When forming any business, it’s important to consider the legal formation of the business early on. In freelancing businesses in particular, there are specific tax ramifications to the legal business structure that you select. This is particularly true in the U.S., and may be true elsewhere as well.
There are three main types of legal forms of business to consider when starting a freelancing business. These types include sole proprietorships, partnerships, and corporations. In this post, I’ll discuss two of these three types of business in detail.
The Most Popular Business Form for a Single Owner
A sole proprietorship is the most common structure for any entrepreneur starting a freelance business that is owned by only one person. This form of business is also the easiest to legally form since it requires no paperwork and can be created quickly.
Sole proprietorships have certain advantages depending on the situation (i.e. plans for the business, your personal life, etc.), but there are quite a few tax and audit risks that a freelancer considering a sole proprietorship needs to be aware of.
While starting a business as a sole proprietorship may be ideal, it’s important that you revisit the legal form of your business as the business changes since being a sole proprietorship may actually become a disadvantage. One potential downside in a sole proprietorship structure is that you may end up paying just as much money in self-employment taxes as you pay in income taxes.
Here’s an example…
Let’s say that your freelance business has a year-end profit of $80,000–not bad! If your business is a sole proprietorship, then you’ll pay regular tax at your usual tax rate. However, you’ll also pay approximately $11,000 in self-employment text. Think of the self-employment tax as a replacement for the Social Security and Medicare taxes that your employer would have had to pay if you had worked for another company. Depending on how much revenue your freelancing business generates, this option can end up costing you more money in the long run compared to other forms of business.
A Corporation with Unique Tax Benefits
The “S” Corporation is basically a corporation that’s taxed in the same manner as a partnership. In an S Corporation, the corporation pays you–the owner–fair wages for your work just like you would get paid for a traditional job. Any left over profit at year-end passes through the corporation to you and you’ll pay income tax on the pass-through amount. The S Corporation divides the owner’s income into two categories: wages and pass-through distributions.
For a freelancer, the S Corporation might actually be a very attractive model due to the tax structure of the S Corporation. As an S Corporation, your wages are subject to the same percentage (15.3%) of tax that you would pay as self-employment tax. However, you do not have to pay social security or self-employment tax on the amount of the dividend pass-through.
Using an S Corporation, the owners of the corporation can create a tax savings through a reduction in the self-employment tax compared to the previous sole proprietorship example.
So Which Structure Is Right for You?
While both of the structures described above have their own legal and tax advantages, it’s important that you consider your specific situation to make the best decision. In many cases, new freelance business owners consult with an attorney, so their decision is usually influenced by the legal nuances surrounding the formation rather than the tax breaks available.
If you are in the process of forming a freelance business and don’t have a specific reason why you’re choosing the structure you’re considering, then you need to look deeper into the choice from a tax perspective. That’s a common situation I see with new clients and something that is a sign that you have not considered the tax advantages available for your business in the long run.
While planning for tax advantages can seem confusing during the formation of your business, it’s important to understand that the right decision can save you thousands of dollars or more in the years to come. With that said, the tax code can be very complex and is something you’d probably rather not focus on–after all, you’re going to have a freelance business to run.
If you need help determining which entity is right for you, consult a professional who not only has a good knowledge of the tax code and filing requirements, but someone who will work with you proactively throughout the year to make sure you are taking advantage of every available break.
(Editor’s Note: This post is based on the knowledge of our guest poster. It does not represent legal or accounting advice on the part of Freelance Folder. If you have a specific question in this area, consult with a professional.)
What business structure have you selected for your freelancing business? Why?
Share your answers in the comments.