Protect Yourself & Go Legit
Working as a freelancer is hard. Freelancers have to run their businesses, find clients, and meet deadlines, all at the same time. So, it’s no wonder why incorporating their businesses isn’t always a top priority. It can also be a scary, expensive, and confusing process, but it really doesn’t have to be so daunting. You just need to know how to get started.
Organizing your business into a “legal entity” can protect you and your work. Forming a legal entity can impact the amount of taxes that you have to pay, if you’re personally on the hook for all of your business debts, and whether or not you’re liable for other business-related problems. It can even help you land bigger jobs and make you look more professional.
There are three main types of legal entities that freelancers working on their own should consider:
- Sole Proprietorship
- Corporation (C Corporation & S Corporation)
- Limited Liability Company (LLC)
It’s important to understand the pros and cons of each type before deciding what legal entity will work best for you and your business. So you should consult with a lawyer and/or an accountant when weighing out your options.
Choices, Choices, Choices
Have you been working on your own and not yet formed your business into a legal entity? Congratulations, you’re already a sole proprietor!
A sole proprietorship is the easiest way to organize your business. It’s also the cheapest because there really aren’t any formation fees.
As a sole proprietor, you don’t file separate taxes for your business. You report your business income and losses on your personal tax return. Additionally, you have to file a separate IRS Schedule C, listing your business income and expenses. You are also required to estimate and pay Social Security and Medicare taxes 4 times a year to the IRS and you can also be liable for state self-employment taxes.
As a sole proprietor, you are personally liable for all business debts and can be personally sued for something that goes wrong with your business. So if you are a sole proprietor, liability insurance can be a good idea.
- THE GOOD: It’s really easy to form, because you don’t have to do anything, and it’s also the cheapest to form.
- THE BAD: If your business has a lot of income, you’ll likely be taxed at a much higher rate than if you incorporated or formed an LLC. With a sole proprietorship you’re also responsible for your business’ debt and liabilities, which means your personal assets may be on the line.
Corporations are separate and distinct beings from their owners and employees. In fact, corporations can do a lot things that a real person can do like borrow money, purchase property, go to court, and hire employees. Unlike a sole proprietorship, a corporation is the “person” who shoulders the business’ debts, liabilities, and tax responsibilities in most cases.
There are two types of corporations: “C” Corporations and “S” Corporations. One main difference between the two types of corporations is how the federal government taxes them:
All corporations have to start out as a C corporation first. To change the corporation type to an S corporation, you’ll need to file Form 2553 with the IRS.
C corporations are required to pay income tax, but a C corporation’s income tax rate may be lower than personal income tax rates. You’ll only pay personal income tax on the money that your C corporation distributes to you (e.g., salary or dividends).
You can also keep up to $250,000 in a corporate bank account without having to pay extra tax on it. A portion of the money kept by the corporation won’t be subject to employment taxes (15+%). C corporations can also provide their employees with fringe benefits like healthcare and retirement plans that can then be deducted from the corporation’s taxes as business expenses.
For tax purposes, S corporations are not considered separate legal entities from their owners and are taxed like a sole proprietorship. The income earned by the business is required to be reported on the owners’ individual taxes. S corporations usually don’t file any taxes, but are required to file Form 1120-S with the IRS.
Although, there are benefits to incorporating your business into a corporation, the fees, corporate formalities, and some of the tax requirements, like unemployment taxes for it’s employees, can be too burdensome for freelancers.
If you do choose to incorporate, remember that requirements and taxes for corporations can vary from state to state. So make sure that you check with the appropriate state agency in the state that you are incorporating about additional requirements or responsibilities.
- THE GOOD: The taxes on your business’ income can be lower if you incorporate as a C corporation. You’re protected against your business’ debts and liabilities (i.e., your business’ bad mojo can’t touch your personal assets).
- THE BAD: In terms of administration, it is the most burdensome type of entity to create and to maintain. It can also involve more complex tax requirements than some of the other types of legal entities.
Limited Liability Companies
LLCs are a relatively new, but popular type of legal entity that can provide you with a lot of the benefits of a corporation, but without some of the downsides. With an LLC, you’ll be taxed just like a sole proprietorship, but since the LLC is it’s own separate entity, you’re personally protected from a lot of the liability incurred by the business.
The formalities for forming and maintaining an LLC are much easier than for a corporation. However, LLC members usually have to pay self-employment taxes on the profit that they receive from the LLC regardless of whether it’s in the form of a salary, distribution payment, or if it stays with the company. There are also state taxes, which can very depending on the state. Additionally, some states don’t allow certain professions, like lawyers, from forming an LLC or require them to form a special type of LLC, which is subject to special rules.
- THE GOOD: It’s administratively easier to form and maintain an LLC than a corporation. However, like a corporation, you’re protected against your business’ debts and liabilities.
- THE BAD: You may be subject to more taxes than if you were a corporation.
You now have a general sense of the different types of legal entities. You’re halfway there to protecting yourself! Next step is deciding which form is right for you. Included below are some resources to help you on your journey to becoming a “legal” business:
The above information is for educational and informational purposes only, and is not a substitute for an attorney’s or an accountant’s advice. Please consult a licensed attorney and/or accountant in your area about questions or concerns about your specific situation.