When considering the different types of entity options for freelance businesses, it’s crucial to weigh the pros and cons to determine what’s best for an individual business’s situation. Time managing on this aspect is very indeed. There are many rescuetime alternatives, that will help you and give you time for your other works.
Sole proprietorship
A sole proprietorship is the most common business structure for freelancers. Simply put, a sole proprietorship is a single individual operating a business.
Pros:
- Filing federal income taxes is easy for sole proprietors. Sole proprietorships are known as “pass-through” entities, which means any earnings made by the business are simply declared on a separate form (Schedule C) and entered into the individual’s Form 1040 (however, self-employment and estimated taxes still need to be paid).
- The overall tax rate is also the lowest among all business entities.
- Equipment that is used for the business belongs to the individual alone.
- A sole proprietorship requires minimal or no paperwork, and the business may not need to be registered.
- As a sole proprietor, you may be able to give your business a different name for marketing purposes, known as “doing business as” or DBA.
Cons:
- There is no legal separation between a freelancer and their business as a sole proprietor. The owner may be held personally responsible for all financial and civil liabilities.
- If a creditor seeks to have debts repaid, all of the freelancer’s assets could be at risk, including their personal bank account, personal property, real estate, and other assets.
- It can be harder to raise money for the business because a sole proprietorship has no mechanism for raising capital as a company.
- Banks often see sole proprietorships as less credible than the other business structures, and as a result, banks may be more hesitant to lend money to the business.
Partnership
A partnership business structure is a straightforward entity. Partnerships offer business owners the ability to share ownership responsibilities, liabilities, and successes amongst multiple people. When two or more individuals go into business together, they can form a partnership.
Pros:
- Usually, partnerships are easy to start without substantial government filings or registration, and minimal paperwork. While it may not be required, it’s good practice for partners to have a written agreement that outlines each individual’s roles, responsibilities, and the division of profits and losses (and some jurisdictions may require it).
- Business losses generally are shared between partners and can be deducted on their personal tax returns.
Cons:
- The tax liabilities of the business may be passed through to the partners. This makes all owners’ personal assets susceptible to creditors when settling unpaid debts or judgments of the business.
- Each partner may be personally liable for other partners’ negligent actions or behavior.
- Disputes among partners can be detrimental to the business’s success and growth (though drafting a substantial partnership agreement can help you avoid this).
- It may be difficult for a partnership to get a business loan, land a big client, or build business credit without registering the business as a more formal entity.
C Corporation
From a legal standpoint, a corporation is a different “legal person” than the person or people who created it. A corporation can own property, accrue its profits, and be responsible for its debts and civil liabilities. The corporation is owned entirely by its shareholders, and the shareholders have a say in the corporation’s overall direction. Some jurisdictions have additional requirements, but generally, a corporation is formed when its articles of incorporation are filed with the Secretary of State.
Pros:
- Corporations generally are not limited to a specific number of shareholders (1+).
- Corporations may be eligible for more tax deductions than any other type of business.
- Corporations can raise funds through the ability to offer and sell company stock.
- The company’s liabilities generally do not flow down to the owners, or shareholders, beyond the amount of money the shareholder invested in the company.
Cons:
- The corporation registration and incorporation fee can be as much as $500 or more, depending upon the state.
- All corporations must apply for a federal tax ID number (also known as an Employer Identification Number, or EIN) from the IRS.
- Establishing a corporation may require substantial government paperwork and corporations are more highly regulated. Since corporate laws are typically written with large businesses in mind, the burden of paperwork for an individual or small group of people may be significant and outweigh any benefits gained by having the corporation in the first place.
- Corporations may be required to conduct certain formalities, like having meetings, electing officers, and so forth, depending upon the jurisdiction.
- Corporations are not “pass-through” entities. Corporations must pay their income taxes on any business profits. Tax considerations for corporations can become quite complicated, depending on the size of the corporation and the jurisdiction it’s in.
- Distributions made to shareholders may be subject to federal income taxes.
- Business losses are reported on the corporate taxes, and shareholders cannot deduct the business losses on their personal tax returns.
S corporation
An S corporation offers similar individual liability as a C corporation. However, an S corporation is considered a pass-through entity for tax purposes, which means the profits and losses are divided among the shareholders. An S corporation is governed by Subchapter S of Chapter 1 of the Internal Revenue Code, hence the name.
Pros:
- S corporation shareholders generally don’t have personal liability for the business’s debts and liabilities.
- No corporate taxation means that the profits for S corporations aren’t impacted by double taxation.
Cons:
- S corporations must operate under all the corporation rules and regulations, including the various compliance reports that must be filed and officer roles that have to be filled.
- S corporations typically face heightened scrutiny from the IRS, looking for S corporation owners incorrectly classifying dividends as wages (or vice versa) to receive better tax treatment.
- Corporations usually are more expensive for business registration than sole proprietorships and partnerships.
- There are more limits on issuing stock with S corps than with C corps.
- S corporations need to comply with corporate formalities, like creating bylaws, a board of directors, and shareholder meetings.
Limited liability company (LLC)
A limited liability company (LLC) is a newer business entity developed in the last few decades to take the positive features from each of the other business entity types. LLCs offer limited liability protection, similar to corporations, but usually have less paperwork and ongoing requirements. An LLC is not a federally recognized IRS tax entity, but is a corporate entity allowed by many state jurisdictions.
Pros:
- The LLC combines the corporation’s limited liability with a sole proprietorship’s pass-through taxation.
- An LLC may be established by one or more individuals, who then become members of the LLC.
- In the case of a single-member LLC, it’s a disregarded entity, which means income is reported to the IRS the same way as a sole proprietorship. If there are multiple members of the LLC, the IRS treats it as a partnership for taxation purposes.
Cons:
- The appropriate paperwork must be filed with the state Secretary of State, along with a fee to establish an LLC.
- Renewal fees and miscellaneous fees associated with forming and maintaining an LLC may be higher than those for a corporation.
- Most jurisdictions do not require an operating agreement for multi-member LLCs, which creates a risk that the LLC members will not draft one and could face issues as a result. Without a clear operating agreement, it may be challenging to know who may enter into a contract on behalf of the LLC or make day-to-day decisions without individuals identified as the LLC officers or directors.
Conclusion
There are many factors to consider when deciding which entity to use for a freelancing business. The breakdown above demonstrates some of the reasons why spending time to choose the right model is a worthwhile investment for freelancers. To reiterate, I am not a tax, financial, or legal professional. This article is not intended to be legal, financial, or tax advice. Consult with a business attorney and licensed tax professional to discuss which type of entity is optimal for you and your business.