Freelancers are business owners. And as business owners, freelancers need to be mindful of how their business is structured from a legal and accounting standpoint. The right business entity is needed to give your freelance business the right foundation from which to launch and grow.
Understanding the differences between the main legal business entities is key to making sure your business is setup, not only to grow, but to provide you as the business owner with the right amount of protection and leverage.
The Most Popular Business Entities for Freelancers
Most freelancers are likely to be setup under one of three following business entities.
- Sole Proprietor (DBA)
- Limited Liability Company (LLC)
- S-Corporation (S-Corp)
Below, I will explain the basics of these popular entities as well as the pros and cons and hopefully help you determine with business entity is right for your business.
Sole Proprietorship: Starting Out Small
Starting out as a young freelancer, I did most of my work at night or on the weekends. I freelanced as a side hustle and I had a small list of clients that kept my spare time occupied. And while I made some nice side income, for many years, my freelance work was really just a serious hobby. During those years, I had a 9-to-5 job. So, my side income was smaller. I would simply claim this income as a sole proprietor. The process was simple and made tax preparation easier since I was including my freelance income along with the my other income.
A sole proprietorship is a single-person business entity, that does not require a formal entity. Anyone who wants to start a small business can operate as a sole proprietor. No government filing is required.
For marketing purposes, a sole proprietor may create a different name for the business, commonly know as DBA (Doing Business As). Most banks will allow you to set up a DBA account for business accounting. However, check with your Secretary of State to see if your DBA must be registered with your state.
For tax purposes, all business is tied directly to the owner’s Social Security Number. While a sole proprietor is the fastest and easiest way to start a business, all business assets and liabilities are tied directly to the owner as personal property. These can be seized by creditors to settle unpaid debts or judgements.
Multiple sole proprietors in one business is called a Partnership.
Pros: Easy to setup. No government filing is required.
Cons: There is no legal separation between you (the owner) and the business.
Limited Liability Company (LLC): Protecting Your Assets
As your freelance business grows and your income increases, your expenses will like increase as well. And as your business grows and begins to serve more clients, your business might outgrow the simple structure of a sole proprietorship.
With the increased risk of legal or creditor activity, forming an LLC will make sure that your personal assets (bank accounts, personal property, house, cars, etc.) are better protected and not co-mingled with business’ assets.
A Limited Liability Company (LLC) business entity is good option. An LLC protects the business owners from liability, but requires much less oversight than a corporation.
To form an LLC, contact your state Secretary of State and request the appropriate paperwork. Submitting your paperwork, along with the filing fee (usually between $100-$300). The organizer must also request a tax identification number (tax id). Only one person is required to form an LLC; who then becomes a member of the LLC. In the case of multiple members of the LLC, the IRS will see the members as a partnership for tax purposes.
Pros: Combines the limited liability of a corporation with the pass-though taxation of the sole proprietor. Fewer formalities required.
Cons: Filing and other fees might be higher than for a corporation.
S-Corporation (S-Corp): Big Business Benefits in a Small Package
An S-Corporation business entity is similar to corporation (C-Corp), but the profits flow down to the business owners. In order to form an S-Corp, the members of an existing corporation must file Form 2553 with the Internal Revenue Service (IRS).
In addition, contact your state Secretary of State and register your business name as well as obtain a tax identification number (tax id).
Pros: S-Corp is a great option because the profits and losses are divided among the shareholders, making it a pass-through entity.
Cons: S-Corps have to follow all of the same rules of a C-Corp, including all filings and reports. S-Corps are also exposed to greater scrutiny with regard to dispersement of dividends as wages and vise-versa in order to obtain more favorable tax treatment.
Which one is right for me?
As you can see, there are many factors to consider before deciding which entity is right for your freelance business. Spend some time and understand all of the risks and benefits to you, your business and your clients.
If you are still unclear about which business entity is right for you, consider consulting a legal or tax professional and seek their advise or recommendation for your particular situation.