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Choose the Best Legal Business Structure for Your Salon

 salonlife, salon, small business, cosmetology, hairstylist

By Tina Alberino

What do you consider before you decide the right business structure for your beauty business?

Your beauty business's legal structure will impact how your business is taxed and the degree to which you (and any partners) can be held personally liable. Whether you're planning on going solo (as a renter, home or mobile salon owner, or on-location freelancer) or opening a full-scale salon, choosing the right legal structure will be one of the most important decisions you make.

This article provides an in-depth overview of the different structures available and the pros and cons of each so you can make an informed decision.

Sole Proprietorship

(Disregarded Entity) A sole proprietorship is an unincorporated, single-owner business. There is no legal distinction between the individual (you) and the company where taxes or liability are concerned. Here are the Pros and Cons of that structure:

+ Easy to establish. Sole proprietorships don't have to be registered unless the business owner wants to operate under a trade name. (If so, they have to file a DBA, or "doing business as" form, which are typically very cheap and straightforward.)

+/- Pass-through taxation. Sole proprietors report their business's income and expenses on Schedule C, an attachment to their personal tax return. They then pay applicable taxes themselves at their personal tax rate rather than the corporate tax rate. Depending on the circumstances (and your personal tax rate), pass-through taxation could be a pro or a con.

- Not a separate entity. Owners of sole proprietorships are personally liable for the business. Their personal assets are at risk for all business debts, losses, and any potential lawsuit settlements.

- Not exempt from self-employment tax. You will be personally responsible for paying your own Social Security and Medicare taxes, based on the salon's total net earnings.

So ask yourself, "Is a sole proprietorship right for my salon?"

Because we work hands-on with the public, salon owners would be better served by a business structure that shields their personal assets. Too many people assume that professional liability insurance will be enough to protect them, but that's a really reckless assumption to make in such a high-risk profession. We're working with hot tools, chemicals, sharp implements, and other dangerous items routinely, in environments where it can be easy to trip over cords, fall from elevated chairs/beds, or slip on slick/wet surfaces.

Do you really trust an insurance company to defend your home, savings and other assets from litigious clients? Here are things to consider:

If you choose to move forward and establish a sole proprietorship, understand while it may seem like the cheapest and easiest option, that will likely turn out not to be the case when you consider how much you'll have to spend on professional liability insurance. Depending on the circumstances, an insurance company may actually charge more for your policy on account of your sole proprietorship status.

Additionally, you will have to ensure the policy you obtain provides sufficient coverage, as it will be the only protection you have.

Limited Liability Company

(or LLC) A Limited Liability Company distinguishes the business as a separate entity for liability purposes, but not for tax purposes. This flexible structure incorporates elements from all of the others, providing small business owners an ideal mix of options and protections.

States have different laws and requirements for LLCs. Pros and Cons:

+ Easy and affordable to establish. While establishing an LLC does require you to register with the state and pay a fee, the process generally requires very little time and effort. Many states allow you to register, pay, and file annual reports online.

+ Multiple owners (members) permitted. LLCs can have an unlimited number of owners (referred to as "members"). Those members can be individuals or other businesses.

+ Limited personal liability. So long as you don't commit fraud and keep your personal and business finances separate, your personal assets (and those of any other members) are protected from creditors.

+ Pass-through taxation (or not). Just like sole proprietorships, LLCs can enjoy pass-through taxation. Unless you inform the IRS otherwise the facts are:

If you own a single-member LLC, the IRS treats the business like a sole proprietorship (or "disregarded entity") for tax purposes, allowing you to report the business income on your personal tax return.

If you own a multi-member LLC, the IRS will instead treat the business likes a partnership. This will require you to file IRS Form 1065.

However, LLC owners can elect to be taxed as a corporation or S-corporation by filing form 8832. (We'll get to that in a second.)

- Salon owners and personal service providers may not be eligible. Some states (like California) do not allow personal service providers to register their companies as LLCs. Depending on where you live, this option may not be available to you.

- Requires annual maintenance. Every year, your state will likely require you to file an Annual Report. While it sounds intimidating, Annual Reports typically require you to do nothing more than verify the names of the members and that the addresses and phone numbers on file are still accurate.

- Dissolution and reformation may be required. Whenever a member leaves the company (even if that departure occurs as a result of their death), the LLC will have to be dissolved and reformed by registering a new LLC. (For most solo LLC owners, this con won't apply.)

So you ask yourself, "Is an LLC right for my salon?"

LLCs are most widely used by small business owners for valid reasons. They offer a ton of flexibility, taxation benefits, and the security of personal asset protection. In my opinion, I consider LLCs to be the best option for salon owners.

General/Limited Partnership

In a partnership, two or more people agree to join together in a business venture. Each partner contributes something (whether money, labor, skill, or tangible items) and shares in the salon's profits and losses. Pros and Cons:

+ Easy and affordable to establish. Like sole proprietorships, general partnerships typically require no special formalities to establish.

+ Pass-through taxation (or not). Partners include their respective shares of the salon's profits on their tax returns, unless they elect for the business to be taxed differently.

+/- Personal liability (or not). General partnerships are treated much in the same way as sole proprietorship with regards to liability. General partners can be held personally liable, but in limited partnerships, limited partners are barred from participating in management, but in exchange, they can control how much they are responsible for the salon's debts.

- The business will only persist as long as the partnership does. If your partnership breaks down or your partner dies, your business dissolves unless your partnership agreement states otherwise. Partnerships are not considered a separate entity.

- Collaboration required. Unless your partnership agreement clarifies how disagreements are to be handled, you could find your business hitting a wall if you and your partner(s) can't reach a compromise. Partners must collaborate on business decisions.

- Costly to structure correctly. While general partnerships can be started with no special formalities, it's wise to invest the time and money into doing it right. Partnerships, when done correctly, have formal partnership agreements. The only professional qualified to write a formal partnership agreement is a qualified attorney (preferably one with experience in contract and/or corporate, business, or enterprise law).

Is a partnership right for my salon?

The diplomatic way to answer would be to say, "If you have found a trustworthy partner who shares your vision, values, and work ethic, then a partnership might be a great way for you to pool your resources," but I've seen far too many disastrous partnerships to care about diplomacy here. I don't recommend partnerships at all.

Before one of you says, "But Tina, your own LLC has member-owners!" let me make it clear our system only works because I retain super majority ownership and full decision-making authority. Our partnership is solid because our partnership agreement is solid.

While the shared burdens can make partnerships look appealing, please be aware they're extremely prone to collapse. They rarely work. (Don't take my word for it if you don't want to. Even Dave Ramsey says so. (www.daveramsey.com) Every pair of partners I've ever met thinks they're some kind of special exception and their situation will be part of the small percentage of those that succeed, but it's usually evident from the beginning they're wrong (and in every single case I've personally worked on, my predictions have been proven correct).

Instead of a general partnership, consider taking on the partner as an investor with a plan for a buyout. For instance, let's say your friend wants to open a salon with you, but she has nothing to bring to the partnership other than her money. Instead of becoming a partner, she can invest in the salon. You'll need an investor agreement or a limited partnership agreement with buyout terms that'll explain how your friend's investment will be paid back (plus interest). The agreement should make it so that once the investment (plus interest) has been repaid, your friend's interest in the business terminates.

Editor's Note: Part 2 of this article will appear in next month's issue. Watch for explanation of the S-Corp plus ways you can get the IRS to change the way they tax your salon.