When launching a business, there’s a seemingly endless list of tasks and issues to address. Selecting a business structure for your new business usually ends up pretty far down on the list, yet this step is crucial for building a proper legal foundation. A formal business structure is not just for large corporations: freelancers, consultants, and other independent workers can all benefit from the right structure, both in terms of protecting their legal assets…and possibly saving in taxes.
Do you really need a formal business structure?
The sole proprietorship (or partnership if there are two or more people) is the most popular business type for contractors and freelancers. If you don’t formally choose a business structure (i.e. incorporate or form an LLC), your business will automatically be considered a sole proprietorship by default. It’s the simplest business entity to have.
While operating as a sole proprietor requires the least amount of paperwork and formalities, this approach does have its drawbacks. The main concern is that the owner of the sole proprietorship is personally tied to the business, and the government doesn’t see any distinction between the owner’s personal assets and the business.
What does this mean? Should the worst-case scenario ever happen and your business is sued or can’t pay its bills, then your personal assets can be seized. Even if you don’t have much in the way of personal assets today, a creditor judgment against a business owner can last up to 22 years, leaving you vulnerable for years to come.
Many contractors and freelancers never expect to be sued or go into debt, but they also don’t want to take on that much risk. Instead, they opt to incorporate or form an LLC. These business structures create a legal shield between the business owner and the business. Should your business be sued, your personal assets will most likely be protected.
Which Business Structure is Right for You?
If you are ready to transition your small business to a formal business structure, the inevitable question is: which type is right for me?
The most common legal business structures in the U.S. are the LLC and Corporation (S Corporation or C Corporation). There’s no single right structure for all businesses, even all freelance or consulting businesses. Each structure has it own advantages and disadvantages depending on the situation.
However, generally speaking, a C Corporation is overkill for most freelancers and solo businesses. With the C Corporation, the business must pay taxes on any profit, and then the business owner(s) pay taxes on any profits/distributions they take out of the business. In some cases, this can lead to what’s called “Double Taxation” and can increase the tax bill for the business owner.
Again generally speaking, the C Corporation is a solid option for companies that are looking for an IPO or VC financing, as well as those businesses that invest the profits back into the company (instead of distributing them out to the owners).
The LLC and S Corporation address the issue of Double Taxation by giving you the option for “pass through” taxation. In this case, the business doesn’t pay taxes on its profits, but any profits or losses of the business are passed along to your personal tax return. That may sound similar to the way taxation works with a sole proprietorship, but there’s a big difference.
Sole proprietors who pay their taxes on a Schedule C are subject to paying self-employment tax in addition to income taxes. This leaves many wondering what happened to all their hard-earned money.
However, freelancers, independent contractors, and consultants might be able to reduce their self-employment taxes by setting up an S Corporation or an LLC that is taxed like an S Corporation.
When you are taxed like an S Corporation, you can pay yourself in two ways: regular salary and distributions (which are like bonuses). Your salary is subject to self-employment tax, but your distributions are not. Keep in mind that the IRS requires that you pay yourself a reasonable salary for what you do, so don’t think you can just avoid self-employment taxes altogether.
I know that lowering the tax burden is the prime concern for many. However, when selecting a business structure, there are other factors that can have a big impact on your operations and bottom line. For example, if you incorporate as a Corporation or S Corporation, you will need to follow certain administrative requirements like creating a board of directors, holding a shareholders meeting, filing meeting minutes and more.
For this reason, many freelancers and smaller businesses opt for an LLC, and then elect to have the LLC taxed like an S Corporation. With an LLC, there are fewer paperwork and ongoing administrative formalities to follow. With an LLC, you’ll typically need to file an Annual Report with the state and keep up with your taxes, and that’s about it.
Most importantly, the LLC (like the Corporation) will help protect your personal property and assets from anything that happens in the business.
Take some time to familiarize yourself with the different business structures, and even talk to a small business tax advisor about your specific circumstances. These business types are easy to set up and you’ll be giving your business the right legal foundation to grow in the years ahead.