Does a Freelancer have to Incorporate?
It’s a tough question — and one that is often fraught with misunderstanding. The fact is, 70% of businesses in the United States are registered as sole proprietorships, which suggests that few freelancers see much benefit to incorporating.
Then again, because incorporating is such a complex process, it is very easy to overlook some of the hidden benefits. From taxes and liability protection to health insurance discounts, (not to mention invoicing) you might find that incorporating is the way to go. Let’s take a look at what it means to incorporate, and how it may or may not benefit your freelance business.
How Does Incorporation Work for Self Employment?
If you’re a freelancer, you are most likely operating as a sole proprietorship. This is the default business structure that most self-employed workers fall under. You don’t have to formally register as a sole proprietorship — all it means is that you must file a Schedule C with the IRS, which is a form that reports your business income and expenses.
A C corporation (or C corp) is quite a bit different from a sole proprietorship. When you form a C corporation, you’re effectively separating your personal finances from your business finances, which helps protect your personal assets from any bills incurred by your business as well as the potential financial damages of a lawsuit.
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When you form a C corporation, you’ll need to elect at least one person to the board of directors (yourself, if you’re a freelancer that is incorporating), and you’ll need to file a personal tax return for yourself — since you are now an employee for your company — as well as a tax return for your company.
In addition, there are other details you’ll need to attend to, such as filing articles of incorporation with your state. For most freelancers, this business structure is much too complex and costly, and it results in double taxation (both you and your business), which means incorporating as a C corp isn’t always the best idea.
The S corporation (or S corp) allows you to avoid paying taxes twice. An S corporation works similarly to a C corporation in that you’ll need to file similar paperwork and set yourself up as a board director for your company. However, this type of corporation is not required to file business taxes. Instead, the company shareholders (which is you, in this case) each pay taxes on their shares of the company’s profit (known as corporate distributions) and on their salaries as employees (if they receive a salary — more on this later).
Limited Liability Companies
Finally, there are limited liability companies (LLCs). These business entities are unique in that they are simpler and less costly to set up, and they give you some flexibility on how your business is taxed. In other words, when you set up an LLC, you can opt to either be taxed like a C corporation or like an S corporation — a feature that makes LLCs popular among freelancers.
What Are the Tax Ramifications?
From a tax standpoint, a sole proprietorship is most likely your most beneficial option simply because it avoids the double taxation of a C corporation, requires far less paperwork, and doesn’t require you to pay filing fees. However, in rare instances S corporations can provide you with a tax savings.
First of all, as we mentioned above, an S corporation does not pay taxes itself. Only the S corporation’s shareholders and employees pay taxes. If you dole out your company’s profits as corporate distributions, you won’t have to pay Medicare or Social Security taxes on those distributions — only income taxes.
The problem is that you won’t be able to pay yourself solely in corporate distributions. Instead, shareholders of S corporations that perform major duties for that company are considered employees. For freelancers that start solo S corps, this means that since they’re taking on all of the company’s duties, they are by default considered employees. Employees must be paid a salary and that salary is subject to Social Security and Medicare taxes.
You can still pay out some of your company’s earnings as corporate distributions, and thus receive a discount of sorts on Social Security and Medicare taxes. However, the IRS stipulates that S corporations must pay their employee shareholders a reasonable salary. The IRS doesn’t give specific rules as to what it considers a reasonable salary for an employed shareholder, but you can safely assume that a “reasonable salary” would be in line with average salaries for your line of work.
The final thing to consider is that even if your S corporation makes you enough money to pay you both a reasonable salary and corporate distributions, the savings on Social Security and Medicare taxes may not be enough to offset the costs to run your S corporation. For instance, some states have a flat minimum tax that S corps must pay, such as the $800 annual tax in California.
In addition, your taxes will be much more complex, which means that you may need to pay a tax professional to do them, and you’ll need to pay filing fees to register your corporation, which can become quite expensive.
When it comes to LLCs, a member of an LLC is not considered to be an employee, which means that the LLC doesn’t need to pay Medicare and Social Security taxes, even if the LLC is structured like a C corporation. However, all members of an LLC that work actively for the business (which means you!) are responsible for the same self-employment taxes as sole proprietor freelancers, meaning an LLC really doesn’t offer much in the way of tax savings.
What Are the Major Benefits for Freelancers?
As you can see, unless you can pay out a lot on corporate distributions as an S corporation, tax costs will be similar no matter what business structure you choose. So if taxes aren’t a major benefit, then what are the benefits to incorporating? In a word: liability.
Protect Your Personal Assets
Let’s say that you’re a writer and you want to buy office space outside of your home. However, six months later, you realize that you made a severe miscalculation, and now you’re going into debt because you can’t afford the office space. As a sole proprietor, there is no distinction between your personal finances and your business finances, which means you are liable to pay for that office space no matter what. Either you’ll take a massive hit to your credit rating, or you’ll end up doing whatever it takes to pay your debts, including possibly selling your home or declaring bankruptcy.
If, however, you form an LLC, a C corporation or an S corporation, you’ll have some protection against personal liability. In the situation mentioned above, if you’re incorporated, then the business is responsible for paying the debts. While that isn’t good news for your business, at least your home and other personal assets will be better protected.
There is a caveat to this, however. If your business has a short credit history or not enough value to secure loans, then you’ll often have to use your personal credit and assets to secure loans for your business, which makes you liable if your business can’t pay. It’s a lot like co-signing your adult child’s first home or auto loan. On their own, your 20-something kid probably doesn’t have the credit history or assets to get a loan on his own, so you co-sign and agree to pay the debt if your child can’t.
In addition, corporations won’t protect you against your own personal negligence or criminal activity. This means that if you make a serious mistake on the job as a result of your own negligence, you could be held at fault, not the business.
Are There Other Benefits to Incorporating?
It’s a rare freelancer that benefits from the tax breaks and liability protections offered by incorporating, but those aren’t the only reasons to incorporate. There are a few other, smaller benefits that might make it worth your while:
- Credibility: There is nothing quite like adding “Inc.,” “LLC” or “Co.” to your business name. Because incorporating adds a feeling of professionalism to your brand, you’ll get an instant boost to credibility, which leads to not just more customers, but more customers who trust your corporation over unincorporated freelancers.
- Fewer Audits: Freelancers fill out Schedule C at tax time, which reports business expenses and income. Unfortunately, people who fill out Schedule C are the most highly audited group in the United States because it is very easy (or at least, the IRS thinks it is very easy) to over- or under-report deductions. Granted, audits are rare, but incorporating makes them even less likely.
- Health Insurance: Health insurance is quite often the largest cost that freelancers are expected to bear. Incorporating may give you access to corporate insurance rates, which are often much less expensive than individual rates.
So to answer the question of whether or not you should incorporate you must look at several factors:
- Can you save on taxes?
- Do you need the extra liability protections?
- Will boosts to credibility or reductions in health care costs offset the extra expenses of incorporating?
Once you’ve answered these questions be sure to research the costs and requirements for incorporating in your state. For many small businesses, incorporating is an unnecessary hassle, but you can only make that determination once you’ve accounted for the unique needs of your business.
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