Should You Incorporate? Read This First.
Once you have made the decision to freelance - or had the decision made for you - it is time to think about how to structure your business from the legal and tax perspectives. Are you ready to incorporate? That moment may come sooner than you think. Freelancers looking to formalize their business can generally choose from four structures: sole proprietorship, LLC, C corporation, and S corporation. In this article, we will provide an overview of these structures, as well as the key advantages and drawbacks for each. As always, please talk to your own legal and tax advisors to make the best decision for your specific circumstances. This overview is provided for informational purposes only.
Sole Proprietorship
This is effectively the default state for freelancers. A sole proprietorship is a business that has only one owner.
Advantages: There is no additional paperwork to file, you do not incorporate, and you don’t need to file separate tax returns for your business. By freelancing alone and taking no other actions, you are automatically a sole proprietor. This can be a good option when you are just starting out or testing whether freelancing is right for you.
Drawbacks: There must be a catch, right? There is. If you take on debt to grow your business, you are personally liable for the loan. If you get sued, your personal assets may also be at stake. This can be very risky, especially as your business begins to grow.
LLC
One of the most common legal structures for freelancers is the LLC, or limited liability corporation. The definition of an LLC may be slightly different from state to state, but in general, an LLC creates a new business entity that is a separate from the people who own it (who are called its “Members”). You will get a federal tax ID (EIN), but your LLC income “flows through” to its members’ tax returns, which means that, even though you have an LLC for legal purposes, you may still be taxed like a sole proprietor.
Advantages: The LLC was designed to address the liability risk of being a sole proprietor without the administrative burden of running a corporation. The key advantage of the LLC is that its members are not personally liable for financial debts or liability arising through the business. Other advantages of LLCs include being able to raise money for your business, and having greater flexibility with your taxes than in the case of the sole proprietorship. There is no limit to the number of members your LLC can have, and they are one of the simpler business entities to form and maintain.
Drawbacks: There are three key drawbacks. First are the fees you will incur in setting up an LLC. You will need to pay a fee to register the business with your state, as well as a second fee to register federally. You may also hire a lawyer to help you draft your articles of organization and other formation documents, and you may hire a registered agent as well. The second drawback is that there is more administrative complexity in having an LLC than in staying as a sole proprietor. You will have to stay on top of your formation filings as well as your annual reports. Finally, you may be subject to a self-employment tax, particularly if you have a single-member LLC. There may also be hurdles with using an LLC to conduct business internationally and this is likely not the right vehicle if one day you want to take your business public.
Corporation
A “C Corporation” is one of the most common forms of corporations, which we will discuss here. It is a legal structure that separates owner and shareholder assets from those of the business entity.
Advantages: There are several advantages to C Corporations. Like LLCs, corporations help to limit the owners’ personal financial liability for debts and lawsuits. Corporations can be a good choice for international business and for companies that will eventually go public. There is no limit to the number of owners your business can have, and you can raise capital for your business.
Drawbacks: C corporations are rarely preferred by freelancers for two main reasons. First, there is a much higher administrative burden to having a corporation. Like with LLCs you will have to file with your state and the federal government to incorporate, which can be costly. Unlike with an LLC, at a corporation, you will also be required to put yourself on the company’s payroll and pay yourself a “reasonable salary” (most likely with a W-2 tax form). You will also be required to have annual meetings and a board of directors. The second drawback is that corporations are subject to “double taxation”. This means that the corporation’s net income is taxed first for the business. Then the “reasonable salary” you earn as your income will also be taxed, resulting in two taxes for every dollar the business earns.
S Corporation
This is a structure that was designed to avoid the “double taxation” problem of the C corporation. In this case, corporate income flows directly through to the shareholders who, then, pay tax on it only once on their personal tax returns. This is a tax structure, not a legal structure. This means you will freelance as a sole proprietor, LLC, or corporation, but declare yourself as an S corporation on your tax returns with the IRS.
Advantages: The primary advantage of the S corporation is that it addresses both self-employment tax that arises with the LLC as well as the double taxation that arises with a C corporation. This can be a good choice for freelancers, depending on your personal tax situation.
Disadvantages: There are strict guidelines for S corporation eligibility, and S Corporations are not recognized by every state. The IRS requires the following, in order for a corporation to qualify as an S corporation:
Be a domestic corporation
Have only allowable shareholders
May be individuals, certain trusts, and estates andMay not be partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
Further Reading
Want to learn more about sole proprietorships, LLCs, C corporations and S corporations? Here are a few places to start:
Sole Proprietorship - US Small Business Administration
LLC vs. S Corporation - Investopedia
Compare Business Types - LegalZoom
LLC vs S corp- Which is the best for freelancers?
Opinions of linked articles are their authors’ and do not represent the views of The Accidental Freelancer.
