Choosing the right business structure as a freelancer can have a huge impact on your operations. And this means it could have a potential impact on your bottom line, and your financial future. After all, the entity you choose can determine how much tax you pay, the risk level to your personal assets, and even how you can access funds.
As such, choosing a business structure as a freelancer is not a decision that should be taken lightly. In this blog, we want to help you understand your options, and the pros and cons that come with each, to ensure that you can make an informed decision.
Understanding Business Structures
Choosing a business structure as a freelancer isn’t always a straight-forward choice, as each has its own benefits or drawbacks.
To start with, let’s take a look at the different options available to you.
- Sole Proprietorship: The ideal structure for an individual freelancer. It’s easy to set up, but does not protect your personal assets from potential business debts.
- Partnership: A good choice if you’re starting a company with another person. Partnerships are relatively easy to form, with no state-specific paperwork, although they usually involve shared liability for business obligations.
- Single Member Limited Liability Company (SMLLC): An SMLLC allows for easy tax filings because it’s considered a disregarded entity, so income is reported on your personal tax return. It also provides liability protection.
- A Corporation: S Corps and C Corps are the more complex of the business entity options available, each offering different pros and cons.
Considerations for choosing a structure
There are also several factors to keep in mind when choosing a business entity. These include:
Liability: If your business faces crippling debts or lawsuits, it’s essential that this not affect your personal assets. But not all entities offer liability protection.
Scalability: Do you have plans to grow your business over time, or go public and include shareholders? You’ll need to choose a business structure that allows for this.
Taxes: The tax rates vary between business entities, and so do the implications for your personal taxes. For instance, some entities allow you to report business income and expenses as part of your personal taxes, while others require separate filings.
Administration: Some entities are easier to establish and manage than others. Also keep in mind that they may need to be registered at both a state and local level, which can involve a lot of paperwork and patience.
Fundraising: A business entity may limit your ability to raise capital, especially when it comes to bank loans, selling stock and shares, or acquiring assets.
Control: Are you willing to go into business with others, and if so, will you be sharing profits, losses, and control? Some entities allow you to draw up specific agreements with your co-owners to negotiate who is responsible for what.
Now let’s take a look at each of the above structures in more detail.
Sole Proprietorship
A sole proprietorship is easy to form, and from an administrative standpoint, it’s simple to manage. In fact, you’re automatically considered a sole proprietorship if you conduct business on your own, without registering as any other kind of entity. Although you do also have the option to choose a trading name when you get your local business license.
As such, they’re often the first choice for freelancers who want to test their business idea before forming a more formal entity structure. As a sole proprietor, you’re basically seen as self-employed, so you also don’t need to share profits with anyone.
But keep in mind that if you form one, it does not actually produce a separate business entity. In the eyes of the law, you and your sole proprietorship are seen as a single entity. In other words, your business and personal assets and liabilities aren’t separate. On the upside, this allows for easy tax filings. You can file returns using your personal tax filing information. But it also means that you can be held personally responsible for your company’s debts and obligations.
It’s also important to note that being a sole proprietor might limit your ability to raise funds for your company. Some banks may consider it a risky investment to give loans to you. You also won’t be able to sell shares to raise funds. In a nutshell, this is the best structure if you already have access to funds to get your business started, like savings, home equity or even loans from friends and family.
Partnerships
A partnership is a formal business arrangement between two or more parties to jointly manage a business, and share profits and liabilities, without incorporating (or legally separating yourself from your business). They offer total flexibility in income and expense allocations. Basically, you can allocate a non-proportional amount of income (or expenses) to partners, according to your partnership agreement, or whether you’re an active or passive partner.
Like sole proprietorships, these are a good option for a business structure as a freelancer, because they’re easy to start, with no state-specific paperwork. You can even deduct your share of business expenses on your individual tax returns. Alternatively, you can elect to be taxed as a different entity, including a C Corp, S Corp, or disregarded entity.
On the down side, it can be difficult to grow and scale a partnership or get funding. Partners have unlimited liability, so you’re all equally responsible for business debts, no matter who incurs them.
Single Member Limited Liability Company (SMLLC)
The biggest advantage of LLCs is liability protection, because as the owner, you’re seen as a separate legal entity from your business. So if your company faces bankruptcy or lawsuits, your personal assets won’t be at risk. This is also often a popular business structure as a freelancer because your profits and losses are passed through to your personal income without facing corporate taxes.
This flexibility comes at a cost, though. Generally, LLC administration is more complex than the other options we’ve already mentioned. For example, any changes must be reported, and you may have to confirm the accuracy of certain information held on public record every year. Moreover, in some states, you must dissolve and reform your LLC if a member joins or leaves, unless you state otherwise in your operating agreement.
Corporations
There are many different kinds of corporations, all of which which offer the most protection to their owners from personal liability. However, they also require more extensive record-keeping, operational processes, and reporting.
But, when it comes to choosing a business structure as a freelancer, you’ll more than likely consider an S Corporation of all the options. And there are several reasons for this. Firstly, they offer liability protection. Secondly, these entities are not taxed at an individual and corporate level, the way that C Corps are. Instead, they allow profits and some losses to be passed through directly to your personal income. It can also be easier to raise capital, as you can sell shares. However, this means they’re not ideal entities for start ups.
To establish an S Corp, you need to file with the IRS as well as your state, because there are some limits on these entities.
Making the Decision
When it comes to choosing the right business structure as a freelancer, what matters most are your business needs. This means considering your liability needs, how your taxes will be structured, whether you need to grow the company, and the administrative requirements.
While the information we’ve provided here is a great starting point, we recommend chatting to a finance expert about your needs, and which business entity is right for you.
Tax professionals like the team at Fusion CPA can help you navigate the nuances of each structure, based on your specific needs and goals, so save you time and money. For help with your business finances and taxes, schedule a free Discovery Call with one of our CPAs today!
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.