One day, your side hustle matured into an “activity engaged in for profit,” and with that transformation, your responsibilities increased significantly. When the IRS considers something a business, you should start filing a Schedule C at tax time, including all its business income within your other taxable income. The LLC may need to file business taxes on its own, and it might also owe state fees; the city where the business is headquartered might require an operating license.
The IRS already has an opinion about your side hustle
According to IRC Section 183, the IRS assumes an activity is an actual business and not a hobby if it generates a profit in at least three of the past five years. If you don’t meet this criterion, the IRS may recharacterize your business as a hobby. This means your deduction of business expenses is disallowed, but you are still required to report all income.
What many people don’t realize is that this criterion helps you safeguard your deductions, but it does nothing to protect your personal property. If a client decides to sue you, or a supplier takes you to court for non-payment, your personal assets such as your home, car, and savings are at risk if you are a sole proprietor. The IRS criteria and liability issues are separate matters. Most people don’t realize the IRS criteria solve only the first one.
Why staying a sole proprietor gets more dangerous as revenue grows
Starting out, it might have seemed okay to operate without a formal entity. There wasn’t much revenue, so there wasn’t much risk. And there wasn’t much reason to spend $1000+ incorporating a business you weren’t sure would still be around in 6 months. But one solid contract or opportunity can change everything while your status quo liability remains the same.
As a sole proprietorship, there’s no legal separation between you and the business. Every contract you sign, every product you ship, every piece of advice you give as a consultant – it’s all attached to you personally, not attached to a business entity that can take on the potential liability instead. More revenue means a bigger target, and you’re more exposed, not less.
LLC vs. S-corp: skip the debate, at least for now
Many new business owners become paralyzed in the decision-making process and stress over whether to file as an LLC (typically taxed as a sole proprietorship or partnership) or file paperwork with the IRS to be taxed as an S-corp. Don’t worry about it. An LLC is the right choice 90% of the time as a first step. It is cheaper to set up, easier to manage, and can provide you with the same liability protection an S-corp does without the added payroll and compliance work.
The LLC gives you pass-through taxation where the money is only taxed at the personal level rather than treated as corporate profit then taxed at the personal level again. And you can always elect S-corp taxation with the IRS at a later time if your business grows to a point where the paperwork makes sense. The only thing you’re in a hurry to do is get some protection in place.
The actual formation sequence, step by step
Creating an LLC is not difficult. But this is the order in which to do things.
The first step is checking your state to see if the name you’d like for your business is available. Your business’s name must not be too similar to another registered name. It also can’t contain any words or phrases restricted by your state. The second step is choosing where you would like to form your LLC. For most small business owners, this will be your primary state of operation. Foreign entities come at a cost, so if there’s no specific benefit to filing your LLC outside your locality, you’re probably not going to want to do so.
Third, you’ll need a registered agent who is your LLC’s authorized representative. They receive official documents and other tax papers for the LLC. The registered agent can be an individual or a business. They must be residents of the state, or else a separate registered agent service must be used. Fourth, file your Articles of Organization. Most founders don’t sit down and manually wrestle with their state’s filing portal. They use a service like https://govdocfiling.com/llc/, which handles the paperwork and state-specific requirements in one sitting instead of stretching the process across a week of confused phone calls.
Filing is step one, not the finish line
This is where a lot of new LLCs quietly lose their protection without realizing it. Filing the Articles of Organization makes the entity, but that shield doesn’t magically pop into existence unless you run all business income and expenses through a separate business bank account.
Get an EIN right after formation. It’s free, it’s quick, and you can’t open a business bank account or file business taxes without it.
Then open that dedicated bank account, and stop using your personal checking account for business. Don’t use it for anything related to the business because the “limited liability” part of an LLC only exists as long as there’s a clear wall between your personal and the business’s financial activities.
If the two mix, and an adversary’s attorney can argue that you were actually running personal expenditures through the company to wrongfully protect yourself from creditors, the judge will agree and that protection you just paid to create doesn’t exist anymore.
An operating agreement matters too, even for a single-member LLC. It’s the first thing a bank, investor, or court will ask for if there’s a dispute.
The tax and bookkeeping shift you should expect
Creating an LLC does not exempt you from the self-employment tax. You will still have to pay that 15.3% on the net income, just like you did when you filed a Schedule C as a sole proprietor. What changes is all the stuff that comes wrapped around it – cleaner separation to track deductions, more authority if clients or vendors need to know your business info, and an actual option as far as that S-corp election if/when your profits become enough to warrant the change and the payroll tax savings are more than the added paperwork.
Prepare for the upkeep expenses. Most states have annual report fees and require a registered agent to maintain the business. So, include those fees in your yearly budget rather than thinking of them as a one-time thing.
What to actually do this week
Retrieve your latest three years of income. If you’ve generated a profit in at least two of them and this year is on track to make it three, then you qualify as a “business” according to the IRS. It only takes a few hours of paperwork to turn yourself into one on paper as well – checking on the availability of the name, securing a registered agent, preparing and filing the Articles of Organization, obtaining an EIN, opening the bank account, and adopting an operating agreement.