Are you a freelancer who’s ready to officially form their own business? That’s great! Just keep in mind that there are several steps involved, one of which is to decide how you’ll legally organize your business.
Why is this such a big deal? Well, your choice has a big impact on how you’re treated by government agencies and how you’re taxed.
Plus, the way you organize your business even determines if you’ll be held personally liable for your company’s debts.
Because there isn’t a one-size-fits-all option when it comes to choosing a business entity, you might not know where to begin. But one of the most popular choices, particularly for freelancers, is the limited liability company (a.k.a. LLC)
Here’s a bit of information on LLCs, including the benefits of organizing your freelance business as an LLC.
Please note that, while we’ve made every attempt to ensure the information below is accurate and up-to-date, it doesn’t constitute legal advice, and it shouldn’t be considered a substitute for legal advice. Always consult with your attorney or tax expert for personalized guidance.
What’s an LLC?
An LLC is one of the ways that you can legally organize and operate your business.
To form an LLC, you file articles of organization with your state’s business filing office. In Texas, that would be the Secretary of State. Seems simple enough, right?
As an owner, you’ll be called a “member,” and invest money and/or services into your LLC in exchange for a percentage of ownership.
Although an LLC can have one member or several members, if you’re a freelancer running a one-person business, you’ll be a single-member LLC (also known as an SMLLC).
Once legally formed, your LLC is its own entity, with an existence separate from your own. Kind of like giving birth to your own LLC baby.
Here are the basics: your LLC is considered its own legal “person,” which means it can do pretty much anything that an actual person can do, like:
- Own property
- Be sued and sue others
- Manage bank accounts
- Borrow funds
- Hire workers
What’s the Point of Forming an LLC?
If you’ve been working as a full-time freelancer for a while, you might be wondering why you should bother forming an LLC, or any other formal business entity. After all, you’ve already figured out that you don’t need to have a business entity to start and run a freelance business.
Before you decide to keep freelancing on your own, though, here are some of the perks of forming an LLC:
It’s Simple to Run Your Business
LLCs are easy to run. In fact, they’re surprisingly simple.
If you were to form a corporation, you’d have to hold and document regular and special shareholder meetings. That’s a paperwork nightmare!. You don’t have to do any of that stuff with an LLC.
As the name implies, a limited liability company provides you with limited liability. This means that you won’t be held personally responsible for paying:
- LLC business debts that you haven’t personally guaranteed, including most routine bills for supplies and equipment
- Injuries (not covered adequately by insurance) that are suffered by people who are hurt by your LLC’s business activities
Who pays for these business debts and injuries? Your LLC!
Basically, only your LLC’s assets and money can be taken to cover these costs. And that means that creditors can’t touch your personal assets, like your house or bank account.
Only LLC assets can be used to pay off business debts. That means that you, the owner, only stand to lose the money that you’ve invested in your business. Again, your personal assets will be protected.
But, we should mention that, even if you form an LLC, you remain personally responsible for your own wrongdoing, such as professional malpractice or fraud. So keep that liability insurance policy, just in case.
Sure, protecting their personal assets is one of the main reasons why so many freelancers choose to form an LLC. But, beyond that, an LLC is also great at tax time.
Here’s what you need to know about taxes and LLCs:
- LLCs aren’t recognized by the IRS for tax purposes. Single-member LLCs are referred to as “disregarded entities.”
- LLCs will be taxed the same as a sole proprietorship, a partnership, or a corporation.
- You, the single owner, decide how you want to be taxed, and that gives you a lot of flexibility. So, whether you want to be taxed like a sole proprietorship or a corporation is up to you.
Sole Proprietor Taxation can be used when you’re a single person who owns an LLC.
Because this is the default tax treatment for single-member LLCs, it’s also the most commonly used.
- If you’re a freelancer who owns a single-member LLC, and you choose to be taxed as a sole proprietor, you’ll file Schedule C, Profit or Loss from Business, when you file your tax return. Yep, it’s the same form you’ve been using as a freelancer all along! Just list all of your business income and deductible expenses. Then you’ll pay income tax on any profit your business earns . It’s pretty straightforward, especially when it comes to paying taxes while running a business.
- Another reason why sole proprietor taxation is popular is that you aren’t considered an employee of your LLC. Rather, you’re the self-employed business owner. This means that your LLC doesn’t have to cover payroll taxes on your income or withhold income tax or Social Security or Medicare tax from your LLC’s profits. But you do pay income taxes and self-employment taxes (Social Security and Medicare taxes) on your LLC’s net income.
- Filling out a Schedule C means you’re entitled to the same tax deductions as any other business, like expenses to cover mileage, software, job supplies, and more.
- Beyond regular business deductions, you might be able to take the new pass-through tax deduction, which is available to sole proprietors. This went into effect in 2018, and is set to last through 2025 (as of the time of this writing. Things could change, so it’s best to stay on top of the latest tax laws).
If you qualify, you might be able to deduct up to 20% of the net income you earn from your LLC from your income taxes. This effectively reduces your income tax rate on your LLC profits by up to 20%. Sweet!
Corporate Taxation is your other option if you don’t want to be taxed like a sole proprietor anymore. If you take this route, your LLC will be taxed just like any other corporation.
- To be taxed as a corporation, you’ll need to file a document known as an “election” with the IRS. Elect to have your LLC taxed like a regular C Corp or S Corp.
- Is corporate taxation common amongst freelancers? Truth be told, not really, especially when it comes to single-member LLCs. But, because the corporate tax rate is lower than it used to be (and, again, that could always change in the future), more business owners are considering this option.
