I’m of the belief that when people are personally on the hook for both profits and losses, they will probably be more committed to the venture. A LOT of people disagree with me, and in 9 out of 10 cases they are probably correct. At the end of the day it comes down to who you’re working with. Therefore take my opinion on this with a huge grain of salt.
If you do go the partnership route, it is important that you get everything in writing to spell out:
1) How profits will be split;
2) How liability is split;
3) Who owns the rights to what (all partners own products of partnership equally on behalf of the partnership unless an agreement states otherwise);
4) When approval rights are required from the other partners (spell this out, as approval isn’t required when one partner enters into a contract on behalf of the partnership);
5) What happens when one person quits;
6) What happens when a person dies (estate planning);
7) What happens upon dissolution of the partnership;
8) How to bring in new partners;
9) And anything else that may come to mind.
Smart business people have a lawyer draft this agreement. However, before going to a lawyer, it’s important that you speak frankly and openly with your partners about how you want these details handled, and vice versa. Sometimes business relationships last longer than personal ones, so it’s important to be honest with each other out of the gate.
Limited Liability Company (LLC)
First a note on Corporations. Corporations are separate entities, and therefore profits may be double taxed. In other words, instead of profits from the business passing through to your personal tax return, the corporation’s profits are taxed independently. Your salary, which is taken from the corporate profits, is also subject to taxation. That money is therefore taxed twice. However, shareholders (i.e. owners) of a corporation are in no way personally liable for the losses of the business. If the corporation can’t pay a creditor, that creditor cannot turn around and require payment from the individual shareholders beyond what has been invested in the business.
An LLC has all of the tax benefits of a partnership or sole proprietorship (business profits are only taxed once) but it also provides the liability shield available to corporations. This means that the members are not personally on the hook for debts owed by the business. It’s important to note that individuals are still personally liable if they personally guaranty a loan or commit fraud. Bear in mind that "pass through" taxation is the default tax treatment for LLCs. One other major benefit of an LLC is that you are able to elect tax treatment. You can be taxed as a sole-proprietorship/partnership and be subject to income and self-employment payroll taxation, or you can elect to be taxed as an S Corp or a C Corp.
There’s also a legal doctrine called "piercing the corporate veil." Treating your business like your own personal piggy bank (in legal parlance, "commingling funds") and failing to observe common company practices (common practices include having routine business meetings with minutes, maintaining business documents, keeping your business license up to date, properly reporting business earnings, etc.) can cause you to lose your limited liability.
An LLC obviously has several advantages—you get all of the protection of a corporation and fewer tax headaches. However, it also requires a lot more work and you may be subject to fairly expensive fees in some states. Registering your LLC can cost you quite a bit and you will need to have several documents (Articles of Organization, Operating Agreement, registration forms, etc.) drafted before you can even get the proper license. As a small business, however, LLCs have several attractive qualities.
As the relationships of the members (similar to partners—members operate the organization) are determined by the operating agreement and Articles of Organization, it’s important that you work out the same factors you needed to consider when forming a general partnership before you start the registration process. It’s too costly and too time consuming to mess up, and as with all things in business, your goal is to do it right the first time. LLCs are advantageous for smaller businesses where personal liability may expose you to substantial risk.
I’ll post more on some of the more complicated business structures at a later time. These are the more common business types for new developers and individuals. If you’re looking for specific information or forms, your state’s Secretary of State Office website can provide a lot of the information you need, including details on business types and all of the forms your state requires for business entity formation.