On today’s Wood Talk “Weekend Edition” we’re talking about our business models and lots of other unqualified business advice that you should take with a grain of salt then go talk to an actual professional accountant.
This topic is inspired by an email from Nick:
I’ve heard you mention several times on the show that you make commission pieces from time to time but I also know 2 of you (I guess Marc too..) have separate day jobs, so I’m curious to know what kind of business license/model you have for your side woodworking commissions.
I’m sure there are resources out there for folks who want to start their own business but I’m curious to hear how you guys operate and if there are various options to consider.
How about you?
Do you have a woodworking business? How did you set it up? Are you a qualified accountant ready to dole out some free advice? Leave it in the comments below.
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15 replies on “WT257 – Woodworking Business Models”
I’m a CPA and wanted to make a couple points. First, we’re worth it. That said, I agree that the most important things getting started with a small business are risk management and planning for not making a profit right away.
As to risk, LLCs and corporations can provide protection from business risk, product liability for example. LLCs haven’t been around as a legal entity for anywhere near as long as have corporations. Consequently, an attorney may have some reservations about using an LLC instead of a corporation. I gather that’s because there hasn’t been enough litigation in which the courts have weighed in on LLCs to provide as much certainty as exists with legal issues arising with corporations. With neither entity is protection of personal assets from creditors absolute, as Marc correctly mentioned.
As to losses, a little history. New businesses probably won’t make a profit in the first year, maybe not by the second year. It used to be that a new business would be formed as an S Corporation. That’s because S Corporation losses would pass through to the shareholder, the business owner. Those losses would count as a deductible loss on the owner’s individual income tax return. (Those losses are limited basically by the amount money you put in the S Corp). C Corporation losses, should the business be shut down in the first few years for never having made a profit, would be lost, not deductible to anyone. So way back when, an S Corp would protect the deduction of those losses. On the other hand, if a new business went well instead of South, the S Corp would eventually convert to a C Corp because there was a tax advantage for a C Corp that doesn’t exist any longer. As far as I know there isn’t a good reason to ever have a C Corp for a small business any more.
So as I see it, if there is little or no business risk, be a sole proprietor. Once risk becomes a factor, be aware that a single member LLC doesn’t need its own tax return, but an S Corp does require a separate tax return. So an S Corp’s administrative cost would be slightly higher and that additional cost can be money well spent in the right circumstances.
Had enough? Well, me too but I should say that any business should have its own checking account and try to dedicate just one credit card for the business. It makes the accounting soooo much easier for you and for the accountant. LLCs and S Corps have to keep the business transactions separate from personal transactions. Doing so is part of your risk management. S Corps usually pay salary so taking money out of the S Corp becomes a more manageable way to deal with business income than with a sole proprietorship or single member LLC treated for tax purposes as a sole proprietorship. There’s withholding on salary, but with a sole proprietorship some spend there gross without realizing they didn’t reserve anything for income and self-employment tax. OOOPS! We don’t have the tax money. We spent it all. With an S Corp it isn’t as easy to just spend it all.
Remember, the above is general advice for generally new businesses and may not be applicable to exactly your situation. It’s written to be general because there are too many ifs ands or buts involved in the specifics.
Charles that was some awesomly detailed info, thanks!
I am also a CPA and a hobby woodworker.
It seems to me a lot of woodworkers find the business/tax side intimidating. It really doesn’t need to be, like Marc said just find an accountant you trust and can relate to. Don’t look to the internet for advice!
Lastly, while the tax and business side can be a hurdle, it is never a springboard. What I mean is either your business makes money or not. Don’t expect the right tax planning or business structure to magically generate a profit for you. It seems to me that some guys think incorporating is the key to getting new business. Its not. Whether your are an S Corp, LLC or proprietorship you still need to take in more than you spend.
Matt, I would considering incorporating if I were you. If some idiot cuts his finger off after watching one of your videos, he might try to sue you. Unlikely as that may be, incorporating will protect your personal assets from litigation.
Mike thanks for the advice! Now I’m absolutely paranoid AGAIN!
I’ve been a hobby woodworker for 35 years, and I love the podcast. I’m also an attorney who works with small business owners. I wanted to clarify a couple of things.
Accountants are great, and every business owner should have one. But, the decision whether to operate as a sole proprietorship, corporation, LLC or partnership should be made after getting advice from an ATTORNEY.
