Like many freelancers, you may have started out doing business “on the side” to either supplement the income you derive from your full-time “day” job or to test the waters before making the plunge into full-time self-employment. In this situation, claiming the money that you make freelancing as additional income on your personal tax return is fine. However, once you decide to pursue freelancing full-time, or you have reached a critical mass in your business, you should take the formal step of establishing a legal business entity. Selecting the right business entity will protect your personal assets from any liability you may incur as a business owner and it may also offer you some significant tax advantages.
Sounds simple enough, doesn’t it? However, the issue that many first-time, would-be business owners face as they make a move to formalize their freelancing activities is related to how they should structure their new entity. Entity selection is an important process that should be thoroughly considered when you start to organize your business, and it can be somewhat confusing given that each type of entity has its own legal and tax benefits. Three of the most common business structures for freelancers are the sole proprietorship, the limited liability corporation (LLC), and the S corporation (S-corp).
Here’s a quick primer on the tax advantages and disadvantages of each entity type:
A sole proprietorship does not offer protection against personal liability that is incurred through your business activities, and this is an important consideration, especially if you are planning to freelance as your full-time job and you have significantly more exposure than you did when your freelancing was on a part-time basis. However, from a tax perspective, a sole proprietorship, like a single-member LLC, allows you to take a more streamlined approach to tax filing. This is because a sole proprietorship is considered by the IRS as a "disregarded entity." This means that your income from your business is reported on your personal tax return (Form1040), instead of on a separate business return.
A single member LLC offers the major legal advantage of protecting your personal assets from the creditors of your business. By setting up an LLC, you also avoid paying both personal and business taxes on tour freelance income. As a "pass-through entity" all the income and expenses from your LLC get reported on your personal income tax return as the business operator.
An S corp, like an LLC, protects you personally from any business liabilities you may be involved in from a financial perspective. Establishing an S-corp also helps you avoid paying both personal and corporate taxes. However, S-corp owners, unlike owners of sole proprietorships and LLCs, pay themselves salaries and receive dividends from any additional profits the business may earn. This adds another dimension of complexity to the tax situation and required tax filings that S-corp owners must comply with. Most notably, S-corp owners must file business returns, rather than using their personal return to file their business taxes.
It is worth noting that under each scenario you would be allowed deductions on pre-tax expenses, such as travel, computers, phone bills, advertising, promotion, car expenses, and health care premiums. You may also be able to deduct home office expenses, if you work from home.
In addition to tax implications, you should also weigh any filing fees and other requirements for entity formation. For example, New York imposes a publication requirement on the formation of LLCs which can be cost prohibitive for some individuals.
The moral of this post is that selecting the right type of entity for your freelance business is a decision that deserves thoughtful analysis and should be done with the help of a qualified financial professional to avoid potential tax issues in the future. Need help with entity selection? Contact us for assistance.
Jonathan Medows is a certified public accountant licensed in New York, New Jersey, Maryland, and Pennsylvania. He is also a recognized expert in taxation for freelancers and the self-employed—often tapped for his expert knowledge and perspective on self-employment taxation by national and regional publications such as The New York Post, BusinessWeek, Forbes taxation blog, WebCPA, CPA Practice Advisor, and others. You can read some of Jonathan’s press coverage here.
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