Going Legit - EMusician

Going Legit

I've seen your living room: your rig, which started out as a 4-track cassette recorder and a DX-7, now has engulfed the entire room, expanding like some
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I've seen your living room: your rig, which started out as a 4-track cassette recorder and a DX-7, now has engulfed the entire room, expanding like some hideous floor-space-eating robot. Your furniture consists of a TV and an Anvil-case chair pathetically shoved into one corner. Your neighbors hate and fear you; they think you're some kind of mad scientist. But you're not — you're a businessperson, and this is your business. You are also typical.

Young entrepreneurs usually start out in the music industry by turning their passionate hobbies into livelihoods. In fact, the music industry is somewhat unique in that most music business is done by individuals — artists, musicians, songwriters, engineers, producers, and so on — working as independent contractors rather than as employees of a large company. However, being in business for yourself doesn't mean you can't be a “company”; most successful individuals in the industry eventually form some type of formal business entity. For example, successful songwriters form publishing companies to administer pitching and selling of their songs. Working musicians and producers form production companies. Successful artists quite often form their own record companies.

Artists and professionals do that because forming a business is considered the best way to legitimize themselves as serious players in the industry. It has quite a few practical advantages, as well. If you are serious about turning your passion into your livelihood, consider creating a formal business entity.

One word of caution before I continue, however: forming a business can sometimes be simple, but it can also be complicated, and the stakes can be high. I will explain the benefits of such an endeavor and provide a general overview of what's involved. Such general information can be invaluable, for example, when speaking to a formation attorney, because you can be sure the attorney adequately and accurately protects your interests. Although self-formation kits are readily available, risks are involved with such an approach, and the money saved may not be worth the cost of inadvertently incurring tax or legal penalties or risking your assets. Therefore, I recommend that if you are interested in forming a business entity, thoroughly educate yourself or consult a competent attorney.

GIMME SHELTER

Life is good — you have work lined up, you're getting paid, and you work your own hours. Why would you want to go through the formality of forming a company? One good reason is that certain types of business models allow you to protect your personal assets. From a legal standpoint, business entities such as corporations or limited liability companies (LLCs) are considered distinct legal entities from their owners. In other words, your company would be considered a legal “person,” separate and distinct from you as a person, and your liability risk therefore is limited to the capital in the entity itself. That means that you are not personally liable for the business's debts, losses, or legal liabilities, including lawsuits.

For example, say you land a fat contract to produce a movie soundtrack. Unfortunately, your cat gets sick, and while nursing it back to health, you miss your deadline. The film company claims your failure to deliver the soundtrack on time has ruined its production schedule, sues you for breach of contract, and is awarded $100,000 in damages. If you are doing business without the protection of a formalized business entity, there goes the house, the car, and probably the marriage (and maybe even the cat). However, if you're doing business as an LLC, for example, and your company signed the contract, then only the company's assets can be attached. Yet heed this word of caution: failure to adhere to legal rules such as keeping your business and personal assets separate can place that protection at risk. That is a good example of how consulting with qualified legal counsel when forming your company can help you avoid running afoul of such rules.

Legal entities such as corporations and LLCs are also considered separate tax entities from their owners. Consequently, you may be able to use the entity to shelter business income instead of paying personal income taxes on all business profits each year. Although the company itself would have to pay income taxes based on revenue or profits, those tax rates are often lower initially than personal tax rates and very well may save you money. Tax laws are complex, so seek the advice of a competent accountant or tax attorney.

As noted previously, one main advantage of creating a formal business entity is that the people you do business with will take you more seriously; even established clients may begin to look at you with new respect once you've formed your business. Certainly banks and other lending institutions tend to take loan or other financing applications more seriously when a business entity rather than an individual is applying. You also will have more loan and financing options as a business rather than as an individual.

KINDS OF BUSINESS

So you're ready to take the plunge and formalize your business. What type of business model should you choose? Sole proprietorship, partnership, and corporation — what's the difference?

Sole proprietorships and partnerships are the most common types of small-business entities. If you set up shop in your garage and start selling your goods or services, you are by default a sole proprietorship. If you work with one or more partners, you are by default a general partnership. Those organizational types are considered informal business entities because they generally do not require registration with the state and do not provide any protection for personal assets. It is important to note that simply filing a Fictitious Business Name Statement (also known as a dba or “doing business as”) is not a type of formal business registration; it merely reserves your business name with the county.

Other types of partnerships are considered formal business entities. Limited partnerships allow for investing partners (the limited partners) to essentially sacrifice management rights in return for personal-asset protection, leaving management of the partnership to the noninvesting partner (the general partner). Limited liability partnerships (LLPs) are partnerships that protect the partners' personal assets but are allowed only for select types of businesses (usually legal, accounting, and architectural businesses).

A corporation is the most recognizable type of formal business. In a corporation, the shareholders actually own the company, and the directors and officers manage the business (although certainly a single person can be both a shareholder and a director or officer). Similar to limited partnerships, the shareholders generally sacrifice management rights (with several notable exceptions, in particular the right to elect the board of directors) for personal-asset protection.

