Should Freelancers Form a Company to Save at Tax Time?
Don’t fall into the paralysis by analysis trap—it’s not that complex.
Photo by Deane Financial / Nappy.co
It doesn’t matter if you’re coding websites or delivering sandwiches—if you’re getting paid by customers or clients for a product or service, you’re considered a business by the IRS. That means even if you’ve never filed any paperwork or picked a company name, you’re technically the sole proprietor of your own business.
But before you add “Entrepreneur” to your Instagram bio (please don’t), there are some serious considerations to make. Just because you start off as a sole proprietor doesn’t mean you have to stay one. Even if your business is just you, it might make sense to form a business entity—in the US, a corporation or a limited liability company (LLC).
You’ve probably heard a lot about new tax breaks and deductions business owners are eligible for this year, thanks to tax reform, officially known as the Tax Cuts & Job Act of 2017. Under the new law, all business owners are allowed to deduct 20% of their pre-tax income, as long as they make less than $157,000 per year.
There are other benefits that come with forming a business entity—you’ll be protected from lawsuits, and depending on which one you choose, may be able to pay a corporate rate that just got slashed.
But there are a few things to know before you make the leap:
How do you create a business entity like an LLC or corporation?
Unlike sole proprietorship, which is bestowed upon you as soon as you start trading products or services for money, an official business entity has some hoops to jump through.
There are two primary types of entities: corporations and limited liability corporations (LLCs). Corporations are further broken down into two sub-entities, S-Corps and C-Corps. S-Corps are “pass-through” entities (as are all LLCs and sole proprietorships), so taxes are charged to the company based only on the profits and losses of owners. On the other hand, a C-Corp is considered its own taxable entity; owners will pay taxes once based on their personal income and once for the company itself under the corporate tax rate (which was just lowered permanently to 21%).
An LLC is a simple, straightforward entity consisting of one or more members or partners. It offers the most flexibility—since an LLC is considered a pass-through business, you can choose to be taxed the same way you would as a sole proprietor. Most notably, an LLC provides protection from legal action, so if you get sued doing business, your personal assets can’t be used in a settlement.
Which business entity is right for me?
Ah, the million-dollar question. The experts I talked to said it depends on your industry and business structure.
“The first thing to consider is how likely it is you’ll get sued. A web designer and a doctor have very different odds of facing legal action,” said Devin Langan, Director of Planning at Legacy Business Advisors.
You’ve also probably noticed that a majority of small businesses are either sole proprietors or LLCs: over 30 million, according to the most recent numbers released by the IRS. “Most of our business clients are either LLCs or S-Corps. It’s pretty rare to see a C-Corp with less than 50 to 100 people,” Langan told me.
If you just want legal protection for your business activities and don’t want to deal with complex corporate tax procedures, an LLC is probably best. It safeguards you from losing personal assets in a business lawsuit, and since you can use it as a pass-through entity, it makes filing taxes pretty simple: profits and losses are indicated on your personal return.
What about incorporating? There’s a reason most small businesses are LLCs. As a corporation, besides having to pay corporate taxes, you’ll have to abide by certain formalities, including choosing directors, holding regular meetings, and recording minutes (more on this below). That’s right—even if your business is just you, you have to name officers and record votes in company meetings. If you thought people at Starbucks were judging you before, wait until you’re holding a one-person board meeting next to the Splenda.
But there are two very specific situations when a corporation may make sense.
The first is if you’re a consultant or contractor working full-time (or close to it) at an on-site location. In these situations, it can make sense to form an S-Corp, since the IRS doesn’t like it when employers don’t classify full-time workers as employees. They are more flexible about a corporation taking on this kind of liability.
The second situation is if you’re making more than $207,500 as a single filer or more than $415,000 if you’re married. That’s because after your taxable income surpasses this level, you are no longer eligible for the 20% pre-tax deduction. In cases like this, you may be better off using a C-Corp, since you’ll be taxed at the new, lower corporate rate.
How much does it cost to form a LLC or corporation?
As mentioned, an LLC is the easiest and most straightforward business entity to set up. You’ll need to submit the appropriate forms (check your state website to find them), pay a filing fee of a few hundred to a few thousand dollars (depending on your state), register your business name, and open a bank account. After that, you’ll need to pay a yearly tax or fee, and some states require you to also submit an annual report.
Filing for incorporation takes those requirements up a notch. You’ll need to file a form with your state, choose a business name, create corporate bylaws, designate officers, and set an address. Once your corporation exists, you then need to submit Form 2553 to the IRS to become designated as an S-Corp. You’ll also need to keep running records of shareholder meetings and votes on company initiatives, even if you’re the only one in the company. For a full breakdown of the steps required to incorporate, check out this article from Quickbooks.
Ok, but do I really have to set up an official business?
Nope, not at all. As mentioned, even if you never filed anything, you are still a sole proprietor eligible for the new 20% pre-tax deduction. If you aren’t at huge risk of getting sued, an LLC is basically just a fancy title and some extra forms and fees.
And while your business entity is definitely important, don’t let yourself get bogged down. You could read about the benefits and drawbacks of different business structures forever, but the reality is that as a freelancer, your time is literally your money. It’s easy to rationalize spending hours picking a business entity, changing your company name, designing a logo, tweaking your website, and so on, but none of this stuff is going to make you money. For the health of your business, you should cut down on it as much as possible, but it’s something many freelancers and business owners—myself included—struggle with often.
Peter Drucker, considered the father of modern management, put it this way: “The business enterprise has two—and only two—basic functions: marketing and innovation. Marketing and innovation produce results; all the rest are costs.”
In other words, as the owner of a business, you should be spending most of your time either finding clients to pay you (marketing), or improving your skills to be able to charge more (innovation). Every activity outside of these two pursuits is a cost of doing business.
Do some research on business structures, make a decision, then get back to the grind. The work never stops, but at least you’re the boss.