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Entity formation during the hustle economy

October 05, 2020 | By Patrick T. McCloskey

With a significant portion of the labor force laid off or furloughed due to Covid-19,1 the concept of a side hustle—an ancillary venture to supplement main income—has suddenly morphed into a broader strategy to bridge the paycheck gap. An article authored by Caitlin Dewey in July: The Gig Economy is Failing, Say Hello to the Hustle Economy, describes a trend of former rank-and-filers seeking to monetize projects to earn cash.

Anyone starting one of these impromptu ventures should carefully consider the liability protection afforded by entity formation.

By default, a business venture without a legal entity is either a sole proprietorship (if there is one owner) or a general partnership (if there is more than one owner). In both situations, these owners are personally liable for the debts and obligations of the business. This means the personal assets of the owner(s)—even assets completely unrelated to the venture—are fair game for a creditor of the business.

While forming an entity does not make the owner(s) bullet-proof, the so-called corporate veil turns personal liability of the business owners into a limited exception rather than a general risk. The scope of protection from personal liability varies from state to state, but, under New York law, business owners:

The knee-jerk reaction in the hustle economy environment is that a limited and temporary project does not justify the time and expense required to form an entity like a full-scale enterprise. This sentiment is short-sighted and somewhat illogical. While some take the position that entity formation does not make sense until a side hustle business reaches a certain maturity,3  this position ignores that fact that the primary benefit of entity formation is not enhancing upside potential, but protecting downside risk—the personal assets of the business owner(s). In fact, one could make the argument that the smaller the project and expected profit, the stronger the case for entity formation. Put another way, it makes little sense for someone to put all personal assets at risk for a temporary project that is only meant to bring some cash in the door during a tight labor market.

Anyone contemplating the formation of a business entity should consult with legal counsel and an accountant or financial advisor. The choice of entity and, where applicable, the related tax election, are critical decisions that require a fact-specific analysis to examine the characteristics of the owner(s), the nature of the business, and the applicable laws and regulations. In addition, entity formation becomes more complicated if the business has already been operating as a sole proprietorship or general partnership. In these situations, a novation signed by the applicable creditor(s) will typically be required to take the business owner(s) off the hook for contracts made or obligations incurred prior to formation of the entity.

Failure to consult with legal counsel in connection with the formation of a business entity has two additional potential pitfalls. First, the failure to adhere to what is referred to as “corporate formalities” could jeopardize the so-called corporate veil, and these formalities differ for each type of entity. Second, legal counsel can provide guidance with respect to the areas where business entity equity holders could have personal liability under applicable law. As examples, under New York law, certain equity owners can have personal liability for New York sales taxes and the ten largest equity owners of a private corporation or a limited liability company can have personal liability for the unpaid wages of employees for services performed in New York.

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This post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).

1In New York City, the shutdown of Broadway productions has been especially hash for the artistic and entertainment community. See, e.g., Daniel Arkin, COVID-19 knocked actors off the Broadway stage. But are the lights dim forever? NBC News, August 7, 2020 https://www.nbcnews.com/pop-culture/pop-culture-news/covid-19-knocked-actors-broadway-stage-are-lights-dim-forever-n1235957

2See East Hampton Union Free School District v. Sandpebble Builders, Inc., 66 A.D.2d 122, 126 (2d Dep’t 2009); aff’d 16 N.Y.3d 775 (2011) (“The general rule, of course, is that a corporation exists independently of its owners, who are not personally liable for its obligations, and that individuals may incorporate for the express purpose of limiting their liability.”) This general rule has been interpreted in New York to extend to sole owners and limited liability companies (LLCs). See, e.g., Mattias v. Mondo Properties LLC, 43 A.D.3d 367, 368 (“A member of a limited liability company ‘cannot be held liable for the company’s obligations by virtue of his [or her] status as a member thereof.’”) Citing Retropolis, Inc. v. 14th Street Development LLC, 17 A.D.3d 209, 210 (1st Dep’t 2005) and New York Limited Liability Company Law §§ 609 & 610. See also Weinberg v. Mendelow, 113 A.D.3d 485, 486 (“[E]ven the sole owner of a corporation is entitled to the presumption that he is separate from his corporation.”) Citing East Hampton, 66 A.D.3d at 126.

3See Chris Caarosa, At What Income Level Should You Switch Your Side Hustle From A Schedule C Sole Proprietor To An LLC Or Corporation, Forbes, January 13, 2020. https://www.forbes.com/sites/chriscarosa/2020/01/13/at-what-income-level-should-you-switch-your-side-hustle-from-a-schedule-c-sole-proprietor-to-an-llc-or-corporation/#1a2f6d8f11a3