As you chat with other freelancers, the topic of forming an LLC is bound to come up. If this makes you feel uneasy, you aren’t alone. We spoke to an expert to decode the legal jargon—and help you decide the best move for your business.
Sole proprietor vs. LLC vs. S corporation—what’s the difference
Sole proprietorships, LLCs, and S corporations are the most common business types for freelancers. Here is a rundown on the key differences between each one.
Sole proprietorship means you are an unincorporated business owner. Legally, there is nothing separating you as an individual from your business, and the same goes for your taxes. Business licenses or permits may be required, but no other formal action is needed to register your business.
This is the simplest and least expensive business structure.
You are in complete control.
There isn’t a separate business tax return.
You are personally liable for all business activities.
Raising or borrowing money for the business may be harder.
You alone are responsible for your business’ success or failure.
Limited liability corporations or LLCs have various filing requirements by state. LLCs can protect your personal assets if your business faces a lawsuit or bankruptcy, but you avoid corporate taxes because profits and losses go on your personal tax return.
Your personal assets have limited liability protection.
You have the flexibility to change your federal tax classification.
This is more expensive than a sole proprietorship.
You won’t automatically receive the tax benefits of S corporation election (see below).
Your liability protection is limited.
S corporation (or S corp) status happens when you make an election with the IRS. You need to be a corporation — like an LLC — first. Tax savings is one of the primary benefits. Profits and losses go on your personal tax return, and the business itself won’t be taxed.
Significant tax savings may be possible — especially on Social Security and Medicare.
There is limited liability protection because your business is separate from you.
There are stricter rules and scrutiny from the IRS.
S corps are more expensive to operate than a sole proprietorship or LLC.
Your liability protection is limited.
Laying the groundwork
We get it—choosing a business entity is complicated.
Before making an impulsive decision, Jennifer Hunt, a Nashville-based attorney at Gordon Law Group recommends answering a few key questions:
What is your likelihood of being sued?
How much money are you making?
What does the future of your business look like?
Take some time to browse the small business section of your state’s website. Familiarize yourself with the process of filing different business entities. For example, Tennessee’s Secretary of State has many free resources. After these steps, you will be ready to speak with a professional about registering your business, if that’s the route you choose.
Should you worry about personal liability? Probably.
Personal liability could be an issue for freelancers operating as sole proprietors.
“Separating your personal assets from your business is always a good idea,” says Hunt.
Hunt notes certain businesses like food service or home construction are higher risk. But no business is free from liability. You may not consider the expense of being sued by a client, but thousands of dollars in unexpected legal bills could become a personal financial catastrophe.
Regardless of which entity you choose, you should always protect yourself with written agreements.
“Clients get angry when expectations aren’t clear on the front end. Communicate risks or potential downsides from the beginning to avoid future problems,” Hunt says.
Your income vs. the cost of changing business entities
How much money your business earns is a consideration too. Filing fees can be $30 to $200, depending on where you live. Plus, there is the expense of professional advice. Legal advice isn’t cheap and having someone file on your behalf may add to the bill. That’s why forming an LLC may not make sense if you are only making a few thousand dollars a year.
“Don’t immediately jump to form an LLC unless you’re dealing with a high-risk job,” Hunt adds.
Predicting the future of your business
Another thing to consider is how long your business will be around. Do you see yourself continuing to freelance for years to come? Can you envision adding partners or employees? Hunt says the future of your business may impact the structure you decide to form now. Are you freelancing temporarily to cover your expenses in between full-time jobs? Or do you expect to embrace entrepreneurship for the long haul? These two different scenarios may impact your decision.
What about online services like LegalZoom?
It may be tempting to skip professional advice — especially when your income is uncertain. Services like LegalZoom offer LLC packages starting at $79 plus filing fees. Hunt urges freelancers to talk to a professional in person, even though it’s more expensive.
“Without speaking to an attorney or CPA, the process of forming your business may be done wrong,” Hunt warns. Online services may lead to missed steps, and the forms may not be specific to your state.
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How much does an attorney cost?
Like many services, costs vary depending on where you live. Most attorneys will charge a flat fee and you can expect to pay up to $1,000. This fee may include advice, walking you through the process, and filing paperwork on your behalf. You will also be responsible for your state’s filing fees.
Where to find a local attorney
Unfortunately, there isn’t a reputable website for attorneys specializing in small businesses. Many of the online databases you may see are paid advertisements. Hunt recommends asking for referrals from other freelancers or business owners.
The bottom line
It’s normal to feel overwhelmed by how to structure your business. There are financial and legal consequences regardless of which option you choose. It’s worth the extra effort and expense of speaking with a qualified professional — especially if you plan on freelancing for the foreseeable future.
“If you are making money on a continual basis — at least for the next year — taking a hard look at your business entity is worthwhile,” says Hunt.