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Sole Proprietorship vs. LLC - How to Structure Your Freelance Business
The further you get into your freelance career, the more choices you’ll be faced with. Among the most talked about is how to structure your business. Do you choose to keep your tax status as a single business owner under a sole proprietorship? Or do you put in a little extra work to form a limited liability corporation (LLC)?
Both are valid ways to run your business, and come with all the perks of being self-employed (such as claiming expenses like the home office deduction), but each has unique benefits -- and a few disadvantages.) Since not all freelancers agree on the right way, it’s wise to know everything you can about each. Read on to see which situation will be best for you!
The Sole Proprietorship Explained
How you conduct your business on a day-to-day basis will likely not look much different between the two types of entities. A sole proprietorship, however, most closely resembles a personal tax set up. In fact, the popular method of filing was embraced by over 23 million tax filers in 2010, with 75% of those reporting a profit on their earnings.
To take advantage of the sole proprietorship status, you’ll report your income from your business on a schedule C form on your personal tax return and then transfer that amount over to a 1040 or 1040 EZ. You don’t most likely won’t need to file any special paperwork or register to be a business entity for tax purposes. It will look and feel very much like when you report income from a typical job.
(Note that you may have some extra considerations regarding taxes, however. You’ll be subject to the self-employment tax, for example, and will want to carefully track your income and expenses – just like any business.)
Because your income is tied to you as a person, you won’t have any special protections that a formalized business might have. Any liability against your business will be held against you, as well. If you get sued for creating content that is considered defamatory, or your services cause a client to suffer losses, you will have no way to separate your personal wealth and assets from your business. In short, claims can be made against everything you have and own to satisfy your business debts.
What’s an LLC?
A limited liability corporation, however, is a true, blue corporation. Most freelancers that choose to “incorporate” (the fancy term for forming a corporation) do so as a single member LLC. They are still solo entrepreneurs, but they have the legal advantages of a corporation. Your personal assets are kept separate in the event that anyone ever goes after your business for damages or debt. It’s an extra step that many feel is necessary to ensure personal prosperity.
There is also a tax benefit for many who incorporate as a single member LLC. Like the sole proprietor, your income is considered “pass through income, and you won’t get double-taxed for both personal and business income.
In exchange for the protection you get from being a corporation, however, there is some red tape to cut through. For one, you have to form and register your corporation with the appropriate agency in your state. Most likely, the Secretary of State’s office can point you in the right direction.
This process isn’t free. In addition to drafting and filing the articles of incorporation (which will cost money if you hire someone to help you), there is the actual filing fee. This ranges from $50 to $500, depending on your state. Then, there is the annual fee to keep your corporate status. A few states don’t charge this, but some require you to report the status of your corporation – along with paying the fee – every one or two years. This can range from $15 to over $250, as well.
Which Choice is Best for You?
While no one can make your tough decisions for you, there are some basic guidelines to help you determine if you’re better of as a sole proprietor or an LLC. For one, if you’re not sure that you’ll take your freelance business from hobby status to business status (earning more than $400 this year), it doesn’t make much sense to spend a lot up front to incorporate. Some people just can’t afford the initial cost to start a corporation, and that’s OK.
Additionally, many people like the straight-forward nature of paying taxes as a sole proprietor. If you do your own taxes, and like the ease of filing a schedule C on a form 1040, you’ll enjoy the quick work that most tax software services make of sole proprietor tax issues. It’s also much more affordable to file this way than to file as a corporation – which may require the help of a tax professional or CPA.
However, no one can dispute that incorporation has its perks, as well. If you foresee making a good living as a freelancer this year, there is no substitution for the protections that incorporation offers. Working in the public eye can leave you open to liability, so it’s wise to look into how an LLC can protect your assets – especially if you have a lot to lose by not doing so. If you live in a state where filing articles of incorporation is affordable, it might be the best option for you.
Can You Change Your Mind?
Fortunately, you aren’t locked into any decision forever. Admittedly, it’s much easier to go from a sole proprietor to an LLC, as this is how most people go about it. If you get into your business and feel like your success warrants the extra protections of an LLC, you can choose to file at any time. You don’t have to wait for a certain time of year or for your business to reach a certain level of success to do so.
Switching from an LLC to a sole proprietorship, however, takes a bit more work. To do this, you’ll need to file articles of dissolution with the state agency that originally filed your incorporation paper with. You’ll also need to notify any creditors of your decision. (This may require you paying off debt in the name of your LLC to clear up all your accounts. You can always set up new accounts under your own name as a sole proprietor.) Finally, you may need to announce your dissolution in your local paper, depending on your state requirements.
Once you’ve dissolved your LLC, it’s possible to pick back up where you left off – only using your own name or your DBA as a sole proprietor. You’ll want to make sure that all of your branding reflects the change, from your website, to your checks, to your invoices.
The Bottom Line
Most freelancers need a little time to figure out the best structure for them, and that’s OK. Actually, it’s best to work through exactly how much you’ll be working, what your earnings might be, and how much liability you’ll really face with your new business. If you’re starting your business toward the end of a tax year, it might not make sense to pay out too much for an LLC in a more expensive state, since it will cut into your earnings. Many choose to do this at the beginning of a year in which they expect to be profitable (making much more than the required $400 in profits to file.)
Like all tax and finance matters, it’s best to address any questions you have by reaching out to a seasoned professional in your area. Find a tax pro that is used to the unique needs of freelancers. It’s better to be safe than sorry, especially when the penalty for not setting up your business correctly could be extra taxes, fines, or worse. Experienced freelancers agree that taking the time to do it right is something you’ll never regret!