LLCs are a fairly recent and popular type of formal business entity. In an LLC, the business generally can be informally structured, like a sole proprietorship or general partnership, but provides personal-asset protection to the “members” (that is, the owners). That, as you may have deduced by now, is an attractive combination for new small-business owners.

WHAT'S YOUR TYPE?

You're probably wondering which type of business model you should choose. As mentioned previously, choosing nothing defaults you to sole proprietorship or general partnership, leaving your personal assets at risk. Limited partnerships are useful if you have a silent partner, which most are not lucky enough to have and still places the general partner's personal assets at risk. LLPs are not usually available to most business types, leaving corporations and LLCs as the most common choices for new small-business owners.

A corporation is the classic choice, mainly because of the fact that many new businesspeople have never even heard of an LLC. The main problem with corporations, however, is that they are relatively burdensome to operate. Adhering to various required corporate formalities such as shareholder's meetings, director's meetings, issuance of stock, and the like can pull you away from valuable time that should be spent running your business. Although some states allow one- or two-person corporations and the formalities for such close corporations are ordinarily less troublesome than for larger corporations, you still must contend with a fair amount of red tape. Furthermore, despite the claims of late-night infomercials, proper setup and operation of even a small corporation can be expensive. However, there are advantages, as well, such as potential tax and image benefits.

The LLC, however, is in most states the best type of formal business entity for new small businesses. Like a corporation, an LLC can protect your personal assets, and like a partnership or sole proprietorship, it is flexible, inexpensive to set up, and operable with few required formalities. In fact, a written agreement between the members is not even required, and some states allow for single-member LLCs. In other words, you can run the business the way you've been running it all along and still protect yourself. That's not to say that a written agreement between you and your partners isn't a good idea — on the contrary, it's a very good idea. The point is, you have the option.

BECOMING A BIG SHOT

“Okay, Mr. Bigmouthed Lawyer,” you say. “You talked me into it. How do I form my business entity of choice?” Unfortunately, step-by-step instructions are beyond the scope of this column. Furthermore, most formation laws are state laws and can vary considerably from state to state. Resources such as books, Web sites, and software kits are great for educating yourself, but to be safe, consult an attorney or prepare to spend a fair amount of time researching the law. (See the sidebar, “Business Smarts,” for a brief listing of resources.) However, I can lay out some general requirements.

All formal business entities must file paperwork with the state in which they do business. Further information concerning the requirements, and sometimes even downloadable forms, likely can be found on your Secretary of State's Web site. In California, for example, LLCs must file initial paperwork called Articles of Organization, which provides the state with basic information about the business. The state requires similar paperwork, called Articles of Incorporation, for corporations. Update paperwork, which is called a Statement of Information for LLCs, or a Statement by a Domestic Stock Corporation or Statement of Officers for corporations, must be filed at regular intervals thereafter.

Corporations are also required to draft bylaws that outline the general rules by which the corporation will operate. Also, significant business actions taken by a corporation must be formally approved through shareholders' or director's meetings and recorded in official minutes of those meetings. Additional rules are often set out in various types of supplemental agreements between the shareholders, such as shareholder agreements or voting agreements. LLCs have no such requirements, though the operating rules of the company are often set out in Operational Agreements between the members.

More steps may be required by your state, county, or city. For example, you may need to obtain a Federal Employer Identification Number from the state in order to pay employees or open a bank account. Your county may require a Fictitious Business Name Statement if you're doing business by a name other than the name filed with the state in the Articles of Organization or Articles of Incorporation. Your city may require a business license. Again, information about those requirements usually can be found on the agency's Web site.

THE BOTTOM LINE

If you're serious about your business, you'll have to jump through these hoops eventually. Consider whether you're in it for the long haul or are simply getting by until your record deal comes through. If you decide to formalize, talk to some of your friends or business acquaintances to get some help in deciding what type of business to form and how to form it. Once you decide how you want to proceed, enlist the aid of an attorney. As Hans and Franz were fond of saying on Saturday Night Live, “You pay me now, or you can pay me later.”

Eric Leachis an intellectual property and business law attorney at Goodman and Leach. A reformed musician, he is the author of several articles concerning the music industry and related legal matters. Contact him ateleach@goodmanleach.com.

BUSINESS SMARTS

Here are a few places to start your research on forming a business. When you're ready to take the big step, consult an attorney. If you can't find a suitable one through word of mouth, your state bar association is a good source for referrals.

Artistpro (www.artistpro.com) sells many music- and music-business-related books. The company also publishes The Recording Industry Sourcebook, which offers hundreds of leads and contacts in every facet of the music industry.

Nolo Press (www.nolopress.com) is a noted legal self-help publisher. It offers many books and software packages about tax laws and forming and running a business. Nolo also offers music-business law books, such as Music Law: How to Run Your Band's Business, by Rich Stim.

The Small Business Association (www.sba.gov) Web site provides a wealth of invaluable information to any small-business owner or owner-to-be. Be sure to check out its links to other resources.

The StarPolish (www.starpolish.com) site has music, music news, columns, and features. The real find on this site is the Advice section, which offers many articles about specific areas of the music business, including financial and legal matters. The site's Resources section lists various professionals and services, such as accountants, attorneys, and industry associations and organizations.