There comes a moment in every young freelancer’s life when it’s time to level up their business, kind of like if Ralph Macchio went from The Karate Kid to The Karate Man. Sure, it never happened, but that dreamy brown-eyed teen idol couldn’t stay a kid forever.
Just like Ralph Macchio grew out of wax on, wax off, your business is probably growing out of being a sole proprietor. Most freelancers hold onto sole proprietorship way longer than they should, and it can cost them big time.
Wondering if it’s time you make the switch? There are four reasons you should stop being a sole proprietor, but before we get into that, let’s answer one crucial question…
What’s a sole proprietor?
A sole proprietor is someone who is the sole owner of an unincorporated business.
Unincorporated means that you haven’t registered your business with your state as its own legal entity. As a sole proprietor, there’s no separation between you and your business. Legally and tax-wise, you are the same.
Wait! I thought I was an independent contractor.
You can be both an independent contractor and a sole proprietor.
A sole proprietorship is a tax classification given to you by the all-mighty IRS. An independent contractor is a classification for a worker who is not an employee.
If you’re a freelancer with an unincorporated business contracted to perform work for a company, you are both a sole proprietor and an independent contractor. #DoubleTrouble
So why shouldn’t you be a sole proprietor? Because…
Taxes are expensive.
As a sole proprietor, you pay taxes on your business’s profits.
Regardless of if you keep the profits in your business, or use them personally if your business makes money, you pay taxes on it.
There are two taxes you pay as a sole proprietor: Income tax and self-employment tax.
Everyone pays income tax based on their tax bracket, and being sole proprietor doesn’t impact your income tax. But, then there’s self-employment tax.
Self-employment tax, which goes towards your Social Security and Medicare, is 15.3 percent and taxed on 92.35 percent of your profits.
When you’re an employee, you’re only responsible for paying half of these taxes (7.65 percent of your wages) and your employer foots the rest of the bill. As a sole proprietor, you’re on the hook for the full 15.3 percent.
As your business grows and profits increase, so does your tax liability.
To give you an idea of how much self-employment tax can cost, here’s an example.
Your business profit is $100,000. $92,350 is subject to self-employment tax. Your total self-employment tax is $14,130.
Whoa! That much?
Yes, that much. Plus, you’ll be paying income tax. #WorstDayEver
Many freelancers switch from a sole proprietor to an S corp to decrease their tax liability.
S corp profits are not subject to self-employment tax, which can save you some serious money.
The tradeoff is that you need to pay yourself as an employee of your business.
Every time you run payroll, you are effectively paying 15.3 percent in taxes on your employee wages. Half is paid for by your business, through employer payroll taxes, and the other half is deducted from your paycheck.
How do I save money if I’m still paying payroll taxes?
Payroll taxes only apply to employee wages, and you don’t have to pay yourself all of your profits, just what’s reasonable for your industry. The rest of your earnings are exempt from self-employment tax. That’s where the tax savings come in.
You have no legal protection.
When you’re a sole proprietor, there’s no distinction between you and your business. You are one- kind of like Peter Parker and Spiderman. From a legal standpoint, this leaves you pretty vulnerable, especially if you don’t have spidey sense to rely on.
If someone sues you, it’s not just your business checking account at risk. All of your personal assets are at risk, too. And when I say all, I mean everything- your house…your car…your early ‘90s Beanie Baby collection.
Even if you don’t see a lawsuit in your future, there’s another way that sole proprietorship puts your personal assets at risk.
If you have business debt that you can’t afford to pay, creditors can come after your personal assets to settle your debt.
Forming an LLC (limited liability corporation) create a legal shield between your business and your personal assets. There are some exceptions, but generally, if you have an LLC, only your business assets can be seized.
If you’re considering forming a single-member LLC, you should know that, unless you request otherwise, you are taxed as a sole proprietor. You’ll still have the legal protection, but you’ll have to pay self-employment tax- which is a bummer.
That is unless you request to be taxed as an S corp. Then you get the best of both worlds- legal protection and tax savings.
You appear less credible.
Some companies, especially larger ones, only work with incorporated businesses, like LLCs, S corp, C corps, and partnerships.
I’ve had several clients lose contracts because a prospective client required incorporation and they were sole proprietors.
Even though I’m sure you’re totally legit, being an LLC or other entity conveys a sense of professionalism, credibility, and establishment. It also shows potential clients that you’re serious enough about your business to register with the state and, in the famous of Beyonce, put a ring on it.
It’s harder to bring on partners.
It’s unlikely someone will want to partner with a sole proprietor.
A sole proprietorship is a business owned by one owner. The other person wouldn’t have a legal connection to the company, and they have to trust you to distribute their portion of the profits.
On the flip side, if you’re a sole proprietor with an unofficial partner, your personal assets are on the line for someone else’s actions. If your partner racks up the business’s credit card bill or does something illegal, you’re liable.
You’re also responsible for all the taxes. Since you and your business file one tax return, all of the business’s profits, and tax liability, falls on you.
If you do plan to own your business with someone else (or many others), then look into forming a multi-member LLC, LLP or general partnership. All three divide the ownership of the business between the owners, so everyone is legally and financially responsible for the entity.
Switching from a sole proprietorship to another, more formal legal entity will give you Mr. Miagi-level mastery over your small business. Who knows, this time next year you might be doing the Crane at a karate tournament…or at the very least, saving a bunch of money on your taxes.
Andi Smiles is a small business financial consultant and coach. She’s helped hundreds of small business owners take control of their business finances while uncovering their emotional relationship with money.