This week we release the next installment of our "news you can use" series. Recent articles have focused on reducing personal liability risk using umbrella insurance, making a 30x-higher return on your cash savings through the TreasuryDirect program, and getting a sound estate plan in place using wills and living trusts.
In this article, we outline the advantages of forming a business — specifically, an LLC — to create revenue, limit your liability, and reduce your taxable income.
How Resilient Is Your Income?
In our book Prosper!, we point out how most people have all of their eggs in one basket when it comes to income. If the family breadwinner loses their job, most if not all income to the household stops.
Sadly, the expenses do not. And without income, expenses start chewing through savings very quickly.
How long could you sustain your household if your main source of income suddenly disappeared? Three months? Six months? More? Less?
Your best defense against sudden income loss—due to recession, layoff, firing, injury, or whatever—is having multiple income streams in place. Remember that redundancy as an important component of resilience, like that seen in animals that give birth to large litters. This is the same concept.
With multiple income streams, if you lose one, you still have the others to sustain you.
And even if the source of the majority of your income disappears, having 20% to 30% of your prior income level is vastly better than having zero. Having some income allows you to pare your expenses down to the bare essentials and perhaps still be solvent and self-supporting. Having none precludes those options.
Wages/Salaries Are Under Pressure
Longtime PeakProsperity.com contributing editor Charles Hugh Smith has been chronicaling how true inflation, which is much higher than the government's officially reported figure, is perniciously eroding the purchasing power of workers' wages at an alarming rate.
His advised strategy to avoid being crushed by real-world inflation is to earn enough extra income to keep up with higher costs. This is problematic in an economy in which wages/salaries are declining as a share of the gross domestic product (GDP).
This is a long-term secular trend that is affecting not just middle-income workers but the highly educated technocrat/managerial class.
The financialization boom that started in the late 1990s directed more of the economy’s winnings to those who own financial assets and reduced the share going to wage earners.
This reality suggests that building wealth on a single salary is running up against powerful secular trends.
The alternative strategy is to seek additional income streams to supplement your wages, and then invest the profits into assets better-positioned to increase in purchasing power more than wages/salaries.
So how does one create an additional stream of income? There’s no one-size-fits-all answer to this question. It depends on your skills, interests, strengths, resources, and appetite for risk.
But there are methodologies you can follow to identify opportunities that will be a good fit. Working with a mentor or a professional adviser, like a qualified business coach, who can walk you through the structured exploration, is recommended. As is reading a few of the many, many books available on the topic, if for no other reason than getting additional exposure to potential income-generating ideas to consider.
New income streams can be any size and require anywhere from 0 to 20-plus hours per week. You can earn them with your labor and expertise (such as starting a weekend lawn-care service), or purchase them with your investment capital (like buying a rental property). Again, your personal circumstances will determine what’s best for you to pursue.
But our advice is to leverage your strengths and diversify. If you’ve developed mastery of a skill (sales, for example) that one employer is already paying you for, then others are likely to pay you for it, too. But strongly consider applying that skill in different sectors; if all of your income streams have the same risk exposure, the likelihood they could all get compromised at the same time increases.
This isn’t empty guidance. Both Chris and I have worked to create income streams of varying sizes across different lines of business to supplement our base earnings from running Peak Prosperity. While our “day job” provides each of us with our largest income stream, should it go away for some (hopefully incredibly low-probability) reason, these other cash flows should keep us afloat while we determine what to do next.
Your next supplemental income source should fit in the overlap of what you want to do, what you can do, what you have time to do, and what you can afford to do. Once you’ve identified the opportunity, pilot the idea with a few potential employers/customers and then iterate from there based on the feedback you receive.
What An LLC Can Offer
Once you've done the hard work of determining how you plan to earn your next income stream, if you expect it to be of any size (i.e., more than a few hundred dollars a month), you'll need to form a business to operate it within — one best-suited for your goals to control, manage, protect and grow it.
There are a number of different options for doing this — and while there are various types of partnership and corporation structures, the most common and appropriate options for small new businesses starting out are being either a "sole proprietorship" or an "LLC".
If you simply start taking payment for goods or services you offer, without filing any paperwork with the state, you're by default a sole proprietorship.
