When starting out as a freelancer, you might think the most important decision you have to make it what pair of sweatpants you’ll wear today. But the truth is, there’s one major decision you’ll have to tackle before moving on to joggers vs. leggings.
That decision is what type of business entity you’ll form. Put simply, this is the choice you’ll make about how you’ll organize your business.
The entity that you choose has a big impact on how you run your company, from how you’ll be taxed to whether or not you’ll be held liable for your business’s debts.
Luckily, there aren’t any “wrong” answers. Every entity has its own set of pros and cons that suit different needs and expectations. Translation? Whatever entity you choose should be what works best for your business.
If you’re overwhelmed, fear not! Choosing a business entity doesn’t have to be complicated. Read on as we explain everything you need to know so you can make the right decision without the stress. And rest assured that you could always switch to a different legal form later on.
Before we continue, please note: while we’ve made every effort to ensure this information is accurate and up-to-date, it doesn’t constitute legal advice, and it shouldn’t be considered a substitute for legal advice. It’s best to talk to your lawyer to get answers if you have any questions about your freelance business.
What Is a Business Entity?
A business entity is the legal structure that your business falls under.
As a business owner, you’re responsible for making all the important decisions in your biz. And one of the first decisions you’ll make as supreme leader is which business entity is right for you.
Based on the entity that you choose, you might have to follow certain operating requirements, file specific government forms, and abide by particular tax rules.
Yes, even the smallest freelance operation has a legal structure or “business entity.”
What are the main types of business entities?
- Sole Proprietorship
- Limited Liability Company (LLC)
Each of these entities, or legal structures, has its own set of pros and cons that you should consider before putting a ring on it.
For example, if you work independently, you can eliminate the partnership option, which requires two or more owners.
Why Bother Choosing a Business Entity?
Truth be told, many freelancers don’t think very much about choosing an entity. They just start doing business without choosing how to legally structure their company.
While this is totally normal, it does come with a major drawback: you’ll end up with one of the default entities, which are a sole proprietorship if you’re working alone, or a partnership if your company has two or more owners.
Default? Default’s good, right?
That depends. These default entities might be perfectly fine for you, but if you settle for them without weighing your other options, you might miss out on some of the perks that come with the alternatives.
Now that we’ve covered the basics, let’s talk details, pros, and cons of the most common entities for freelancers.
Sole proprietorship is the default business entity for freelancers.
This means that if you start working as a freelancer without forming an LLC or corporation you’ll automatically operate as a sole proprietor.
A sole proprietorship is easy and cheap to form and run, so it’s a fantastic choice when you’re first getting up and running.
Plus, you can always go back and form an LLC or corporation later, once your business becomes more established and you’re earning more.
Fun fact: the vast majority of freelancers (over 80%) are sole proprietors. Many people will even continue working as sole proprietors their entire lives.
What’s good about a sole proprietorship?
It’s the cheapest and easiest legal form for a one-person business.
You don’t have to get permission from the government or pay any fees in order to work as a sole proprietor.
You might, however, need to obtain a local business license.
And if you want to use a name other than your personal name for your business, you’ll need to file a fictitious business name with your county.
As a sole proprietor, you personally own your business, as well as all of its assets, just as you own your house or car. And you’re the only one in charge of your business, so you have complete authority.
Taxes couldn’t be simpler!
Because you and your business are considered one for tax purposes, you don’t pay taxes or file tax returns separately from your business.
Just report your income or losses on your personal tax return (IRS Form 1040), and list all of your business income and deductible expenses on Schedule C, Profit or Loss from Business.
Adding your business profits to any other income that you report, like interest income or your partner’s income, gives you your total income which is taxed at your personal tax rate.
And if you incur a loss in your business, you can use that to offset income from other sources.
Finally, as a sole proprietor, you pay Social Security and Medicare taxes (the same taxes that employees and employers pay) on your net business income. This is called self-employment tax and is usually 15.3% of 92.35% of your profit.
What’s bad about a sole proprietorship?
The main reason many freelancers abandon the sole proprietorship is that they want to avoid personal liability.
Because the sole proprietor and the business are one, a sole proprietor is held personally liable for all debts and liabilities.
Translation: a business creditor, which is an individual or a company that you owe money, can go after all of your personal and business assets to get what you owe them. This could include your personal bank accounts, cars, and even your house.
Similarly, a personal creditor, which is an individual or company that you owe money to after buying personal items, could go after your business’s assets. Those could include your business bank account and equipment.
To top it all off, if you’re involved in a business-related lawsuit, you’ll be personally liable if you operate as a sole proprietor.
If a sole proprietorship is starting to sound like a bad idea, rest assured that other entities give you personal liability protection.
Want some more information on sole proprietorships? Read through our Freelancer’s Guide to Sole Proprietorships in California
Next up is the partnership. This is the default entity for a business with multiple owners.
Like a sole proprietorship, it automatically comes into existence when two or more people start a business together.
Obviously, if you’re going to run your business with other people, you can’t be a sole proprietor. Instead, there will be co-owners within the company, and those partners will jointly manage the business.
Also, the partners don’t personally own the assets of their business; instead, the partnership owns them.
