Eager to leave the daily grind and be their own boss, more and more Americans are now working on their own as freelancers.
As of September 2014, 53 million Americans work as freelancers — that’s more than a third of the total workforce!
Some of these freelancers choose to create a formal business entity, while others remain sole proprietors (the default business structure if you never set anything formal). Selecting a business structure is an important decision, and often one filled with anxiety as new freelancers are worried about being open to a lawsuit or paying too much in taxes.
Here we’ll break down some of the key facts and misconceptions surrounding freelancer incorporating so you can make the best decision for your freelancing business.
Freelancers and Liability Matters
One of the key reasons to incorporate or form an LLC (Limited Liability Company) is to help protect one’s personal assets in case the business should be sued.
When striking out on your own, it’s natural to be concerned about liability, and by operating as a sole proprietor, there’s no separation between you and the business.
If your business can’t pay its bills or gets sued, you’ll be personally liable and your personal assets can be called upon to settle the business debt. That’s a pretty compelling reason to form an LLC or corporation as these structures put some separation between your personal assets and the business.
There are a few important things to keep in mind when it comes to liability and incorporation. Forming an LLC or corporation won’t automatically protect your personal assets in all situations. You’re still responsible for your personal actions regardless if your business is a corporation or a sole proprietorship.
And, if you’re a freelancer, chances are you’re providing services (writing, graphic design, consulting, landscape design, etc.) for your clients. If you are negligent when providing these services, you are personally liable for this conduct.
However, there are several key ways that an LLC or corporation can protect your personal assets. First, if you hire employees, contractors or subcontractors, an LLC/corporation can limit liability caused by negligence or misdeeds by these employees.
Second, these business structures can protect your personal assets in matters of contractual liability – should your business not be able to hold up its end of a contract.
For example, if your business needs financing to buy property or equipment, an LLC/corporation can help protect your personal assets (as long as you don’t personally guarantee the loan!).
Incorporating and Taxes
I’ve never met a freelancer who is fond of paying self-employment taxes, but there’s not much you can do to legally avoid them altogether.
One popular strategy to minimize self-employment tax is to form an LLC or corporation and then elect to be taxed as an S Corporation. This way, you’re able to pay yourself in both salary and distributions. The salary portion is subject to self-employment tax, but not the distributions.
Be careful when splitting your payment this way as the IRS watches carefully to make sure S Corporation owners are paying themselves a fair salary for the work they do, and aren’t just getting paid in distributions.
If you’re concerned about taxes and are looking for the best strategy to minimize your self-employment tax, speak with a CPA or tax advisor. In addition, make sure your pricing structure adequately compensates you for meeting your federal and state tax requirements.
Other Reasons to Incorporate
Beyond taxes and liability, there are other important reasons to incorporate or form an LLC for your freelancing business. It can help actually help you win business.
Larger companies typically prefer to work with corporations or LLCs, not sole proprietors.
First, there’s peace of mind that comes with doing business with an established LLC or corporation.
In addition, there are significant tax implications when a corporation hires a sole proprietor as a contractor.
The IRS is watching closely to make sure that businesses properly classify their workers as full-time employees or contractors.
Whenever a business hires a sole proprietor as a contractor/freelancer, there’s a chance that the IRS will double check to make sure that worker is truly operating as a contractor and not as an employee.
But this isn’t a concern when a business hires an LLC or corporation to do the work: there’s no doubt that the LLC/corp is an independent entity and not an employee.
The bottom line is there are several good reasons to consider freelancer incorporating and forming an LLC or corporation for your freelancing business. But it’s important to understand the full picture of how these formal business structures can and cannot help.
Freelancer Image via Shutterstock