While this is the simplest and easiest way to get started, there is no legal separation between you and your business. This means you are personally liable for the debts and obligations of your business, as well as any liabilities stemming from your employees. If your business gets sued by a customer, employee or creditor, your personal assets (including your home, bank and brokerage accounts, car, and personal property) are at risk and you can lose everything.
A Limited Liability Company ("LLC"), however, creates a legal separation between you and your business. This results in a legal protection called the "corporate veil" and is the most common reason why small business owners elect to form LLCs.
Owners in an LLC (called "members") are limited in their liability to the amount of their investment in the company. As a member, should the company fail, your personal assets can't be sued to collect on the business' debts. This is also true if an employee, business partner or the business itself is sued for negligence. The maximum you can lose is the capital you've sunk into the company.
This liability protection is extremely valuable.
It's very important to note, though, that this protection must be earned — you can lose it if you engage in illegal activity or don't run your business separate enough from your personal affairs.
Other advantages enjoyed by LLC members include:
- Tax Advantages — LLC members receive "pass-through taxation". Profits and losses “pass through” the business to the individuals owning the business who report this information on their own personal tax returns, where it is taxed as ordinary income. This avoids the issue of "double taxation" that corporations can experience — where income is taxed first at the corporate level and then taxed again at the personal level if paid out in the form of a dividend.
- More Flexibility
- Owernship — Some business structures limit the number of owners, or put limitations on who can be an owner (e.g., no foreigners or corporations). LLC don't have these restrictions.
- Management — Corporations have a fixed management structure that consists of a board of directors that oversees company policies and officers who run the day-to-day business. Owners, also known as shareholders, must meet every year to elect directors and conduct other company business. LLCs don’t have to use this formal structure, and an LLC’s owners have more leeway about the way they run the business and make decisions.
- Profit Distribution — LLCs can dole out profits any way they like. Corporations, on the other hand, must distribute profits to shareholders according to the number and types of shares they hold.
- Less Red Tape — Corporations are usually required to hold annual shareholder meetings, produce annual reports and meet substantial recordkeeping requirements. LLCs aren't required to meet these standards.
And, as business owner, you will have business expenses. These will "pass through" your LLC and reduce your taxable income.
And a portion of these expenses will actually be putting money back in your pocket.
How? Some involve using pre-tax money for expenses you're currently paying with using post-tax money. For example:
Using a home office for your new business? You can deduct part of your mortgage/rent as a business expense.
Using your car to see clients? There are deductions available for those miles.
Tangible property investments/improvement, insurance, meals, entertainment, continuing education, dues and subscriptions — deductions are available for all of these (click here for a longer list).
In all these cases, you're paying for expenses with money that hasn't been taxed yet. So when it comes time to calcuate your taxes, your taxable income has already been reduced by these costs. Your taxes will be lower than they would have been otherwise.
Additionally, if you've capitalized your business with substantial property or machinery (buildings, equipment, vehicles, etc) then depreciation becomes a factor. Tax law allows you to expense a portion of this capital investment each year to account for "wear and tear". So even though you're not paying out any additional cash, your taxable income is reduced by this depreciation expense. So your taxes will be lower.
Depreciation can be a major factor in reducing your taxable income, especially with income-producing real estate. The recent changes to US tax law allows for a dramatic increase in the scope and speed of depreciation (you'll read more from us about bonus depreciation in the future), which can yield tremendous tax-savings. For a better understanding, consult an experienced accountant.
Forming Your LLC
So if you're ready to form a business to create revenue, limit your liability, and reduce your taxable income — how do you get started?
In Part 2: A Primer On How To Create An LLC, we walk through in detail each of the fundamental steps to take and considerations to make when forming your LLC. These are valuable instructions to know whether you plan to start a new business tomorrow or a year from now.
Controlling as much of your income as possible will be key to controlling your destiny in the arriving era of anaemic, energy-starved economic growth. The time to start buidling your own income streams is now, before crisis arrives in the form of an unexpected pink slip, a return to recession, and/or a market crash.
Those who have profitable side businesses in place before any of those happen will fare tremendously better than those who don't.