In a partnership, the partners contribute money, property, or services. In return, they get a share of the profits.
Bottom line: a partnership requires shared ownership and management of a business.
What’s good about a partnership?
A partnership is a lot like a sole proprietorship, so if you like the perks that come with that legal structure but want to operate with multiple owners, this is a good choice.
Also, a partnership is legally inseparable from the owners.
It’s easy to form a partnership. You aren’t required to file government paperwork unless you need to get a business license or you want to use a fictitious business name.
Even though many partners write partnership agreements, a written agreement isn’t actually required to form a partnership.
Ordinarily, a partnership doesn’t pay taxes itself.
Instead, the business income and losses are passed to the partners and reported on their individual federal tax returns.
You’ll need to file IRS Schedule E with your return, showing your partnership income and deductions.
A partnership is required to file an annual tax form, Form 1065, U.S. Return of Partnership Income, with the IRS. However, this is just an “information return,” letting the IRS know about your partnership’s income, deductions, profits, losses, and tax credits for the year.
Like sole proprietors, partners aren’t employees; they’re self-employed business owners. Therefore, a partnership doesn’t pay payroll taxes on the partners’ income, and it doesn’t withhold income tax.
A partner must pay income tax, as well as Social Security and Medicare taxes (aka self-employment tax), on their share of the partnership income.
What’s bad about a partnership?
There’s a big drawback that comes with running a partnership, and it’s the main reason why partnerships aren’t very popular: owners don’t have limited liability.
This means that the partners are personally liable for all of the partnership’s debts and lawsuits (just like a sole proprietorship).
Beyond that, as a partner, you’re personally liable for business debts that your partners incur, whether or not you even knew about them! Whoa!
Forming a limited liability company (LLC) or a corporation might be a better option if you want to co-own a business but you also want liability protection.
Limited Liability Company (LLC)
A limited liability company, also known as an LLC, is a cross between a sole proprietorship or partnership and a corporation.
LLCs have become increasingly popular because they combine the informality, flexibility, and tax characteristics of a sole proprietorship or partnership with the limited liability of a corporation.
The big difference is that, after forming an LLC, your business has its own legal existence that’s separate from you. It’s even considered its own legal “person.”
This means your LLC can do things like:
- Own property
- Have bank accounts
- Borrow money
- Hire employees
- Sue and be sued
- Do anything else in the business world that a human can do!
Another difference is you don’t personally own the business assets, such as receivables, equipment, and bank account. Instead, the LLC owns these and you own an interest in the LLC.
As the owner of an LLC, you’ll be referred to as a “member.” There could be a single member or multiple members.
One-owner LLCs are called single-member LLCs, or SMLLCs. LLCs with more than one owner are called multi-member LLCS. Members invest money and/or services in the LLC and, in return, own a percentage of the business and receive a portion of the profits.
A multi-member LLC can be a much better choice than a partnership, and the SMLLC can be an excellent alternative to a sole proprietorship.
To learn more, see our Freelancer’s Guide to Sole Proprietorships vs. Single Member LLCs in California.
What’s good about an LLC?
Forming an LLC is easier than forming a corporation.
You don’t have the administrative burdens that come with running a corporation. It isn’t necessary to appoint officers and directors, and you don’t need to have board or shareholder meetings.
An LLC provides its owner(s) with limited liability. This means you won’t be personally liable for any debts incurred by your business, and most business-related lawsuits.
If creditors or people file lawsuits against your LLC, they won’t be able to get their hands on your personal assets; they can only collect against your business’s assets.
There are some limits, though. For example, creditors might require that you personally guarantee LLC debts before they extend credit to you. Plus, you’re always personally liable for your own wrongdoing. If you injure someone as a result of your negligence or malpractice, your LLC won’t be able to protect you.
When it comes to taxation, an LLC can provide you with tons of flexibility.
Basically, you choose how you pay tax on business profits.
Usually, an SMLLC is taxed the same way as a sole proprietor. You report profits, losses, and deductions on your Schedule C. If that’s the case, the SMLLC is referred to as a disregarded entity by the IRS.
If your LLC has two or more members, it’s usually treated like a partnership for tax purposes. Your multi-member LLC will prepare and file the same tax form used by a partnership (IRS Form 1065, U.S. Return of Partnership Income).
But, it doesn’t have to be this way! Whether you’re an SMLLC or multi-member LLC, you have the option of being taxed like a corporation, which means you can be an employee of your business.
All you have to do is file a document called an election with the IRS, which asks that they tax you like a corporation. In some cases, this strategy might even help you save money on taxes.
Want to know more about LLCs? We’ve got you covered. Go to our Guide page to find state by state guides to starting and maintaining an LLC.
What’s bad about an LLC?
LLCs are a bit harder and more expensive to form than a sole proprietorship or partnership.
In order to form an LLC, you need to file articles of organization with your state’s Secretary of State and pay a filing fee. Then you’ll have to follow the registration process outlined by your state.
Even though it isn’t legally required, adopting a written LLC operating agreement, which outlines how the business will be governed, is recommended. Without this agreement, your state’s default laws about LLCs will apply.
