When starting out as a freelancer, one of the most important decisions that you’ll need to make is what type of business entity you’ll use in order to do what you love. Put simply, this is the choice you’ll make regarding how you’ll organize your business.
The entity that you choose will have a big impact on how you run your company, from how you’ll be taxed and how the IRS and state auditors will treat you, to whether or not you’ll be held liable for your business’s debts.
Thankfully, there aren’t any “wrong” answers, as every entity has its own set of pros and cons to suit different needs and expectations. This gives you the opportunity to choose the one that works best for you.
If you feel overwhelmed, don’t worry; this isn’t as complicated as it might seem at first. We’ll explain everything so you can make the right decision when forming your business. And rest assured that you could always switch to a different legal form later on, if necessary.
Before we continue, please note: while we’ve made every effort to ensure this information is accurate and up-to-date, it doesn’t constitute legal advice, and it shouldn’t be considered a substitute for legal advice. It’s best to talk to your lawyer to get answers if you have any questions about your freelance business.
- What Is a Business Entity?
- What If You Don’t Bother Choosing a Business Entity?
- Sole Proprietorship
- Limited Liability Company (LLC)
- Ready to Start a Sole Proprietorship or LLC?
A business entity is defined most simply as the legal structure that your business will fall under.
As a business owner, you’ll be responsible for making all of the most important decisions. And one of the first decisions that you’ll need to make is which business entity will be right for you. Based on the entity that you choose, you might have to follow certain operating requirements, file specific government forms, and abide by particular tax rules.
Note: even the smallest freelance operation has a legal structure, or “business entity.”
What are the main types of business entities?
- Sole Proprietorship
- Limited Liability Company (LLC)
Again, each of these entities, or legal structures, has its own set of pros and cons that you should consider before diving in. For example, if you’re going to be working independently, you can eliminate the partnership option, which requires two or more owners.
Truth be told, many freelancers don’t even think very much about choosing an entity. They’ll just start doing business without making any decision about how to legally structure their company.
Sure, this happens, but it does come with a drawback that you should think about: if you do this, you’ll end up with one of the default entities, which are a sole proprietorship if you’re working alone, or a partnership if your company has two or more owners.
What’s so bad about that? Well, these default entities might be perfectly fine for you, but if you settle for them without weighing your other options, you might be missing out on some of the nice perks that come with the alternatives.
Now that we’ve covered the basics, let’s move and discuss the details, pros, and cons of each of the main types of business entities.
Sole proprietorship is the default business entity for freelancers. This means that, if you start working as a freelancer without forming an LLC or corporation, you’ll automatically be operating as a sole proprietor. Simple enough, right?
A sole proprietorship is easy and cheap to form and run, so it’s a fantastic choice when you’re first getting up and running. After all, you could always go back and form an LLC or corporation later on, once your business has become more established and you’ve begun earning a more substantial income.
Fun fact: the vast majority of freelancers (over 80%) are sole proprietors. Many people will even continue working as sole proprietors their entire lives.The vast majority of freelancers (over 80%) are sole proprietors. Click To Tweet
What’s good about a sole proprietorship?
- This is the cheapest and easiest legal form for a one-person business.
You don’t have to get permission from the government or pay any fees in order to work as a sole proprietor.
You might, however, need to obtain a local business license. And if you want to use a name other than your personal name to identify your business, you’ll need to file a fictitious business name with your county. Fear not, as none of these actions are difficult to complete.
As a sole proprietor, you’ll personally own your business, as well as all of its assets, just as you own your house or car.
You’re the only one in charge of your business, so you have complete authority.
Taxes couldn’t be simpler! Because you and your business are considered one and the same for tax purposes, you don’t pay taxes or file tax returns separately from your business.
Just report your income or losses on your personal tax return (IRS Form 1040), and list all of your business income and deductible expenses on Schedule C, Profit or Loss from Business.
Adding your profits to any other income that you’re reporting, such as interest income or your spouse’s income, allows you to come up with the total that’s taxed at your personal tax rate. And if you incur a loss, you can use that to offset income from other sources as well.
Finally, don’t forget that you must also pay Social Security and Medicare taxes (the same taxes that employees and employers pay) on your net business income.
What’s bad about a sole proprietorship?
