Earlier this month I wrote about some of the advantages of replacing work lost to the coronavirus pandemic with self-employment. I want to continue that discussion today with some questions to ask before and as you get your self-employment up and running.
Is your self-employment a business or a job?
This question confuses people in the United States due to the unfortunate terminology used by our tax code: technically all self-employment income is reported as business income, whether on Schedule C or on the K-1 issued by an S corporation. A surprising number of people are even tricked by this sophistry into believing they own and operate a small business when they deliver groceries or walk dogs, just because their income happens to be reported on a 1099 instead of a W-2.
I prefer a simpler distinction: will there be any residual value left if you personally stop working? If so, you may have a business. If not, you definitely have a job.
Take two simple examples from the world of reselling, or retail arbitrage. In the first case, a reseller drives around the region buying up bleach wipes and hand sanitizer, then lists it for sale on Amazon. In the second case, a reseller buys a warehouse in a state without sales tax, hires employees, and trains them to find good resale opportunities.
From a tax perspective, the two cases are very similar, if not identical. But in the first case, as soon as the reseller stops reselling, the company is immediately worthless, while in the second case, the business retains assets that can be sold on to a buyer (for example, if the reseller’s employees wanted to buy out the founder and run it themselves).
Likewise, renting out a second bedroom on AirBNB is a job: part housekeeping, part marketing, part photography, part hospitality. As soon as you delist the bedroom, your job disappears.
On the other hand, buying a bunch of condos and renting them out on AirBNB is a business: even if the units are delisted, the business retains assets that can be held for some other purpose, or sold on to another buyer.
Of course there are some situations which fall somewhere in the middle: if you buy a new car, drive for Uber for a year, then stop driving, you technically have an asset (a year-old car) that can be sold to another driver.
The point is not to make a hard-and-fast distinction, but to help guide your decision-making. If all you want is a job, then you can worry less about things like incorporation, insurance, and payroll. If you’re building a business — something that you think you will or may sell on to a buyer in the future, then you’re going to need to focus earlier on things like business processes, company policies, titling of company assets, etc.
I’ve only ever been self-employed in jobs, rather than businesses. When I lived in a two-bedroom apartment by myself, I rented out the second bedroom. Then my lease ended and I moved; my job ended. I track my self-employment income and meticulously report it (as I recommend everyone does), but if I decided to stop blogging, my business assets consist in their entirety of an internet domain and the copyright on an out-of-date book. In other words, it’s a job.
If you decide to build a business instead, then think about what kind of assets you can build or invest in that will retain their value under a new owner:
- Real estate. If you want to build a hospitality empire, it’s better to own real estate rather than sublet year-to-year leases, and if you want to build a reselling empire, it’s better to own a warehouse than use your garage.
- Intellectual property and trade secrets. Of course you can file for patents and copyrights, but also consider other kids of intellectual property, like business practices, algorithms, and other trade secrets.
- Client information. This is extremely common in the case of medical practices, lawyers, and financial advisers, where often the only thing that makes them businesses instead of jobs is their client list, since if the firm is sold many clients may stay with the practice even under new management.
- Equipment. There’s a small chain of middle eastern restaurants in Cambridge, Massachusetts, called Clover, which has no distinguishing characteristic (the food isn’t even that good, although it’s good for Cambridge) except that they imported authentic Israeli pita ovens to bake their bread in. It’s those ovens that give Clover value above and beyond the fact they occupy extremely valuable commercial real estate in one of the world’s wealthiest cities.
Capital structure: borrow or sell?
Another reason the distinction between a job and a business matters is that it can help you decide how you want to finance your self-employment: by borrowing your startup costs, or by selling a share of the business’s value. Alternately, this is the difference between self-financing or raising capital from outside investors.
I say these are alternate ways of expressing the same idea because even if you don’t need to actually borrow money, and are instead able to finance your self-employment entirely from savings, you should properly account for that drawdown in savings as a loan from yourself to yourself — you should only “loan” money to yourself if you expect your self-employment to have a higher return than your savings!
If you are creating a job, then self-financing or borrowing money might be more appealing, since a lower percentage of your annual income will go to paying down the debt.
If you are creating a business, then selling a share of the business’s future value to outside investors may be a better option, especially if it allows the business’s potential final value to rise faster.
Finally, this introduces the question of risk. Different industries have acquired different norms for capital structure, partly due to nuances in the tax code, and partly due to real or perceived risks. For example, residential real estate has historically been viewed as a relatively safe business model, which increases the willingness of lenders to lend and decreases the appeal of selling shares (setting aside commercial property conglomerates like REIT’s). After all, the more certain you are in the outcome of your investment, the less willing you should be to split the proceeds with outsiders.
Conversely, new restaurants have historically had very high failure rates, which decreases the willingness of lenders to provide cash they’re unlikely to see repaid, and leads outside investors to demand a relatively high stake in future earnings (this is why top restaurants are invariably owned by LLC’s ending in “Group.” Celebrity chef José Andrés is the face of the Think Food Group, for instance; it’s a group of investors, not a group of restaurants).
Your own decision whether to self-finance, borrow, or raise outside capital should certainly be informed by these norms, but not determined by them. There’s an unfortunate tendency to believe that the only reason anyone should consider becoming self-employed is to become fabulously wealthy.
But this isn’t a law of nature or economics; if Danny Meyer wanted, he could have kept selling burgers and shakes out of a cart in Central Park. This isn’t a criticism of Danny Meyer or the Shake Shack empire, it’s merely to point out that how you decide to build and grow your job, or your business, is a choice, and there’s no rule that says you have to make the decisions that leave you with the highest net worth on your deathbed.