The freelance workforce is growing at a rapid pace.
And as it becomes more profitable, more and more people are ditching traditional jobs to work full-time or part-time as freelancers. In fact, some studies suggest that freelancers will make up more than 50 percent of the workforce within the next 10 years.
It’s easy to see why this trend is occurring. Freelancing allows people the chance to work whenever, and sometimes wherever, they want.
And thanks to companies such as Uber, Lyft, DoorDash, Grubhub and many more, it’s also a chance for people to try out new jobs and make some extra cash, or maybe even an entire living.
But one of the potential downsides of freelancing is complying with relevant rules and regulations, especially tax laws. This is because technically, as a freelancer, you are an independent contractor who owns your own business.
Does that mean freelancers need a business license? Not exactly.
There are several different businesses entities you can establish as a freelancer, each one with its own set of advantages and disadvantages. So to help you make the right decision, here’s an explanation of your different options as well as some of the pros and cons of each.
1. Sole Proprietorships for Freelancers
A sole proprietorship is one of the most basic and most logical options for freelancers. Essentially, a sole proprietorship is a fancy way of saying that an individual runs his or her own business.
In this type of arrangement, there is no legal separation between the person running the business and the business itself. Because of this, a sole proprietorship ends up being the default status for all businesses. This means that if you haven’t done anything to change the type of business you run, then you are already running a sole proprietorship.
Also, if you haven’t done anything to change your status, then technically your business is run using your name. However, you can set up a DBA, which stands for “Doing Business As,” which allows you to use a different name for the business without changing the status of your company. This is often useful for people who want to market their business but don’t want to use their own name.
The main advantage of a sole proprietorship is how easy it is to set up, since you don’t need to do anything at all to establish it.
If you want to use a DBA, then you will need to register it with your Secretary of State or other local government body.
This process of setting up a DBA doesn’t require much more than filling out a few forms and perhaps paying a small fee.
The other big advantage to a sole proprietorship comes when it’s time to file taxes. As a sole proprietor, you don’t need to file any additional returns. You simply declare your business revenues on Schedule C of your tax reform, and this gets entered into your regular 1040 form.
Because of this, the tax rate for sole proprietorships is lower than for other business entities.
The biggest disadvantage of a sole proprietorship is that you, as an individual, are liable for any and all business debts. This means that if you take out a loan, or finance some equipment, using your business name, and you fail to pay this obligation, creditors can come after not only your business assets but also your personal assets.
Or if your business is sued, it’s essentially you that is getting sued. There is no protection against your personal assets, unlike the other entities we’ll discuss later on.
This can be scary, as it means your personal bank accounts, your home, and any other assets you own are at risk should you fail to pay back your debts.
The other major downside is if you want to raise money for the business. Since you cannot sell shares or stock, investments in your business will go straight to you. Some investors may not like the idea of handing money directly over to you with no legal obligation like there is with a corporation.
Who Should Use a Sole Proprietorship?
This type of business entity is ideal for freelancers who don’t plan on requiring investment or who don’t plan on going into debt to grow the business.
Freelance writers, web developers, drivers, artists, graphic designers, etc. can all probably do just fine with a sole proprietorship, as there is not a lot of need for debt, which reduces the risk of your assets being seized as a result of non-payment.
However, if you are going to stick with a sole proprietorship, you may want to enlist the services of a tax accountant. A tax preparer will help make sure you’re filing your taxes correctly and making the right deductions.
For example, if you work from home, and if you meet the requirements, you may be able to deduct the expense of your home office. But you probably shouldn’t do this without first consulting a professional, as mistakes on your tax return can lead to hefty fines and other more severe punishments.
A partnership is essentially the same as a sole proprietorship, except instead of there being just one person running the business, there are at least two.
Typically, you don’t need to do anything to form a partnership, although it’s smart to put together some sort of written document outlining the responsibilities of each partner, as well how the profits will be divided amongst the different people involved.
The advantages to a partnership are essentially the same as a sole proprietorship.
It may be easier to raise money for the business, as you will have more people who can contribute to it. But you still may find it hard to convince investors to buy in since a partnership still carries the same amount of risk as a sole proprietorship.
The main drawback of a partnership is similar to those of a sole proprietorship, but there is one extra layer of risk. Since you and your partners are all considered equal in the eyes of the law, a situation could occur where you are liable for debts assumed by your partner.
So if your partner does something you don’t know about, and then things go south, you could end up having to sacrifice personal assets to cover a mess created by your partner. In some cases, this can cause good friendships to end in an ugly legal battle.
Make sure you know what you’re getting into when forming a partnership.
Who Should Form a Partnership?
This is a good option for people who find it advantageous to team up with others, but only when the risk is low. If there will be large investments needed to get the business going, or if you think you’ll need to go into debt, then this type of arrangement exposes you to similar risks as a sole proprietorship.
3. C Corporation and S Corporation
If you do find yourself in need of investment or debt, or if you are looking for ways to limit your liabilities, then you may want to create a corporation.