The main reason why many freelancers abandon the sole proprietorship form of doing business is because they want to avoid personal liability. What does that mean? We’ll break it down for you.
Because the sole proprietor and the business are one and the same, a sole proprietor is going to be held personally liable for all debts and liabilities.
Translation: a business creditor, whether that’s an individual or a company that you owe money to, can go after all of your personal and business assets to get what you owe them if you can’t pay them. This may include your personal bank accounts, car, and even your house, as a few examples. Yikes!
Similarly, a personal creditor, who would be an individual or a company that you owe money to after purchasing personal items, will be able to go after your business’s assets. Those might include your business bank account and equipment, as a couple of examples. Double yikes!
To top if all off, if you’re involved in a business-related lawsuit, you’ll be personally liable in that case as well if you operate as a sole proprietor.
If this doesn’t sound appealing to you, rest assured that other forms of business can give you the protection from personal liability that you seek.
Want some more information on sole proprietorships? Read through our Freelancer’s Guide to Sole Proprietorships in California
Next up is the partnership. This is the default entity for a business with multiple owners. Like a sole proprietorship, it automatically comes into existence, but you need two or more people starting a business together for this to occur.
Obviously, if you’re going to run your business with other people, you can’t be a sole proprietor. Instead, there will be co-owners within the company, and those partners will jointly manage the business. Also, the partners don’t personally own the assets of their business; instead, the partnership owns them.
In a partnership, the partners contribute money, property, or services. In return, they get a share of the profits, if any.
Bottom line: a partnership requires shared ownership and management of a business.
What’s good about a partnership?
- A partnership is a lot like a sole proprietorship, so if you like the perks that come with that legal structure but you want to operate with multiple owners, this is a good choice.
A partnership is legally inseparable from the owners.
It’s easy to form a partnership. No government filings are required, unless you need to obtain a business license or you want to use a fictitious business name because the partners don’t want to use all of their surnames in the company name.
Many partners enter into written partnership agreements, but no written agreement is actually required to form this type of business.
Ordinarily, a partnership doesn’t pay taxes itself. Instead, the business income and losses are passed to the partners and reported on their individual federal tax returns. You’ll need to file IRS Schedule E with your return, showing your partnership income and deductions.
A partnership is required to file an annual tax form, Form 1065, U.S. Return of Partnership Income, with the IRS. However, this is just an “information return,” letting the IRS know about your partnership’s income, deductions, profits, losses, and tax credits for the year.
Like sole proprietors, partners aren’t employees; they’re self-employed business owners. Therefore, a partnership doesn’t pay payroll taxes on the partners’ income, and it doesn’t withhold income tax. A partner must pay income tax, as well as Social Security and Medicare taxes, on their share of the partnership income.
What’s bad about a partnership?
There’s a big drawback that comes with running a partnership, and it’s the main reason why partnerships aren’t all that popular: they don’t provide owners with limited liability. This means that the partners are personally liable for all of the partnership’s debts and lawsuits (just like a sole proprietorship).
Beyond that, as a partner, you’ll be personally liable for business debts that your partners incur, whether or not you even knew about them! Whoa!
Forming a limited liability company (LLC) or a corporation might be a better option if you wish to co-own a business with one or more people but you want liability protection.
A limited liability company, also known as an LLC, is a cross between a sole proprietorship or partnership and a corporation.
LLCs have become increasingly popular because they combine the informality, flexibility, and tax attributes of a sole proprietorship or partnership with the limited liability of a corporation.
The big difference is that, after forming an LLC, it will have its own legal existence that’s separate from you. It’s even considered its own legal “person,” which means your LLC can own property, have bank accounts, borrow money, hire employees, sue and be sued, and do anything else in the business world that a human can do.
Another distinguishing feature: you don’t personally own the business assets, such as the receivables, equipment, and bank account. Instead, the LLC owns these and you own an interest in the LLC.
As the owner of an LLC, you’ll be referred to as a “member.” There could be a single member or multiple members. One-owner LLCs are often called single-member LLCs, or SMLLCs. And, put simply, those members will invest money and/or services in the LLC in order to get percentage ownership interests in return.
A multi-member LLC can be a much better choice than a partnership, and the SMLLC can be an excellent alternative to a sole proprietorship. To learn more, see our Freelancer’s Guide to Sole Proprietorships vs. Single Member LLCs in California.
