Should I Start An LLC As A Freelancer?
Freelancers, if you just started your own business, congratulations, you are one step ahead in this long and terrific journey. Starting your own business is an exciting experience. You will enjoy the freedom of being your own boss, setting your own schedule, and choosing the projects you want to work on.
The world is quickly changing to a “gig economy”, which means more and more people are freelancing full-time or part-time every year. However, you’re not just a freelancer, you’re also a business owner! Since 1099 workers are a small business, a common question accountants get asked is, "should I start an LLC as a freelancer?". You see, there’s a lot to know about running a business, the federal tax implications, and all kinds of risks if things aren’t done right. Don't worry, incorporating and business taxes for independent contractors don't have to be complicated.
In this article, we’ll go over some common business formation questions like:
- is it better to legally establish a business or remain as a sole proprietor?
- Am I going to get penalized for sticking to a sole proprietorship and not doing anything?
- Why do most people choose an LLC or a corporation?
- What in the world is an S corporation?
- Do I also have to switch to S corporation? If I do, then when is the right time?
Let’s get into it!
LLC vs Sole proprietorship
The biggest benefit of the LLC over the sole proprietorship is that when you form an LLC, you establish a new business entity that’s legally separate from its owners. This separation provides what is called asset and liability protection.
This means an LLC owner only risks the amount of money he has invested in his business – the owner’s personal assets such as homes and cars are safe (even if the LLC’s creditors can go after the LLC’s assets). Owners are still liable for debts that they have personally guaranteed though.
Setting up a legal entity for your operation makes you an official business. You can now have your customers pay you through your “official” LLC instead of having your customers pay you directly.
Furthermore, now you can apply for an Employer Tax ID (EIN) and set up a business bank account for your business. This allows you to have a place to keep your business income and expenses. This helps you separate your business and personal finances.
This kind of “corporate shield” can protect your personal finances in case of a lawsuit (they can only go after your business assets). If you’re doing business as a sole proprietorship, you have personal liability. This means you might be at risk of losing your personal assets in a lawsuit as you wouldn’t have any of the legal protections or separate business finances.
Therefore, if you’re intending to continue and grow your freelance business and establish business credit, you must consider the LLC sooner or later. However, if you’re still “testing” your business startup and don't want to be bothered by any required state paperwork (e.g. annual filings) but still enjoy all of the same tax benefits of being self-employed, you may want to remain as a sole proprietorship.
Check out this article if you are wondering if LLC's get a 1099.
LLC vs Corporation
Now, you understand and know that you should form a business entity. But, you have questions about which is better, LLC or corporation? What is different?
To make the right decision, it is important to understand how LLC s compare to corporations when it comes to ownership, taxation, and other compliance requirements.
Although “corporation” has been around for a long time (prior to the 17th century), this limited liability company (LLC) concept came out much later (1977) than the corporation. LLCs and corporations are both business entities that are created by filing formation documents with the state.
Owners of both entities are generally not personally liable for business obligations. Although an LLC is similar to a corporation, it offers more flexibility in management and taxation and has lesser IRS compliance requirements. A lot of the times, freelancers become a single-member LLC. Corporations are more suitable for people who plan to seek outside investors, especially foreign investors.
C-corporation vs S-corporation vs LLC
Another common question is if you should form a C-Corp, S-Corp or LLC for independent contractors. There are two main corporate types for tax purposes. Corporations are taxed as either C-corporations or S corporations. An LLC itself doesn’t have their own tax rate classification. They can choose how they will be taxed – sole proprietorship, partnership, S-corporation, or C-corporation. C corporations pay corporate income tax on their net income and shareholders pay income taxes on dividends that they receive from corporations. This is called “double taxation.”
However, S-corporations are not subject to double taxation because of the business structure. S corporation profits pass through to shareholder’s individual income tax returns, and so shareholders are taxed only one time on their personal tax level.
There are certain conditions that corporations and LLCs can be treated as an S-corporation for tax purposes. There must be 100 or fewer shareholders. Also, the shareholders cannot be corporations, partnerships, or non-resident aliens.
When is the right time to switch to an S-corporation?
Most small business owners set up an LLC first and then switch to an S-corporation for many reasons. Most of the time, saving taxes is a common reason. Switching to an S-corporation means you can pay yourself through a form W-2. By doing payroll, you can save almost half of your self-employment tax (which is social security and Medicare tax). However, this also means that you should withhold and pay payroll taxes on a monthly or quarterly basis (depending on the amount of taxes).
This will cost you an additional monthly/quarterly payroll tax service fee and separate S-corporate tax return fees. However, as I said, it saves you a good bit of self-employment taxes.
Most people start thinking to switch to an S-corporation when their net income (gross receipts - expenses) starts to exceed $30,000. An S-corporation status will save you self-employment taxes about $2,000 if your net income is $30,000 and it will save you about $3,000 if your net income is $40,000. However, if your payroll tax services fee is $100 per month ($100 x 12 = $1,200) and your S-corporate tax return fee is $800, your total extra spending for switching to an S-corporation is about $2,000.
As such, if your net income exceeds 30,000, that is when you should consider changing your entity structure to an S-corporation for tax purposes. You should really juggle your cost and benefit and decide when you want to proceed to form an S-corporation.
To sum it all up, setting up an LLC is pretty common for many independent contractor jobs. They are most favored by small business owners that want flexibility and the least compliance requirements. Corporations are, however, a good option for businesses that plan to gather more investors from outside. An S-corporation can save you a great bit of self-employment taxes as long as you do payroll with a reasonable salary amount on a yearly basis. Although starting your own business can be pretty overwhelming, it’s a big leap and you’ve already leveled up into a next journey. Enjoy!