You’ll probably need a local business license to operate your company. And some states require that you pay annual taxes and fees to maintain your LLC.
A corporation is the most complex type of business entity to form and run. It’s also the most expensive.
But, even though the term “corporation” tends to conjure up images of high-rise buildings and swanky suits, even a small one-owner business can function as a corporation.
Here’s the thing to keep in mind as you read about corporations: you can get the same benefits that you get from forming a corporation by forming an LLC. And it’s easier and more affordable.
What’s good about a corporation?
A corporation provides its owners (known as the shareholders) with limited liability. Translation: shareholders aren’t personally liable for corporate debts or lawsuits against the business.
This entity is a good choice if you want to attract outside investors since investors usually prefer to invest in corporations so they can receive stock ownership.
Plus, incorporating is necessary if you want to attract investors through a public stock offering.
Note: it’s possible to give investors a membership interest in an LLC, but it isn’t a very attractive option for investors. Also, the process can be difficult and confusing.
Another reason to issue corporate stock options: it’s a great way to motivate and keep key employees in your business.
When it comes to taxes, there are two types of corporations: the C Corp and the S Corp.
You can start off as a C Corp and switch to an S Corp, or vice versa, so you have the flexibility to choose what’s right for you. Just be sure to discuss it with a tax pro before making the switch.
When you go through the process of forming your corporation, it’ll automatically become a C Corp, which is the only business form that’s taxed separately from its owners.
C Corps pay income taxes on their net income and file their own tax returns with the IRS. They also pay federal income tax at a flat 21% rate, which is lower than individual rates at some income levels.
While a C Corp might be a better choice for businesses that bring in substantial profits, it isn’t such a good option if you expect to lose money in the first few years. That’s because you can’t deduct those losses from any other income you earn, like your salary.
The other option is to file an election with the IRS to be taxed as an S Corp. An S Corp is the most popular type of corporation for one-person businesses because it can reduce the amount of Social Security and Medicare taxes you pay. And, unlike a C Corp, an S Corp isn’t a separate taxpaying entity.
As an S Corp, corporate income or losses are passed through directly to the shareholders (that means you and anyone else who owns your business). As an S Corp owner, you’ll also enjoy the Qualified Business Income (QBI) deduction, which can help lower your tax bill.
Normally, an S Corp doesn’t pay any taxes, but it must file an information return with the IRS. This reports how much the business earned or lost, as well as each shareholder’s portion of the corporate income or loss.
Shareholders must divide the taxable profit according to their shares of stock ownership, and then they report that income on their individual tax returns.
Pro tip: Did you know that you can form an LLC and elect to have it taxed as a C Corp or S Corp? This means that you could get the benefits of corporation taxation even if you want to operate as an LLC. The best of both worlds!
What’s bad about a corporation?
There are a few things to consider before opting to form a corporation.
First off, they’re harder to form and run than an LLC.
In theory, every corporation consists of three groups of people:
- Those who direct the overall business are referred to as directors.
- Those who run the day-to-day affairs are called officers.
- Those who invest in the company are referred to as shareholders.
The good news is that, when you have a one-person business, you can perform all of these functions yourself, so you don’t have to hire a board of directors.
Secondly, a corporation is formed much the same way as an LLC. You file your articles of incorporation with your Secretary of State and pay the required fees.
However, you’ll also need to adopt written bylaws and hold an organizational meeting, and you’ll be required to have annual directors meetings.
Plus, everything the director(s) do must be written down in corporate minutes. Yes that means more paperwork. And failing to perform these formalities could result in you losing your limited liability protection.
On top of all of that, you automatically become an employee of your corporation if you work in the business. That’s true even if you’re the only shareholder and aren’t under the direction or control of anyone else. You’ll wear two hats: owner and employee.
And, when your business pays you as an employee, it must withhold Social Security and Medicare taxes and submit regular tax payments to the IRS.
All of this means that a corporation can be more expensive to operate than a sole proprietorship, partnership, and LLC, since none of these have members who are considered employees for tax, unemployment insurance, workers’ compensation, or other legal purposes.
Ready to Start a Sole Proprietorship or LLC?
Understanding the pros and cons of each business entity helps you figure out which one is right for you. Even though thinking about legal entities can be BO-RING, it’s a pretty major decision in your business. So really do your research and take your time.
If you’ve looked through all of the information above (we know, it’s a lot!) and you’ve decided that you want to start your freelancing business by forming a sole proprietorship or an LLC, Collective can help.
There’s so much to do when it comes to forming and maintaining your business, it can get overwhelming fast.
Tax savings for the self-employed
Collective is tax deductible and starts paying for itself in less than 2 months.
From formation to taxes, you get all support you need for one affordable monthly price.
When you sign up for a Collective account, we’ll help you with every step involved in legally forming your business. Then, we’ll stick with you after your business is officially formed and help you stay on top of your bookkeeping, file your taxes, and stay on top of important filing deadlines. Think of us like your business sidekick–you know, the one that does all the boring, tedious stuff while you’re out saving the world.
Have questions about business formation and the many ways that Collective can make the process super simple? Contact us today to learn more!
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.