What’s good about an LLC?
- Forming an LLC is easier than forming a corporation.
You don’t have the administrative burdens that come with running a corporation. It isn’t necessary to appoint officers and directors, and you don’t need to have board or shareholder meetings.
An LLC provides its owner(s) with limited liability. This means you won’t be personally liable for any debts incurred by your business, and the same holds true for most business related lawsuits, too.
If creditors or people file lawsuits against your LLC, they won’t be able to get their hands on your personal assets; they would only be able to collect against your business’s assets.
There are some limits, though. As an example, creditors might require that you personally guarantee LLC debts before they extend credit to you. Plus, you’re always personally liable for your own wrongdoing, so your LLC won’t be able to protect you if someone is injured as a result of your negligence or malpractice.
When it comes to taxation, an LLC can provide you with loads of flexibility. Basically, you can choose how you pay tax on business profits.
Usually, an SMLLC will be taxed like a sole proprietor would, so you’ll report profits, losses, and deductions on Schedule C. If that’s the case, the SMLLC is referred to as a disregarded entity by the IRS. Easy peasy!
If your LLC has two or more members, it’s usually treated like a partnership for tax purposes. Therefore, a multi-member LLC must prepare and file the same tax form used by a partnership (IRS Form 1065, U.S. Return of Partnership Income).
But, wait, it doesn’t have to be this way! Whether you’re an SMLLC or multi-member LLC, you have the option of being taxed like a corporation. All you have to do is file a document called an election with the IRS so that you’ll be considered an employee of your LLC for taxes. In some cases, this strategy might even help you save money.
Want to know more about LLCs? We’ve got you covered:
What’s bad about an LLC?
LLCs are a bit harder and more expensive to form than a sole proprietorship or partnership. Here’s why:
In order to form an LLC, one or more people must file articles of organization with the California Secretary of State, as well as pay a filing fee.
You must also file a Statement of Information, Form LLC-12, with the Secretary of State within 90 days of filing your articles of organization. This will include your business address, along with information about your registered agent and members. Then, you’ll have to file this statement every two years thereafter. (Note: Hyke can help! Just sign up for an account and we’ll help you file all the right forms without missing any deadlines).
Even though it isn’t legally required, adopting a written LLC operating agreement, which outlines how the business will be governed, is recommended. Without this agreement, the default provisions of California’s LLC laws will apply.
You’ll likely need a local business license to operate your company. (Tip: if you sign up with Hyke, we can make it a snap when it comes to figuring out what license(s) you need and applying for them so you can do business without worry.)
California LLCs are subject to special taxes that include a minimum $800 annual tax to the California Franchise Tax Board (you have to pay this even if you don’t make any money!). And any LLC that earns more than $250,000 must pay even more. Do sole proprietors and partnerships in California have to pay these taxes? Nope.
So far, we’ve covered a lot of information about the different types of business entities that you can choose from. But we’re not done yet—we still need to cover corporations!
This is the most complex type of business entity to form and run. It’s also the most expensive. But, even though the term “corporation” tends to conjure up images of massive operations like General Motors and Amazon, even a small one-owner business can function as a corporation. It’s true!
Here’s the thing to keep in mind as you continue reading about corporations: the benefits that you get from forming a corporation can be obtained more affordably and more easily by forming an LLC instead. For this reason, the corporation isn’t typically the form of business that most freelancers opt for.
What’s good about a corporation?
- A corporation provides its owners (known as the shareholders) with limited liability. Translation: shareholders aren’t personally liable for corporate debts or lawsuits against the business. Nice!
This entity is a good choice if you want to attract outside investors, as they often prefer to invest in corporations so they can receive stock ownership in return. Plus, incorporating is necessary if you want to attract investors through a public stock offering.
Note: it is possible to give investors a membership interest in an LLC, but this isn’t as attractive to them, in most cases. Also, the process can be difficult and confusing.
Issuing corporate stock options is a great way to motivate and keep key employees in your business.
When it comes to taxes, there are two types of corporations: the C corporation and the S corporation. You can start off as a C corporation and switch to an S corporation, or vice versa, so you have flexibility to choose what’s right for you. Just be sure to discuss it with a tax pro before making the switch.