Comparing LLCs to Other Types of Businesses
If you still aren’t sure about whether an LLC is right for your freelance business, you also have the option of operating as a sole proprietor or a corporation.
Weighing the pros and cons of each will help steer you in the right direction.
A Couple Quick Points About Sole Proprietorships:
A sole proprietorship is the default business entity for a one-person business. Basically, it comes into being automatically once you start working as a freelancer and earning money. It doesn’t get much easier than that!
A sole proprietorship isn’t a separate legal entity. This means that you, the business owner, personally own all of the assets, and you’re in charge of the day-to-day operations.
You report your income or losses on your personal tax return. Then, you pay tax on any profit at your individual tax rates. Translation: no limited liability perks.
You’ll be held personally responsible for all of your business debts and any business-related lawsuits. Now that could be scary!
Some Quick Points About Corporations:
When you set up a corporation, it becomes its own legal entity. It’s formed when you file articles of incorporation with your Secretary of State, just like you’d do when forming an LLC.
Like an LLC, your corporation has a legal existence separate from its owners, so it’s considered a legal “person.” Translation: you get limited liability perks. Woohoo!
A corporation is owned by its shareholders, who invest money or services in exchange for stock. A corporation must have one or more directors who are ultimately in charge. And it must have officers who run the daily operations.
If you’re a one-owner business, though, you can be the single person directing and running the corporation, and you can own all of the corporate stock.
You’ll work as an employee of the corporation, in addition to fulfilling your other corporate roles. This differs from LLC members, who aren’t employees of their businesses for tax, unemployment insurance, workers’ compensation, or other legal purposes.
This means that a corporation could cost more to operate than an LLC, especially if it has to pay for unemployment insurance and workers’ compensation coverage for employees.
There are two types of corporations
- When you form a corporation, it automatically becomes a C Corp for federal tax purposes.
This is the only type of business that isn’t a pass-through entity. Instead, it’s taxed separately from its owners. A C Corp pays income taxes on net income and files its own tax returns with the IRS. It also has its own income tax rate.
Another thing to consider: C Corps are subject to double taxation. Any direct payment of profits to shareholders is considered a dividend by the IRS and taxed twice.
First, the corporation pays corporate income tax on the profit on its own return.
Then the shareholders pay personal income tax on the money they receive, at the capital gains rate (higher income shareholders might even have to pay an additional Medicare tax).
All of this could add up to more than the tax an LLC member would pay on the same amount of profits. But, you could avoid double taxation by paying all profits to employee-shareholders in the form of salary, benefits, and bonuses.
- As a corporation, you have the option of being taxed as an S Corp instead, which is considered a pass-through entity.
This means that corporate income or losses are passed directly to shareholders who then divide the taxable profit according to their shares of stock ownership.
Then they report that income on their individual tax returns, avoiding double taxation.
Ready to Form an LLC? It’s Time to Decide Where to Do It
After weighing the pros and cons of sole proprietorships, LLCs, and corporations, you may have decided that, yes, an LLC is the best option for your freelance business.
Now the question is, where will you form it? That’s entirely up to you! But don’t take this lightly. It’s an important choice because your LLC will be governed by the state of formation’s laws.
Choose the state where you want to set up your business, and file articles of organization with the Secretary of State. So, for example, if your business is located in Texas, you should form an LLC in that state.
Note: Even if you hear rumors about the advantages of forming an LLC outside of Texas, keep in mind that most of those benefits aren’t all they’re cracked up to be. In the end, if you form your LLC in another state, it will likely cost you more because you’ll have to pay two filing fees.
How Much Should You Expect to Pay?
When you form an LLC in Texas, you must pay a $300 fee to file Certificate of Formation with the Secretary of State’s office.
You might also need to get other local and state business licenses and pay a fee for those. That will depend on the type of work your LLC is engaged in your location.
There might be additional fees involved with performing a thorough LLC name search to figure out if the name you’ve chosen for your business is actually available. In Texas, reserving an LLC name for up to 120 days costs $40.
Finally, if you decide to do a professional trademark search, that can cost anywhere from $30-500 for each trademark searched.
Click here to read our “Freelancer’s Guide to Trademark Research” for more information.
More Fees to Consider – Oh My!
Forming an LLC could get pricey pretty quickly. Ultimately, how much it costs to complete and file all of the necessary paperwork depends on who does the work.
Will you be doing it yourself, perhaps with the help of a book? Then you’ll pay the legal costs of your state and invest a lot of time and effort into the process.
If you use an online LLC formation service, you could pay up to $300.
And if you hire an attorney, you could expect to pay anywhere from $500 to over $1,000.
But, wait, there’s more!
You also need to designate someone to accept legal papers for your LLC. And, while you can take a DIY approach, it’s best to use a professional registered agent. How much will that cost? About $75-150 annually.
For more information, check out our “Freelancer’s Guide to Registered Agents”
We’re not done. We have some good news and bad news.
- The bad news: Texas imposes a franchise tax on some LLCs that do business in the state.
- The good news: Your LLC must earn over $1,130,000 to be subject to this tax. So most LLCs pay nothing. If you do earn this much, the tax is 0.75%.
It’s Definitely Worth Looking into Becoming an LLC!
There are so many awesome benefits when your freelance business is transformed into a legal entity of its own.
From limited liability and pass-through taxation, to flexible profit-splitting and flexible management, it’s no wonder that so many savvy freelance pros and self-employed professionals are taking the steps to form an LLC.
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.