Forming a new business involves three basic concerns: (1) taxes; (2) liability protection; and (3) control. Accountants are only qualified to advise you on the first category – taxes. They are not trained nor licensed to advise business owners about liability protection or control.
Not only that, but immediately after forming a new entity, you’re going to need bylaws for a corporation, an operating agreement for an LLC, or a partnership agreement for a (duh) partnership. And, again, an accountant isn’t trained, qualified or licensed to draft those documents. It matters, too. You do not want the generic documents that come with the “kit.” Those documents govern your liability protection, your ability to bring in additional owners. They can become very important if you are ever sued, declare bankruptcy (personal or business), go through a divorce, or pass away.
Now, something useful …
When you operate as a SOLE PROPRIETORSHIP, you have no liability protection at all. If you do something in your business and get sued, they can come after your personal assets or your business assets. Basically, anything you own is up for grabs. If you cannot afford the other options and must operate this way, at least please buy liability insurance, including an umbrella policy.
When you operate as a CORPORATION, you have inside-out liability protection. That means your personal assets are protected from business activities. If you build a deck that collapses and takes out half the NFL all-star squad, the damages could be a billion dollars, but your losses would be limited to the corporation. They could take your business, but they couldn’t take your house. However, a corporation does not have outside-in protection. If you are out with the family and get into a car accident, the court can take your corporation away from you to satisfy the plaintiff’s damages.
When you operate as a LIMITED LIABILITY COMPANY aka LLC, you have inside-out and outside-in protection from liability. It can create a complete wall of separation between your business and personal assets. The outside-in protection is tricky, though. It’s not automatic and you can mess it up.
I generally prefer LLCs, but only when done properly.
Lastly, planning to go INTO business is actually about planning to go OUT OF business. EVERYONE goes out of business. You either shut it down, go bankrupt, sell it, give it away, or die. There are no other options. The selection of entity and drafting of the controlling documents is governed by how you want to handle those events, if they occur.
Most of my clients don’t have complete clarity about those issues. So, a large part of what I do consists of making the documents flexible enough to handle all of the different possibilities that might come up later.
Drafting documents is a lot like building furniture. You need to know which direction the wood might move and make sure that you allow for the movement without making the piece pull itself apart.
I hope this helps.
Attorneys are great, and every business should have one.
I know all you big shot wood talk celebrities guys have a lot to lose if everything goes bad for you and I certainly understand the right thing to do is to protect yourselves legally. But for a feller like myself making built-in wall units and benches for sun rooms and mud rooms and the occasional entertainment center I don’t see where my risk and liability is.
If I make a nice mahogany bench for John Popper (have you seen John Popper lately) and the bench completely disintegrates under his girth and Mr.Popper takes me to court, I’m pretty sure the judge is going to side with the defendant. Especially after I tell him I’ve learned everything I know from the Wood Talk Guys.
Sole proprietorship is the way I go and am always cognoscente of the fact that in order to “lose everything” you first have to lose in court.
“But for a feller like myself making built-in wall units and benches for sun rooms and mud rooms and the occasional entertainment center I don’t see where my risk and liability is.”
Entertainment centers and built-ins could be a large liability issue for you. If for some strange reason the TV shelf gives and a 60″ TV falls on a child playing in front of it and causes severe injury… you’re cooked. Same with a built in… a shelf gives out and causes injury or shatters the ming vase that was setting on it… you’re cooked.
Keith, don’t think that I take my own advice!
With LLC’s and liability, it’s important to get specific legal advice in your state.
For example, in my state of CT, _single member_ LLC’s don’t offer anywhere near the liability protection that may be provided in other states, if you’ve personally done the work or provided the service.
Adding a second member, or having multiple LLC’s, with varying entities, providing different services and owning different assets is extremely common.
For example, a store that owns the building they occupy will often create one LLC to own the property, and another to provide the service operating the store. A portion of the building might be set aside for rental to a third party, eliminating the service business as the sole occupant.
To David’s collapsing deck example above… In my state, if you personally built the deck, with no subcontractors or employees involved, as a Single Member LLC you may not have much protection.
With micro businesses where the owner is doing lots of hands-on work, it’s important to have all the specifics that exist in your locality.
David wrote: “If you are out with the family and get into a car accident, the court can take your corporation away from you to satisfy the plaintiff’s damages.”
