Which Business Structure Maximizes Your Freelance Tax Benefits?

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.

Your Turn

(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.

Comments

  1. says

    After long consideration and asking both accountants, Score business advisors and colleagues I ended up forming an S-elected LLC for my one person business. This combination benefited from the S-corp tax benefits, but with less paperwork. I work as a freelance translator (English into Swedish) and get most my business online, through email, and have few and low expenses.

  2. EachPixelCountsHere says

    I’ve always read (including on old tax articles here) that a dba freelancer should pay about 30% of what s/he makes in taxes at the end of every quarter. Do that along with recording businesses expenses that you can write off, and you may be lucky enough to not owe come April. Is this 15-16% self-employment tax on top of that? Or do you suppose those articles were including it into that 30% figure? Because that would be pretty crazy if they had not.

    Take your example of 80k in one year. 80k minus 30% for regular taxes and then minus 11k for self-employment tax leaves that person with only about 45k. Anyone making less than 58k starting would be below 30k a year, give or take, which is regarded as the cut-off for living anywhere near comfortably (and leaves virtually no where near enough to save for retirement).

    45.3% in total taxes for someone who is also paying for their own health and business expenses is ridiculous, IMO. Please tell me I’m getting the numbers a bit wrong.

  3. says

    My accountant just switched me to an S-Corporation for tax purposes last year and I got a huge refund. Big caveat: Create a separate checking account for your business, and make sure all checks/payments are made out to the business, not to you. Otherwise, he said, you can’t count that as corporation income and you pay more taxes on it.

    @EachPixelCountsHere: 30% is waaaayyyyyy too much. Both my tax accountant and another CPA who helped me with a business grant said to set aside 15% of each check. This has worked well for me.

  4. says

    Wow, I’m so glad I read this! I certainly don’t think about taxes as much as I should. @Catena: Great point, and I think having a separate account for your business is good practice, it keeps you from forgetting that the goose that lays the golden egg is the business, and it needs to be invested in to stay healthy!

    Great article, Dominique!

  5. says

    Question: I’m new to all this finance stuff (don’t laugh or call me an idiot… im 19 and just know how to spend money). Is there a guide where I can learn all about finance?

  6. says

    Excellent read. You got fantastic nice ideas there. Almost all peoples will accept your site. Much appreciated.I found your blog via Google while searching for a related topic, your website came up, it looks great. I’ve bookmarked it in my google bookmarks.

  7. says

    @Tess Whitty Sounds like you were able to find a good match for your needs. While it can take time (and probably money since you chatted with your Accountant), it’s definitely worth the time in the long run. Good luck!

  8. says

    @EachPixelCountsHere

    RE: quarterlies, it should be noted that you usually pay quarterlies based on last year’s income. Therefore, you’re basically paying 25% of the taxes you paid last year each quarter of this year. You don’t technically have to base your quarterly payments on this years income since that’s not finalized yet. While you could pay quarterlies based on this year’s income, why not invest that money in a savings account that gives you some interest until it’s time to pay uncle sam? They’ll accept your money early, but you don’t have to send it early.

    RE: your numbers. My calculations weren’t necessarily related to the quarterlies issue noted above, although I think that’s how you came up with your numbers. Let me know if you still have a question after the quarterlies answer above.

  9. says

    @Jarod Online First of all, GREAT JOB on taking initiative to learn this stuff early on. Many people learn things the hard way over time, which can be frustrating (and expensive).

    Are you going to school right now? If you’re doing a business degree, a few conversations with your accounting 101 professor should not only help you out but will also score you some points with the professors. Many professors really appreciate students taking initiative in their courses, and the fact that you can apply his or her lessons to your own business projects will be great!

    Apart from professors, I would recommend The Business Owners Guide to Business Law, by Bagley- it’s not only got great foundation level tax stuff, but it’s also got info on nearly everything you’ll encounter in business from a legal perspective (leases, contracts, and much more).

  10. says

    @Dominique

    Thanks, and I was waiting for your response since you started making comments (just got my iPad 2 =] lol). But I looked on Google to find it, and I saw it on Amazon. The only thing was that it said “The Entrepreneur’s Guide to Business Law”; not “The Business Owners Guide to Business Law.”

    Am I looking at the wrong book?

  11. says

    @Jarod Online

    You’re 100% correct- it’s “The Entrepreneurs Guide to Business Law”…was answering that comment at the end of a long day. That’s the one!

    iPad 2 rocks! We’ve been integrating it into lots of our processes lately, but that’s probably a blog post for another day = )

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