In general, there are two types of corporations: C Corporations and S Corporations. The letters refer to the subchapter of the tax code that details them, and they really have no meaning other than that.
The main thing to remember about a corporation is that it exists entirely separate from the individuals running it.
Setting one up requires filing “articles of incorporation” with the Secretary of State, which involves a fee that can range from under $100 to more than $300 depending on where you incorporate.
A corporation is owned by shareholders, and in the articles of incorporation, you’ll need to decide how many shares you are going to offer and how people can go about acquiring these shares.
Also, a corporation is, for all legal purposes, a “person.” It can own property in its name, take on debt and own all the property in its name. And along with all of this, corporations are required to make regular disclosures to relevant governing bodies to make sure they are following all rules and regulations associated with a corporation.
Furthermore, you must also be able to prove that the corporation indeed exists entirely separate from the individual. This means making sure to hold formalities such as yearly shareholder meetings, as well as elections for boards of directors and officers. If this doesn’t happen, then the courts may rule that your corporation isn’t really a corporation, which would dissolve it and return it to sole proprietorship or partnership status.
When we think of corporations, we tend to think of large companies, and most of these are C Corporations. But another type of corporation is an S Corporation, and these are intended more for small businesses, since they can be designated as a “pass-through entity.”
A “pass-through entity” means that incomes and wages can still be accounted for as personal income, which makes it a little easier to navigate the paperwork of owning a corporation.
However, C Corporations still need to go through all of the regulatory paperwork associated with a corporation, which means they will continue to be complicated entities.
There are two main advantages to setting up your business as a corporation, whether you choose C or S. They are:
- Corporations can be owned by any number of people, and they can sell stock. This makes it significantly easier for you to raise money for the business. Essentially, you sell stock, which gives a person part ownership, and the funds they use to buy the stock can help cover the expenses of the business.
- Corporations exist separately from those who own it. This means that only the assets of the corporation can be used to pay the corporation’s debts and liabilities. This effectively protects your own personal assets in the event the company should have trouble paying its bills.
Corporations were designed with large companies in mind, so the paperwork and procedures around setting up and maintaining one tend to be rather intense. This can often be too much for smaller firms to handle, and it’s one of the many reasons small businesses do not go this route.
Also, corporations are subject to what’s called double taxation.
Corporate profits are taxed, and then any wages or dividends you pay out are also taxed on an individual’s personal income taxes. So in this sense, the profits you make in a corporation are taxed twice before they are turned over to employees or shareholders as disposable income.
Who Should Form a Corporation?
It’s hard to imagine a scenario where a C Corporation would make sense for a freelancer. The paperwork involved is often going to be more of an expense than it’s worth, especially as compared to that of a sole proprietorship or a partnership.
However, an S Corporation could make sense in instances where you will need to make a heavy investment. For example, if you wanted to start a business of Uber drivers, and you needed to buy cars to offer to your freelancers, then an S Corporation would prevent exposing your own personal assets in the event the business struggled to make car payments.
But for most other types of freelancer businesses, this type of arrangement is probably going to more of a headache than it’s worth.
LLC stands for Limited Liability Company, and it serves as a halfway point between a corporation and a sole proprietorship or partnership.
Essentially, an LLC allows you to keep your assets separate from the business without having to go through the hassle of setting up a corporation. And what’s more, an LLC can be set up with just one individual, making it an attractive option for some small businesses and freelancers.
Income from an LLC can still be claimed on individual income taxes, which helps keep your tax rate low and also reduces the amount of paperwork you need to file with the IRS come tax time.
Also, an LLC offers the same protections as a corporation, meaning you don’t need to worry about your personal assets being seized should the business struggle to meet its obligations.
The main drawback to an LLC is actually linked to its main advantages. Because it’s so easy to start, no operating agreement is required, and this means many people do not make one. This can lead to some gray area about who is able or capable of acting on behalf of the company. And if there is a dispute, it’s unlikely the courts would be able to help resolve it. But this only happens in the event of a multi-party LLC.
However, the workaround here would be to make sure to establish an operating agreement that is signed by all relevant members before entering into an LLC.
Who Should Form an LLC?
Because of its easy setup, this is a great option for any freelancer or small business owner worried about risk. If it’s just you operating a small freelancer business out of your home, then you’re probably still safe to stick with a sole proprietorship.
But when you start adding people to the business, and if you start acquiring assets or going into debt, then it might become a good idea to form an LLC.
When it comes it a freelance business, it’s hard to beat the simplicity of a sole proprietorship or partnership.
But as your freelance work and business gets more complicated and takes on more debt and liabilities, then it might be smart to switch to an LLC.
Only in extreme cases does a corporation make sense, and if you decide to go this route, make sure to hire an accountant or a financial analyst to make sure you have all your paperwork in order.
Any questions or comments? Which business entity do you use and why? Are you thinking of switching?
Let us know by leaving a comment below.