One of the many reasons people enjoy freelancing is that they get the freedom to be their own boss. However, that comes with the business obligations of being an employer and certain legal and financial responsibilities.
The question you’ll have to answer is: do I need to register or incorporate my freelancing business? From breach of contract lawsuits to employment taxes, the business structure you choose can make a big difference.
It can be daunting to make sense of all of the various business structures and feel assured you’ve chosen the right one. That’s why we compiled a guide to help you think through why or why not to register or incorporate your business. We also provide tips to set up the best business structure for your freelancing career.
The 3 Most Common Business Structures
Most freelancers choose to operate as either a sole proprietorship, an LLC, or an S-Corp. There are other options as well, such a C-Corp, but those typically make more sense if you are starting a company with partners or investors. Here’s a description of the three:
1. Sole Proprietorship
A sole proprietorship is usually the most simple and inexpensive way to begin your career. Startup costs are lower and there are no legal filings — you basically just start working.
This setup, however, provides no legal distinction between the business and the owner. In other words, as a sole proprietor, you are personally accountable for all the business debts and liabilities.
2. Limited liability company
A limited liability company, or LLC, is a business structure that combines elements of a corporation with some of the tax efficiencies and operational flexibility of a sole proprietorship. While LLC structures can vary from state to state, they all have many common features.
The main benefit of setting up an LLC is your personal protection against liability. For example,if your business is found liable in a lawsuit, plaintiffs cannot access your personal assets.
3. S corporation
An S corporation is a corporate structure that protects your personal assets from any liabilities as well. It also is the most complex of the three common business structures, both in terms of initial setup and associated taxes.
Despite its relative complexity, many freelancers choose to incorporate as an S corporation because of the tax advantages it can afford. As an S-Corp, you’d have to pay yourself a “reasonable” salary and pay standard personal income taxes on that amount. However, anything left in the corporate account after your salary is taxed at a lower level, often resulting in thousands of dollars in tax savings.
How to Determine Which Business Structure Makes Sense
Before deciding on which business structure is best for you, you must first understand how each type could affect the future of your business.
- Liability. Liability protection is one of the main reasons why freelancers often incorporate their business. At the beginning of your freelancing career, the idea of someone suing you because of your work might seem ludicrous, but what if a client claims you violated a nondisclosure agreement in your contract? Are you willing to risk losing your personal assets, such as your car, house or savings, if you lose the court case?
- Taxes. As a freelancer, you are responsible for paying personal income taxes as well as employment taxes for Social Security and Medicare. However, with certain business structures, you can avoid paying employment taxes on some of your earnings. While this may seem advantageous, these corporate structures make tax filings more complicated. Depending on how much money you make and the state you live in, you might not see any savings at all—you might even end up paying more.
- Raising capital. It’s much more difficult to get a loan to expand your business without the right business structure. Banks are much more likely to provide a loan to an incorporated business.
- Credibility. Including “LLC,” “Inc” or “Corp” in your business name suggests a level of professionalism, authority and credibility that can help you find potential clients. Once you understand the various legal and financial issues at stake, you can better decide which business structure is best for you.
Sole proprietorship = simplicity
A sole proprietorship is the simplest business structure—there are no filings or complicated taxes associated with it. All earned income is reported on your personal tax return.
If there’s a low risk of incurring significant business liabilities and no long-term need for a business loan, a sole proprietorship might be the best business structure for you. However, if you start to earn a higher income, it’s a good idea to consult a business formation attorney to check if you could lower your tax burden by incorporating.
LLC = simplicity + protection
A limited liability company is the simplest business structure for protecting your personal assets from business liabilities. Taxes work just like with a sole proprietorship: all income and expenses are reported on your personal income tax return. Incorporating can also open up lines of credit at banks and adds a certain level of credibility.
S corporation = more savings + more paperwork
Along with liability protection, an S corporation allows for you to avoid paying employment taxes on a certain amount of your earnings: pay yourself a “reasonable” salary. This amount will be taxed. You can then pocket the rest of your business profits without having to pay employment tax on it.
In order to claim this benefit, you will have to file a complicated set of forms and multiple tax returns. You will also have a higher chance of being audited by the IRS. Auditors will hone in on whether your salary is considered “reasonable.” See the helpful resources at the end of this lesson to determine an average salary.
Confer with a business formation attorney before settling on this business structure. Depending on the state you live in, you might end up paying more in fees and other taxes than you would save by not paying employment taxes.
How to Set Up Your Business Structure
Sole proprietorship. Simply start working and pay all of your taxes. It’s that easy.
LLC. The rules to set up an LLC vary state by state. However there are some common steps to set up a single-member LLC:
- Choose a business name that adheres to state rules
- File an Articles of Organization (name, address, owners) with your state
S Corporation. Before filing your business as an S corp, you must first file as a regular corporation with your state. Once recognized as a corporation, you must then file IRS Form 2553 to establish your business as an S corp. You do have the option of taxing your LLC like an S Corp by making a special election with the IRS. Legally, your business is still be an LLC, but for tax purposes, it will be treated as an S corp.
Remember to Register a Business as a Freelancer
Regardless of the business structure you choose, registering your business is likely a good idea. Not only does registering your business protect its name, but it also ensures you have obtained all the proper licenses and permits to operate legally.
There are three basic steps to registering your business:
1. Choose Your Name
Think of a name that looks good as part of a logo and on social media. Make sure it’s unique and evokes the feelings you want it to. Check with the US Patent and Trademark Office to make sure it’s not already trademarked.
Most states provide an online tool to search for trademarked business names as well. If you plan on doing business in other states, search for your desired trademark in those states as well. Even if you complete just a single transaction in another state, you may be considered as doing business within that state.
2. Register Your Name
If you’re doing business under a name that isn’t your personal name, you probably have to register it with your local and/or state authorities. Look under helpful resources for the SBA link to local guidelines.
3. Obtain Necessary Business Licenses
Depending on the work you’re doing, you might have to obtain a business license from your local and/or state authorities to register your business. Check the SBA’s permit search tool in the helpful resources section.
Consider Hiring an Attorney and Accountant
While there is an upfront cost associated with hiring an attorney or accountant to help set up your business, doing so could pay off in the long run. The more complex your legal filings and business taxes are, the higher the chances that you make a costly mistake. Plus, the time you save by hiring an expert could be used to expand your freelancing career.
There are several cost-effective legal and accounting resources that specialize in providing high quality services for freelance businesses. Consider online marketplaces for attorneys and accountants like UpCounsel or Angi, or consult with your local Chamber of Commerce for good recommendations.
