If you work as a freelancer — even if it’s from home, in your PJs — you’re an entrepreneur. After all, on some level at least, you’re running your own business. And if you do it for long enough, you may want to consider creating an actual company — either an LLC or an S-Corporation — for that business. Doing so is “literally forming a separate entity [under] which to operate your business, as opposed to just operating as an individual,” said Paul Kassabian, legal product counsel at LegalZoom. But how do you know when you’re ready to take that step, and what are the implications of doing so? Here’s what you should know.
When is the right time to form a company?
The Freelancers Union recommends taking this step when your freelance business occupies more than 25% of your working time or revenue, but there’s no hard and fast rule to follow. “It’s not terribly complicated,” Kassabian said. “It’s sort of one of these things where, when you feel as though you actually have a business that you plan on operating on an ongoing basis, either as a part-time operation or a full-time operation, and you’re pretty sure you’re going to do this for a while, that’s one factor.”
And, he added, it’s something to consider carefully so that you don’t go through the work of forming a company only to change your mind later. “Then you have to go through the dissolution process…[which] costs money, so you want to be fairly certain that the business you’re involved in is going to continue for some period of time,” he said. “And generally you can tell if you’ve operated as a sole proprietor and it’s been going well for some period of time — six months, a year or more — you get a better sense of [if] this is actually something that’s going to continue.”
What are the primary benefits of forming a company?
Perhaps the main consideration in the decision to form a company is whether you need to be concerned about liability — essentially, how likely you are to get sued. “The primary benefit of a corporation is that there’s a level of liability protection, so potentially protecting yourself, as an individual, from liabilities that your business might incur,” said Mike Slack, lead tax research analyst at The Tax Institute at H&R Block.
Think about the nature of your business, the people you work with and the risks that come with all of it. “If you start to grow the business and you have a number of different clients, and you’re entering into a number of different agreements or even leasing office spaces, all of a sudden you’re making commitments to people and it increases the possibility that you’re going to get sued,” Kassabian said. “If you operate under an LLC or corporation properly, the person pursuing you can’t pursue your personal assets; they can only pursue your business assets.” That said, he caveated that it’s important to properly maintain your status as a business entity — through things like documentation and financial dealings — to benefit from these protections. “If somebody were to sue [your company], you could say, ‘Look, I’ve been operating this business as a separate entity,’” Kassabian said, continuing, “‘Look at my records, look at my bank account — I created a separate bank account and make sure all my income and all my expenses went through this bank account. I truly did treat it as a separate entity...so you have no right to collect from me as an individual.’”
What are the tax implications?
Filing taxes as a freelancer is unique from being a full-time employee whether or not you’ve formed a company. For example, even if you operate as a sole proprietor (aka, just freelancing as yourself and not as a company), you’ll need to file forms like a Schedule SE to pay self-employment tax. And both S-Corps and LLCs are considered pass-through entities, meaning they’re not subjected to federal income tax: The profits pass through to you as an individual, and you pay the necessary taxes only once on your personal return.
Beyond that, the tax implications of forming a company vary based on which route you take. If you form an LLC and you’re the only member of the business, you can choose to be taxed as a sole proprietor — so “the same way you would have been taxed had you not formed the LLC,” Slack said. “Essentially, the situation doesn’t change. You just now have a layer of liability protection that the LLC provides.” On the upside, the process is relatively simple. On the downside, you’ll still be subjected to the 15.3 percent self-employment tax.
With an S-Corp, “you’re no longer subject to the self-employment tax on your full [income],” Slack said. You’re required to pay yourself a salary, and you only pay the self-employment tax on that amount. That said, Slack noted, S-Corps are subjected to payroll taxes (which includes Social Security and Medicare tax) and other potential business taxes based on your state; but per Slack, “an S-Corporation, from a tax perspective, is typically one of the most advantageous entities you can form” with “a little bit more room for savings.”
What are the other differences between an LLC and an S-Corp?
Aside from the tax implications, the primary differences between an LLC and an S-Corp have to do with the responsibilities of maintaining them. While the formation process varies a bit between the two (such as filing Articles of Incorporation for an S-Corp versus Articles of Organization for an LLC), Kassabian said that either way, it’s somewhat simple. (If you do want assistance, an accountant or attorney can help you get things set up).
As far as operating your business, however, an S-Corp comes with more requirements. “An LLC has a little less paperwork that you have to deal with on an ongoing basis,” Kassabian said. “You don’t necessarily have to have... meetings with yourself and document those meetings, whereas you have to do that with an S-Corp.” If you’re just one person, of course, you probably won’t have spoken meetings with yourself; but Kassabian said you do have to have formally-named officers (for example, you are the president of the company) and document any decisions you make as meeting minutes. “If you entered into a lease, for example, you’d want to document the fact that you entered into a lease and when you did,” he said. “If you signed any significant contracts...or you entered into any sort of relatively long-term agreement, you’d want to document that you, as the board of directors of the corporation, authorized that agreement. If you lease something as simple as a [copy] machine [or make a] major financial contractual commitment, you’d want to document that.”
And, as an S-Corp, you’re also required to file an annual report with your state’s department of state (or designated agency in your state) — though, Kassabian noted, it’s a relatively simple document. While some states may require LLCs to file annual reports as well, not all do.
Ultimately, Slack said, it’s important to carefully weigh the benefits and “burdens” that come with forming a company before you take the step — and a professional, like an attorney or accountant, can help you make that determination.
But if you’ve done your research and feel it’s the right step for you to take, “don’t be afraid,” Kassabian said. “If you feel like you need help in the form of a professional, take full advantage. Go find somebody to help you, and within a year or two, you’re going to feel...like running one of these entities isn’t nearly as intimidating as you might have thought.”