If you are starting a business as a freelancer, you have a choice of the legal type of business structure (entity) that you choose. There are advantages and disadvantages among becoming a Subchapter S Corporation, a C Corporation, a Limited Liability Corporation, a Sole Proprietor, or a Partnership.
Since there are both legal and tax implications attached to each type, it is best to get your lawyer, financial advisor, and/or accountant involved in the decision making process.
Most people want to pay a little tax as possible, and incur the least amount of paperwork overhead when running their own business. In this article we will detail the facts that you need to consider, along with their consequences, so you can have a good starting point of reference when you meet with your legal and tax professionals.
About Being A Sole Proprietor
This type of entity will happen de facto if you choose no other form of entity for your business. There is no set up or filing necessary to become a sole proprietor although it is recommended that you will want to contact the IRS and your state/local tax agency to get estimated tax forms necessary as taxes will no longer be directly pulled out of your paycheck. It will be your responsibility now to determine how much tax you owe. In addition, as a sole proprietor, you will be responsible to pay both halves of the Social Security and Medicare tax where in the past you paid half and your employer paid half. Whoever pays you for your work will send you a 1099 at the end of the year which you must claim as gross income in your business. You will be able to deduct many different things attributable to your freelancer business. I recommend you buy a program called neat receipts (www.neatreceipts.com ) which can help you keep track of receipts, expenses, etc.
While the sole proprietorship is extremely easy to get up and running, one major downside is unlimited liability. Should you get sued, it is possible to go after your personal assets beyond the assets in the business. This is a major consideration depending upon the type of freelancing you are doing within your business.
About S Corporations
Subchapter S Corporations are limited to no more than seventy-five shareholders and all of them must be U.S. citizens or resident aliens. Most people choose to follow the calendar year for tax reporting purposes although this is not a requirement.
S Corporations first appeared in the mid 1950's and were designed to simplify the tax and paperwork burden of running a business.
Limited Liability Protection
Like a "C" corporation (also called a general corporation), an "S" corporation provides what is known as Limited Liability. Essentially this means that the officers of the corporation are able to protect their personal assets (real estate, personal income, personal automobiles, etc.) from seizure by creditors or judgments that are incurred by the business.
In order to prevent creditors from piercing the Corporate veil, which means having a court rule that your corporation wasn't run like it should have been, therefore your personal assets aren't protected, there are some basic rules that must be followed:
- Be sure that you file any annual reports that your state and the IRS requires.
- Keep a separate business checking account, and get a business credit card, so you do not co-mingle your personal and business money.
- Conduct all business in your corporate name.
- Sign all documents and contract with your corporate title.
- Have at least an annual Board of Directors and Annual Shareholder Minutes Meeting.
- Keep your corporate book and resolutions up-to-date.
Tax Advantages of S Corporations
No income taxes are paid with the corporate return. The profits (and losses) of the business are reported on the personal tax returns of the S corporation's shareholders. Also, as long as you pay yourself a reasonable salary, you may take what is known as shareholder distributions out of the business and avoid paying of FICA and Medicaid taxes on those amounts.
If your S Corporation posts a loss, and some of your money was used to start, operate, or grow the business, deduct those losses on your personal return.
If you do not have Basis in your corporation, which means that you haven't personally contributed any money to it, then you lose those tax advantages that result from losses. One way to get around this is to personally borrow money from the bank, or a friend or relative, and then loan that money to the corporation. Now you have basis and any losses that you fund are deductible.
About C Corporations
If you do not qualify to become an S corporation, either because you have too many shareholders, or some shareholders are foreign nationals, or you plan to go public at some future date, then you need to consider being a C Corporation.
Taxation of C Corporations
Owing a C corporation results in double taxation. That is because the C Corporation itself must file a tax return and pay taxes on its profits and then, when the money passes to the shareholders they also pay taxes on it. This is not a good situation for the average small business, so you really want to try to meet the S corporation's requirements.
Other than the double taxation problem, a C corporation enjoys the exact same limits of liability as an S corporation does, and it needs to follow all of the reporting rules, and operational rules, outlined in the S corporation section above.
Converting from a C to an S Corporation
A C Corporation can make an election to become an S Corporation if it meets all of the requirements. Since there are broad tax implications, and IRS rules to be followed, you should never do this without consulting with your tax professional.
About LLC's, LLP's and Forming a Partnership
Limited Liability Corporations (LLCs), Limited Liability Partnerships (LLPs) and General Partnerships are all taxed the same way. If you have no particular compelling reason to choose one of these entity types, then you should opt to be an S corporation.
Here are some reasons why you might want to choose to become an LLC, LLP, or General partnership:
Below are some of the reasons you might want select an LLC, LLP, or General Partnership as your entity choice:
Companies such as Law Firms and Doctor's practices put all of the partner's assets at risk if they are a General partnership and even one partner is found responsible for any legal or financial problem.
If they are formed as an LLC or an LLP, only the offending partner's personal assets are at risk. These are special protections that are afforded under the Professional Service Statutes but do not apply to other types of businesses such as a retail store, or florist, or auto repair shop, etc.
Another example is in the case of a real estate developer who has a piece of property that appreciates greatly in value. The developer could transfer that property to an LLC, LLP, or General Partnership without having to pay any capital gains tax.
As an additional consideration, any of these entity types allow you to take shareholder distributions that are not based upon ownership, whereas in an S or a C Corporation they must be based upon ownership.
The only real advantage of a general partnership is that you don't have to register with the State nor do you have to pay any registration-related fees. A general partnership is normally a pass through tax entity meaning that the partners, not the partnership, are taxed unless you specifically elect to be taxed like a corporation. This makes filing income tax returns easy and straightforward.
You are not required to file separate tax returns, one for the business, and one for the owner, like you are in a C corporation.
The downsides are that the business-related actions of one partner legally bind all others, so it is important that you choose partners that you can trust. it is equally important to prepare a written partnership agreement that details, among other things, each partner's share of profits or losses, day-to-day duties and what happens if one partner dies or retires.
In general, a partnership is a really bad idea and should be avoided if at all possible.
Now you have enough basic information to work with your legal and tax professionals to make an informed decision about how to set up your business. No matter which entity you choose, you are about to embark on the exciting journey of owning your own small business.
The information provided in this article is for informational purposes only and should not be used as the basis for making any legal or financial decisions. Always consult a licensed tax or legal professional when making important business decisions.