What (US) Legal Structure is Best for a Website?

There are broadly several types of revenue-generating website models: 1) Ad-supported, 2) Subscriber supported, 3) Sales of a service, and 4) Sales of physical goods. The New ^3 Economy (see below) has lead to many people creating new sites to either supplement their income or look for greener employment pastures. From a tax standpoint, which legal entity is best for each?

New ^3 = (global recession), (post-internet bubble), (widely available web 2.0 software).

 

I am neither a lawyer nor an accountant and always suggest that people consult one when asked about legal matters and incorporation. Still, I’d like to be able to know the basics. As per usual, I turned to my network to find the answers.

Elaboration

Let’s assume that the website would be a standalone business.

Ex.1: Ad-Supported. The business’s total expenditures are the operation of the website (hosting, design, content, graphics, etc.) and all revenue comes from Pay Per Click ads.

Ex 2. Service. Imagine a on-line resume writing service. This business establishes contracts via the web. Payments are made via PayPal. Upon successful payment and questionnaire upload, the website’s staff creates a resume and ships it to the client. Expenditures = website operations, staff, contractors, and consumables (pens, paper, printing, shipping.)

Ex 3. Goods. Imagine and on-line health food supplement store. Customers purchase an order and have it shipped to their homes.

As it turns out, incorporation may be more of a function of liability and personal tax structure than I previously thought. Troy Janisch Publisher at Business Owner’s Toolkit provided an incredibly detailed re-assessment of my initial question examining your personal level of involvement of a website and its revenues compared to your personal situation.

Websites as a Hobby

Maybe you spend only now and then on your hobby. Maybe you do it on a regular basis–as a sideline for now but hope to turn it one day into a full-time business. Whatever level of sales you have, now may be the time to take legal steps to formalize your selling activities.

From a tax perspective, any income from any activity you conduct is reportable and taxable. However, the expenses related to your activity, such as car use, postage and supplies, subscriptions and membership fees, Internet access fees, and expenses of a home office may or may not be deductible, depending on whether you have a hobby or are running a business.

For a hobby–all income is reported, but deductions are limited to the income you take in. These deductions can only be claimed as miscellaneous itemized deductions and only the total in excess of 2% of your adjusted gross income (AGI). For example, if your AGI is $60,000 (which includes $2,000 of income from your hobby activity), and your expenses from this activity are $1,500, you can only deduct $300 ($1,500 – 2% of $60,000). If your expenses are $1,200 or less, nothing is deductible. And, if you claim the standard deduction instead of itemizing, you cannot deduct a thing. Moreover, if you are subject to the alternative minimum tax (AMT), any write-offs taken for regular tax purposes are lost because miscellaneous itemized deductions are not allowed for AMT.

Websites as a Business

-For a business–all income is reported, but it can be offset by various business expenses. And, if you are profitable (your income exceeds your expenses), you can shelter income and save for your retirement by putting money into a retirement plan on a tax-deductible basis.

As your level of activity grows, it may be wise to formalize your business organization by incorporating or forming a limited liability company (LLC). This action achieves several important functions:

1) You gain personal liability protection. If you incorporate your activity or form a limited liability company (LLC), your home, car and other personal assets are fully shielded from the claims of creditors no matter what befalls the business.

2) You gain a tax edge. While formalizing your activity as an S corporation (explained later) or LLC is no guarantee that the IRS won’t question your hobby status in an effort to disallow your deductions, it is an important factor that you can use to show the IRS you really mean business. (Losses of C corporation are not subject to attack under the hobby loss rules, but the losses can only be used by the corporation, not its shareholders.) Most people with hobbies don’t bother to take this step and invest the money to create a formal business enterprise.

3) You gain a financing edge. Vendors and banks may be more willing to give financing to a business viewed as “permanent,” which is one denoted by the Inc., Corp., Ltd. or LLC after the name.

Which type of organization is right for your activity?

There’s no fixed answer. All of these entities will provide you with personal liability protection and help in proving you are running a business and not a hobby. S corporations and LLCs are commonly used for sideline activities. Both enable you to grow your business and take on new owners. Both pass through income to owners who report it on their personal returns. Both cost about the same to set up.

Taxwise, an LLC is taxed similar to an S corporation, with income and expenses of the business reported on your personal tax return. If you are the only owner (member) of an LLC, you are viewed under the tax law as a “disregarded” entity. This means you report the LLC’s income and expenses on Schedule C of Form 1040–the same schedule used by sole proprietors.

A C corporation is also a separate taxpayer, with income and expenses taxed to the corporation and not to its owners. As a practical matter, most small businesses do not opt for C corporations because of this tax feature.
 

Important, not Always Necessary

JC Brandon, Owner, JCB Capital Performance   focused his answer on litigation protection.

A primary reason for establishing a ‘separate entity’ is protection against litigation. There should be a business behind the web site – the business may be sued therefore the business needs protection.

Unless you are potentially injuring people (slander, defamation, copyright/trademark infringements, etc…) – harmless web sites populate the WWW.

Additional Resources

Thanks to Andy Hoffman for suggesting http://www.taxguruhelp.com as an additional resource.

{ 3 comments… read them below or add one }

Ryan @ Planting Dollars April 15, 2010 at 1:49 am

Helpful article… if one decides to set up an LLC do you have any recommendations for vendors / sites to use?

Reply

Charlotte Web Development April 20, 2010 at 4:21 pm

Hi Ryan,

I very much support contacting local accountants and attourneys to set up what you need. While it is possible to use several available on-line services, it may be more advantageous to your business in the long run to have developed a relationship with professionals in those fields.

What do you think?

Reply

George Cardona January 17, 2011 at 7:03 pm

Hi Ryan,

Thank you for providing this valuable information.

Best Regards,
George Cardona

Reply

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