Which I take to mean that to the extent you are underinsured personally, almost anything you own, including stock in your own corporation, can be taken away from you by a court to compensate someone you injured. I say almost anything because of OJ Simpson. His football qualified retirement plan couldn’t be taken from him. That special protection for an employee who has earned a qualified retirement plan benefit may be a good thing and in the public interest.
I would like to think that a court in some state would consider outside-in protection of an LLC a mere legal fantasy that’s not in the public interest. As a layman I have no idea how courts have ruled on that issue, or how a court might rule in the future. I would think then that there is a good reason to insure personal assets for the same total amount whatever the form of business?
You raise some good points. I was mostly addressing the differences between a corporation and an LLC. In either case, if you get sued and lose, your insurance coverage can save your butt. They only go after other assets if you can’t pay the judgment.
There are some concerns about the outside-in protection for LLCs. And, not all states are created equally. Delaware, South Dakota and Nevada are my personal favorites. (That doesn’t mean other states are bad.)
Here’s how the protection works. When a plaintiff gets a judgment against you personally, many states say that the plaintiff can only go after your LLC interests by getting a “charging order.” Basically, a charging order is like a garnishment. The plaintiff gets the right to intercept distributions. So, if the LLC never distributes to the members, then the plaintiff gets nothing.
In some states, the LLC can earn income, opt to make no distributions, and then issue K-1s for the retained income. We call this a “KO by K-1.” It can be a huge disincentive for plaintiffs. Many attorneys will not pursue charging orders for that reason.
Since you’re a CPA, I’ll “talk shop” a bit. The K-1 approach is somewhat controversial. Some folks (myself included) question whether a charging order has sufficient economic substance in order to justify sending a K-1 to the holder of a charging order. Delaware and South Dakota seem to have given that issue the most thought. If there is a bunch of money involved, I would strongly recommend those states.
Lastly, YES, insurance is very important. I don’t sell insurance, but I strongly recommend it. On top of the general liability and errors & omissions, it’s a great idea to add an umbrella policy. It’s super cheap and can save your bacon.
Insurance is key and is cheap.
Practically speaking, most of us don’t have enough assets that a personal injury attorney (working on contingency) wants to risk a jury trial. While an umbrella is super cheap, it becomes a huge asset if there is ever a claim against you. Rather your personal assets being at risk, the attorneys will just strike a settlement with your insurance company’s attorneys. I am going through this now with a car accident that left my father severely brain damaged. When I hired an attorney, I had visions of court room drama. Really it is a glorified real estate closing, with my attorney pushing a bunch of paperwork between the insurance carriers snd the medical providers. They payout becomes pretty formulaic, with state laws on how insurance policy can be stacked and overall limits on medical liens really dictating the payout.
But putting my CPA hat bat on, an LLC might give you better liability protection. However, an S Corp can save you on self employment taxes. With an S Corp you only have to pay self employment taxes on the portion of your business income you pay to yourself as salary. With an LCC you might have to pay self employment tax (which is 15.3%, it is FICA for self employed people) on all your LCC earnings (up to the statutory limit of $118.5K of income). So if your business earns $110K of income, with an S Corp you can pay yourself a $75K salary and only pay self employment taxes on that $75K. With an LCC, you will pay self employment tax on the entire $110K. In that case, the LLC is costing you $5300 of extra self employment tax (110-75 * .153). Your actual tax savings will be less than $5300 (because half of it is deductible against your 1040 income), but in any case you can buy a lot of liability insurance with that $5300.
Since there are attornies reading this, please note this does not constitute tax advice and is meant to be illustrative only. Please consult a licensed CPA and licensed attorney for proper tax and legal advice.
Thanks David! I’ve been inactive for a few years and I appreciate the new information.
Back to the basics and another word of caution for all of us home-based woodworkers is the local HOA! When I was in Arizona and thinking about making a legit business, I looked at our HOA docs and it stated that no manufacturing was to be done out of the home. Ancillary business only. That was my experience. I have built occasionally for other people, but I didn’t want to fill out business applications that gave my home address as my manufacturing location.
I have a photography business as well. That one is legit and registered with the state and county. I pay quarterly taxes to the state and annual personal property tax to the county of all of my photography equipment. I didn’t want to pay that for all of my tools too! Your county may vary.
I have never had a neighbor complain about my noise. If the neighbors know that you are running a business out of your garage, it may give them reason to complain to the HOA. Just be cautious.