Entity Formation

One major question facing many freelancers and self-employed individuals is whether they should form some kind of legal entity for their business activities. The answer: It depends.

This may seem frustrating, but the truth is that there is no one-size-fits-all solution that covers every situation. There are several types of legal business entities and there are advantages and disadvantages to each of them. There are also important tax implications associated with each.

You need to get specific advice, tailored to what you are doing as a freelancer, how you make and spend money and what your long-term goals are, before you make this decision.

Here’s some information about the various options and which generally works best for what kind of freelancer:

The simplest way to do business is not to form a legal entity at all. If you take this route, you will work under your own name in what is called a sole proprietorship. This is the default position for a business that opens its doors with nothing more than a license (if one is required) and a business bank account. In some instances, sole proprietors must file a DBA form (doing-business-as), which establishes the company name under which they will be conducting business.

You may also want to apply for a special federal tax number, called an EIN, for your sole proprietorship. The IRS website has an easy test to help you determine whether you need an EIN: http://www.irs.gov/businesses/small/article/0,,id=97872,00.html. Alternatively, as a freelancer, you can file taxes under your personal Social Security number, as you probably already do. And if you’re a home-based service provider, you probably don’t even need a DBA to get started.

Although it is easy and inexpensive, there are some drawbacks to operating as a sole proprietor. One is legal liability: As a sole proprietor, you are the business. If something your business does triggers a lawsuit and a settlement is entered against your company in court, you will be personally liable for paying the damages. Any assets you own, including your home and bank accounts, could be seized to satisfy such a judgment. If you form a corporation or an LLC, which we’ll talk about shortly, you may be able to shield yourself and your family from this kind of liability.

A partnership is a legal entity you’ll form if you’re going into business with someone else. Just like in a sole proprietorship, the major drawback here is that a partnership does not offer limited liability protection to its owners.

If you choose to form a partnership, it is important to consult an accountant and an attorney about how you and your partners will own and operate the business. Not having a formal, legal agreement with a partner is a classic mistake made by many entrepreneurs who go into business with friends or relatives “on a handshake.” Although things may seem amenable at first, businesses are complicated and the decisions associated with them are often very difficult. Not having a legal agreement in place is often fatal to a partnership’s success.

If you are concerned about being personally liable in case someone sues your company, you have two business entity choices: an LLC or an S-Corp. Neither provides iron-clad protection from legal liability in a lawsuit, but if these entities are set up correctly, they can effectively shield your personal assets from a court judgment. Of course, only you know whether your business activities are likely to become the target of a lawsuit. Certain businesses and industries are much more likely to be sued than others. Talk to an accountant if you’re not sure where you company stands in terms of lawsuit risk.

A limited liability company is an alternative to incorporating your business. In some states, it is easier and cheaper to form an LLC than it is to form a corporation. In others, this is not true. New York State offers information about LLCs at its website: http://www.dos.state.ny.us/corps/llcguide.html. It strongly recommends that you consult with an accountant before you decide whether to choose an LLC.

That’s because there are complex decisions about how to have your LLC taxed that most freelancers without tax and finance experience are unfamiliar with. In addition to federal taxes, there are state and local tax issues (particularly if you will be operating your freelance business in New York City) that should be factored in when you decide whether to form an entity. There are definite advantages to incorporating or forming an LLC, with a shield from liability chief among them, but annual expenses and paperwork are also involved that may make the process too cumbersome and expensive for most freelancers.

Oftentimes, entrepreneurs form LLCs very early on in their business process and the company does not work out or they get another job and move on. Unfortunately, they are out of the money they spent on forming the entity - and they must spend more to properly close it.

Another common entity for self-employed people and freelancers is an S-corporation. The S-corp is one form of corporate entity; there are others, but we won’t concern ourselves with them here because they do not apply to freelancers. If you’re interested in setting up an S-Corp, you first must form a corporation and then get permission from the IRS and your state to “elect” S-Corp status.

An S-corporation is taxed similar to a partnership or an LLC, in that it is what we call a “pass-through” entity. That means that any business income you get from freelancing passes through the corporation and is declared on your personal income tax return. You must still file a corporate tax return each March, however.

Incorporating does offer tax advantages to some self-employed people. Owners of S-Corps are required to pay themselves a salary. They are also allowed them to take advantage of employee and retirement benefits that they would not have as sole proprietors. Health expenses can also be purchased through certain kinds of corporations established by freelancers.

On the downside, S-Corps must buy insurance coverage, such as worker’s comp and disability. They must register for unemployment insurance and pay the appropriate tax.

Can you set up a corporation of LLC yourself online? Technically, yes. There are many software companies and online legal outfits that advertise low prices on online entity formation. However, as you can see from this short discussion, the choice of entity is complicated and difficult to remedy if you make the wrong decision. Unless you have done thorough research and you are positive that you have made the right choice of entity, you may end up making a costly mistake and spending far more to unwind it than you would have had you gotten professional help to start. We are experts in entity formation and can take a look at your specific situation and help you determine whether you need a legal entity and if so, which will give your freelance business the best chance of success.