Written by Christopher Clemence
As a freelancer, we often get so focused on delivering a great product or service, it’s easy to put the administrative part of managing our business on the backburner. However, being a freelancer doesn’t just mean freedom and independence. It also means we’re business owners and entrepreneurs. How you organize your business is every bit as critical to your success as the quality of the product or service you offer.
This may seem like a bunch of irrelevant and boring adminstrivia, but operating your business under the wrong type of entity could cost you. This could range from a few hundred dollars lost on your annual income taxes, to losing all of the assets you own, including your personal car and home.
To help you decide which entity is right for your freelance business, here is a brief and general overview of common business entities in the United States. Each state’s laws are different, so be sure to consult a local attorney so he or she can explain your state’s rules and regulations to you before making a decision.
The simplest and most common entity most freelancers work under is that of a sole proprietorship. A sole proprietorship is an individual running his or her own business. There is no paperwork to be filed or forms to fill out, as it is the default status for running a business in the U.S. In other words, if you haven’t chosen another entity for your business, you’re a sole proprietor.
As a sole proprietor, you may give your business a different name for marketing purposes. This is known as “doing business as” or DBA. While completely legal, it is important to know that many states require registering DBAs with the Secretary of State or another government agency, to avoid more than one person using a particular name. Also important to know is that establishing a DBA does not change the sole proprietorship into another business entity. As the person running the business, you still hold the same rights and responsibilities as before.
Filing federal income taxes is easy, as sole proprietorships are known as “pass through” entities, which means any earnings made by the business are simply declared on a separate form (Schedule C) and entered into the individual’s Form 1040 (however, self-employment and estimated taxes still need to be paid). The overall tax rate is also the lowest among all business entities. Also, all equipment that is used for the business belongs to the individual alone. The lack of paperwork and the complete control over the business make it an easy and appealing choice.
As a sole proprietor, there is no legal separation between you and your business. This means you are personally responsible for all liabilities, including financial losses, civil liability, and the bad acts of any other person acting on your behalf, while they’re working for your business. In the event a creditor seeks to have debts repaid, all of your assets could be at risk. This includes your personal bank account, personal property, real estate, and other assets. Not only that, it can be harder to raise money for the business, because a sole proprietorship has no mechanism for raising capital by selling stock. Also, banks often hesitate to lend money to an individual who has not chosen a more formal structure for his or her business. Banks often see individuals as more credible when their business is more formally structured.
This entity is rather straightforward. When two or more individuals go into business, they become a partnership.
Usually, no government filings are needed to form a partnership, but it’s good practice for partners to have a written agreement between or among themselves regarding each individual’s roles and responsibilities, and the division of profits and losses.
As with sole proprietorships, tax liabilities are passed through to the individuals. This makes your personal assets available to creditors when they’re settling unpaid debts or judgments. In certain cases, this includes debts and liabilities incurred by the other partner.
A corporation (also known as a “C corporation”) is a legal entity distinct from the proprietor of the business. From a legal standpoint, a corporation is a different person than the person or people who created it, and is therefore able to own property of its own, accrue its own profits, and be responsible for its own debts and civil liabilities. Some jurisdictions have additional requirements, but generally, a corporation is formed when its articles of incorporation are filed with the Secretary of State of the state in which the organizers choose to have it organized and the appropriate fee is paid. The fee is usually between $80 and $300, depending upon the state. The corporation is owned entirely by its shareholders, and the shareholders have a say in the overall direction of the corporation.
There can be any number of shareholders to a corporation, and, as long as the corporate formalities are recognized by the shareholders, the only liability the shareholder has for the corporation’s actions is the amount of money he or she has invested in that corporation’s stocks.
Though corporations are a common way to conduct business, there are significant disadvantages, especially for individuals and small partnerships. First, a corporation must carry out a great deal of compliance with government paperwork. Since corporate laws are typically written with large businesses in mind, the burden of paperwork for an individual or small group of people may be significant and outweigh any benefits gained by having the corporation in the first place. Also, corporations with more than one individual involved must conduct certain formalities, like having meetings, electing officers, and so forth, depending upon the jurisdiction. If these formalities are not strictly adhered to, creditors may potentially make the case to a court that the corporation doesn’t exist. This is known as “piercing the corporate veil,” and, if the court agrees, the business will be treated as a sole proprietorship or partnership and as a result the personal assets of the shareholders are available to cover any business debts or liabilities.
In addition, corporations are not “pass through” entities. Tax considerations for corporations can become quite complex depending upon the size of the corporation and the jurisdiction, but all corporations must apply for a tax ID number (also known as an Employer Identification Number, or EIN) from the IRS. As corporations are distinct entities in the eyes of the law, they must pay their own income taxes on any profits made by the business. However, instead of paying under the rules for individuals, corporate taxes are governed by Subchapter C of Chapter 1 of the Internal Revenue Code. Additionally, distributions to shareholders are also subject to federal income taxes as well.
An S corporation is governed by Subchapter S of Chapter 1 of the Internal Revenue Code, hence the name. In order to form an S corporation, the members of an existing corporation must file Form 2553 with the IRS.
An S corporation is an option for smaller corporations. The main difference between an S corporation and a C corporation is that the profits and losses are divided up among the shareholders, making it a “pass through” entity.
The S corporation still operates under all the other rules as a C corporation, including the various reports that must be generated and filed, and offices that have to be filled. In addition, S corporations typically face heightened scrutiny from the IRS looking for S corporation owners incorrectly classifying dividends as wages (or vice versa) in order to receive a better tax treatment.
The Limited Liability Company (LLCÃƒâ€šÃ‚Â) is a new business entity developed in the last few decades, inspired by the German business entity Gesellschaft mit beschrankter Haftung (GmbH), and is popular with small businesses. In order to form an LLC, the appropriate paperwork must be filed with the state Secretary of State, along with a fee, usually in the $100 to $300 range. The organizer must also request a tax ID number, which can be done the same way as with a corporation. An LLC may be established by as few as one individual, who then become members of the LLC. If there are multiple members of the LLC, the IRS treats it as a partnership for taxation purposes.
The LLC combines the limited liability of a corporation with the pass through taxation of a sole proprietorship. In the case of a single member LLC, it’s a disregarded entity, which means income is reported to the IRS the same way as a sole proprietorship (except for the District of Columbia, which considers an LLC a taxable entity). In addition, it’s more difficult for creditors to pierce the corporate veil due to the lack of formalities required for an LLC. Generally, the most important issue is whether the LLC’s funds were commingled with that of a member.
Although the LLC is very advantageous for individuals and small businesses, there are some disadvantages to keep in mind. First, in multi-member LLCs, since the law does not require an operating agreement, there is a risk that the members will not draft one. Therefore, rights and responsibilities for each member may not be well defined, potentially leading to problems. As a result, it may be difficult to know who may enter into a contract on behalf of the LLC, or who may make day-to-day decisions, as there may not be any individuals identified as officers or directors of the LLC. In addition, renewal fees and miscellaneous fees associated with forming and maintaining an LLC may be higher than the fees for a corporation.
There are many factors to consider when deciding which entity to use for your freelancing business. As you can see from the potential risks involved, spending time to choose the right business entity may protect you, your business, and your clients.
This story was submitted by freelance writer Christopher Clemence, and does not constitute the views or opinions of Upwork.