When you go through the process of forming your corporation, it’ll automatically become a C corporation, which is the only business form that’s taxed separately from its owners.
C corporations pay income taxes on their net income and file their own tax returns with the IRS. They also pay federal income tax at a flat 21% rate, which is lower than individual rates at some income levels.
While a C corporation might be a better choice for businesses that bring in substantial profits, it isn’t such a good option if you expect your business to lose money in the first few years because you won’t be able to deduct those losses from any other income you earn, such as your salary.
On the other hand, you can file an election with the IRS to be taxed as an S corporation instead. Doing so will allow your business to be taxed like a sole proprietorship or partnership.
An S corporation, which is the most popular type of corporation for one-person businesses because it can result in reduced Social Security and Medicare taxes, isn’t a separate taxpaying entity. Corporate income or losses are passed through directly to the shareholders (that means you and anyone else who owns your business).
Normally, an S corporation doesn’t pay any taxes, but it must file an information return with the IRS. This will indicate the amount of money that the business earned or lost, as well as each shareholder’s portion of the corporate income or loss.
Shareholders must divide the taxable profit according to their shares of stock ownership, and then they need to report that income on their individual tax returns.
Pro tip: Did you know that you can form an LLC and elect to have it taxed as a C corporation or S corporation? This means that you could get the benefits of corporation taxation even if you want to operate as an LLC. The best of both worlds!You can form an LLC and elect to have it taxed as a C corporation or S corporation. Click To Tweet
What’s bad about a corporation?
There are a few things to consider before opting to form a corporation.
First off, they’re harder to form and run than an LLC. In theory, every corporation consists of three groups of people. Those who direct the overall business are referred to as directors, while those who run the day-to-day affairs are called officers. Then there are those who invest in the company, who are referred to as shareholders. The good news is that, when you have a one-person business, you can perform all of these functions yourself, so you don’t have to go out and hire a board of directors.
Secondly, a corporation is formed much the same way as an LLC because you file articles of incorporation with the California Secretary of State and pay the required fees. However, you’ll also need to adopt written bylaws and hold an organizational meeting, and you’ll be required to have annual directors meetings. Plus, everything the director(s) do must be written down in corporate minutes. Failing to perform these formalities may result in you losing your limited liability protection. Ouch!
On top of all of that, you automatically become an employee of your corporation if you work in the business, even if you’re the only shareholder and you aren’t under the direction or control of anyone else. So, you basically wear two hats: owner and employee. And, when paying employees, Social Security and Medicare taxes must be withheld from their salary and submitted to the IRS. Therefore, a corporation can be more expensive to operate than sole proprietorships, partnerships, and LLCs, which have members who aren’t considered employees for tax, unemployment insurance, workers’ compensation, or other legal purposes.
Finally, California corporations must pay some of the highest taxes in the country. While C corporations must pay a California corporate 8.84% income tax, S corporations must pay a 1.5% tax. And even if a corporation doesn’t earn income, it must pay an annual $800 minimum tax to the Franchise Tax Board (you don’t have to pay this tax the first year that you’re in business, though).
Analyzing the pros and cons of each type of business entity will help you determine which one is right for you. This isn’t a decision that you should take lightly, so really do your research and take your time.
If you’ve looked through all of the information above (we know, it’s a lot!) and you’ve decided that you want to start your freelancing business by forming a sole proprietorship or an LLC, Hyke can help.
There are a lot of steps that need to be taken, not only when forming your business, but also when maintaining it for the long run. At Hyke, we know that it can quickly become overwhelming, especially if you’ve never run a business of your own before.
When you sign up for a Hyke account, we’ll help you with every step involved in legally forming your company. Then, we’ll stick with you even after your business is officially formed. Never worry about missing an important filing deadline ever again!
Have questions about business formation and the many ways that Hyke can make the process super simple? Contact us today to learn more!
Stephen has dedicated his career as an attorney and author to writing useful, authoritative and recognized guides on taxes and business law for small businesses, entrepreneurs, independent contractors, and freelancers. He is the author of over 20 books and hundreds of articles and has been quoted in The New York Times, Wall Street Journal, Chicago Tribune, and many other publications. Among his books are Deduct It! Lower Your Small Business Taxes, Working with Independent Contractors, and Working for Yourself: Law and Taxes for Independent Contractors, Freelancers & Consultants.