With most freelancers working solo, forming an official business structure doesn’t make a lot of sense. But there are plenty of good reasons to understand business entities and your options, particularly if you want to lighten your tax burden and liability.
What is a business entity?
A business entity is simply the type or structure of a business regardless of the industry. This legal structure dictates how you pay your taxes as a freelancer and what kind of liabilities you have.
In the US, business entities are formed per state each having its own requirements or regulations. For instance, filing fees in California will be different from the filing fees in Texas. As a freelancer, it’s your responsibility to understand what kind of requirements your state carries and comply with them.
The Four Business Entities:
• Sole proprietorship
Most freelancers and small business owners are sole proprietorships by default. Other than a business license and relevant permits, there’s no need to file any additional paperwork. A sole proprietorship’s tax filings are also simple. As the sole owner and operator of the business, the income is taxed on your personal tax return. There’s no need to separate the business’ taxes and your personal taxes. This is what’s called a pass-through business because the business’ profits are “passed through” to the owner.
The drawback, though, is that you will be personally held liable for the business. It means that you will have to answer for whatever is demanded of the business, be it debt or a lawsuit.
• Partnership
A partnership functions very much like a sole proprietorship in terms of taxation and liability, except that the structure has more than one member. There are two types of partnerships: general and limited. The first is when a partnership equally divides the management and profit-sharing of the business among its owners. A limited partnership, on the other hand, can also have partners who don’t actively handle the business but only as investors.
• Corporation
Corporations don’t have to be in a high rise with hundreds of employees. A group of freelancers forming a small business can also incorporate. The main difference from the first two entities is that a corporation separates the business from the personal, liability and all.
There are also two types: C corporation and S corporation. A C corporation is more ideal for a big company with significant revenue. Not only is it complicated to set up and maintain, C corps are also taxed twice, which doesn’t make sense if you’re not making a lot of money. Meanwhile, S corps are pass-through business that are not subject to corporate taxes. Corporate tax can be a heavy burden depending on the state you operate in. Iowa, for example, levies a 12% corporate tax while South Dakota and Wyoming don’t have them it all.
• Limited Liability Company
A limited liability company (LLC) is a hybrid of sole proprietorships or partnerships and corporations. The main feature of an LLC is the liability protection that separates the owner from the business. Should you get sued, you won’t have to settle with your personal assets. Plus, you can function as a pass-through business and not have to pay twice the tax.
Like other business entities, LLCs have different requirements in each state. Here in California, setting up an LLC only takes six steps which can be completed with the help of an appointed agent by the state. The base filing fee is cheaper too at $70 compared to the earlier example of Texas that has a $300 filing fee.
Which one is right for me?
A sole proprietorship or partnership make sense if you’re still establishing your freelancing career and don’t have a lot of income. In truth, corporations aren’t really applicable to freelancers unless you’re planning to launch a conglomerate or grow your business.
However, setting up an LLC should be a consideration for you down the road. The main reason is that lawsuits are a very real risk for freelancers and you can get sued for something like breach of confidentiality or negligence. That scenario can be detrimental for your freelancing business and reputation as well as your personal assets.
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