How to Structure Your Freelance Business
Should you form an LLC or an S corporation?
Deciding to work full-time as a freelancer is liberating.
You no longer have to commute to work. You say goodbye to wasteful meetings about meetings. You have the ability to take on projects that interest you — instead of just doing whatever your boss tells you to do.
This freedom, however, comes with a price — and a pretty hefty one at that.
Whereas regular employees get taxes withheld from their paychecks, freelancers almost always treated as 1099 workers and paid in lump sums. Someone who charges $50/hour and bills a company for 20 hours of work can expect to receive a $1,000 check, for example.
While it might feel nice to get heavier checks, the thrill is short-lived. Freelancers are required to send the government estimated tax payments each quarter. These payments tend to be more significant than one might expect due to the self-employment tax surcharge. In traditional working arrangements, employers and employees typically split payroll taxes, paying 7.65% each. Freelancers, on the other hand, are forced to pay the full 15.3% out of their own pockets.
Unfortunately, many rookie freelancers don’t realize they owe Uncle Sam more money than regular employees. And they also aren’t aware they have to send in quarterly payments to both the federal and state government (unless, of course, they live in a state that doesn’t have an income tax).
As a result, many first-year freelancers are subsequently penalized after they settle their taxes in April alongside the rest of the workforce.
Succeeding as a freelancer requires knowledge of tax law and the right business structure.
If you want to keep growing your freelance business, not only do you need the the right kind of personality traits and a freelance system that works, you also need to figure out how to structure your business to avoid paying more taxes — or incurring more risk — than you legally need to.
Otherwise, you may end up working really hard without seeing as much financial upside as you’d hope. And, in the worst case scenario, you can end up completely broke.
This is not to say you need to become a tax expert yourself. But you may want to at least do some research and talk to a professional tax accountant to see whether it makes sense for you to hire them. While a tax planner might set you back a couple hundred bucks each year, they will almost certainly save you lots of money and time while eliminating unnecessary stress.
When you’re starting your freelance business — and certainly once it’s starting to grow — you may want to set up a legal business entity. In addition to potentially enjoying some tax benefits, you’ll also protect your personal assets in the (however unlikely) event you’re sued.
Generally speaking, you’ll have three options when it comes to structuring your business:
- Sole proprietorship
- Limited liability company (LLC)
- S corporation
Let’s explore the differences between the three.
1. Sole proprietorship
Most small businesses start as sole proprietorships. In fact, according to the Small Business Administration, more than 70% of U.S. businesses are sole proprietorships.
If you’re operating your business under your personal name, there’s nothing you need to do to establish your business as a sole proprietorship. You will, however, need to fill out paperwork if you decide to do business under another name.
On the plus side, sole proprietorships are really quick and easy to set up. The moment you start your business, you become a sole proprietor by default (unless you’ve structured your business differently). You and your business are one in the same, so you don’t have to fill out a separate tax return for your freelance work at the end of the year. You control the money that comes into the business and are responsible for all major decisions.
But sole proprietorships are not without their downsides. For starters, because you and your business are considered one entity, you are responsible for 100% of your company’s obligations and liabilities.
In theory, your personal responsibility could be unlimited. If a client were to sue you, they could potentially win claim to your business assets and your personal assets. Further, because they are the easiest type of company to set up, sole proprietorships can give off a less-than-professional vibe.
If your freelance business is considered risky, an LLC or S corporation probably makes more sense because your personal assets will be protected.
2. LLC
An LLC is much like a sole proprietorship except your personal assets are protected from any business liability.
Many freelancers who feel like they need extra protection opt to form single-member LLCs to ensure their personal assets are secure.
There are some tax benefits associated with forming an LLC. You can distribute profits to yourself which are then taxed at your lower marginal tax rate. You can also pass through business losses to offset some of your other tax liabilities (e.g., dividends or capital gains). What’s more, because you’ll be able to call yourself “Your Business Name, LLC,” your company will instantly sound more “credible.”
On the flipside, you’ll have to fill out a good amount of paperwork to establish an LLC. You’ll have to get a federal tax ID number (EIN) to start operating your business, for example. And it may cost up to $500/year to register your business and keep that registration current — and even more if you decide to bring a lawyer into the process.
LLCs are easy to manage and offer the additional liability protection, so you may want to consider forming one as your freelance business continues to grow.
3. S corporation
Freelancers can also opt to establish their businesses as S corporations, which provide additional tax benefits while eliminating the personal liabilities that can hurt sole proprietorships.
Under the tax code, owners of S corporations are required to pay themselves a “reasonable salary.” Let’s say you’re a New York City-based graphic designer who works really hard and made $120,000 last year. Research suggests that the average graphic designer who works in New York City gets paid about $55,000 a year. In theory, under an S corporation, you could pay yourself a full-time salary of $55,000 — and pay yourself $65,000 in dividends, without having to pay employment tax on those funds.
It bears repeating: S corp owners need to pay themselves a fair salary. Otherwise the IRS may audit you.
Unlike regular corporations, S corporations are not treated as separate legal entities. Instead, they are taxed like sole proprietorships; income earned by S corporations is reported on individual tax returns.
Out of the three types of business entities, S corporations require the most time to set up and the most paperwork. First, you need to establish yourself as a corporation. Then you need to file IRS Form 2553.
Keep in mind that you can create an LLC that’s taxed like an S corp — perhaps giving you the best of both worlds.
Which option makes the most sense for your specific situation?
The easiest way to find out is by talking to a qualified tax accountant to see what they have to say.
Partner with the right tax planner and you’ll save a ton of money, stress and time while reducing your personal liabilities — and growing your freelance business.
Getting your freelance business to the next level takes time. Not only do you need the right business structure, you also need tools that were designed to make your job easier — like Lancelot.
Learn how Lancelot can help freelancers like you increase productivity and land more gigs. And if you found this article helpful, please click the clap button so other people will see it, too.
