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Freelancing is becoming very popular nowadays. In fact, a 2018 study found that more than 56 million people—about 34 percent of the national workforce—are freelancing in the U.S.
There are numerous benefits to freelancing, including a better work/life balance and greater flexibility compared to working for a traditional employer.
But are there risks involved in working as a freelancer? And does incorporating as a freelancer protect individuals against these risks?
When you operate as a sole proprietor, your home, car, and savings are at risk if your business faces legal action or incurs debts. Incorporating as a limited liability company (LLC) or corporation creates a legal distinction between your personal and business assets. This means that, in most cases, your assets cannot be seized to pay business debts or liabilities.
Liability protection becomes more paramount for freelancers working in industries with a higher risk of lawsuits. For instance, if you’re a consultant, designer, or developer, a client might sue you for perceived errors or unsatisfactory work. The process of incorporation helps mitigate this risk by ensuring that your personal assets stay with you.
Clients often see incorporated businesses as more established, reliable, and committed than sole proprietorships. This perception can be a deciding factor for potential clients who may feel more comfortable working with a legally recognized entity rather than an individual.
An LLC or corporation can even open doors to larger contracts and higher-paying clients. Many companies, particularly larger ones, prefer to work with incorporated businesses due to the legal and financial protections they offer. In short, you show that you take your business seriously.
While sole proprietors must report all their business income on their personal tax returns, incorporated businesses have more options for tax planning. For example, if you form an S Corporation, you can pay yourself a reasonable salary and take additional income as distributions, which may be taxed at a lower rate.
In some cases, incorporated businesses can deduct a more comprehensive range of expenses. These include health insurance premiums, retirement plan contributions, and other business-related expenses. By taking advantage of these deductions and tax strategies, you can keep more of your earnings, which can be reinvested into your business or saved for the future.
Banks and investors are usually more willing to provide loans or investment capital to incorporated businesses than sole proprietors. This is because the former are seen as more stable and have a more formal structure, which reduces the risk for lenders and investors.
Moreover, you may be eligible for grants, contracts, and business resources unavailable to sole proprietors. Many government and private programs specifically support small businesses, especially those legally recognized as LLCs or corporations.
Incorporating your freelance business makes it easier to plan for the future, especially if you intend to pass the business on to others. If you retire or pass away, your business may cease to exist as a sole proprietor. However, an incorporated business has a separate legal existence, which means it can continue operating even if ownership changes.
When employees work for a traditional employer, the company protects against legal liabilities in the workplace. Unfortunately, freelancers are at risk when they are self-employed.
For example, negligence, defamation, confidentiality breaches, intellectual property infringement, and data protection are the most common risks freelancers face.
As a freelancer, you’re responsible for self-employment taxes, such as Social Security and Medicare payroll. You don’t have to worry about that as a full-time employee because employers split this expense with employees. But you will pay the total amount as a freelancer.
Understanding how to handle taxes as a freelancer is notoriously ambiguous. However, the easiest thing to remember is that you will not just owe taxes on April 15th; you’ll also have to send in estimated quarterly taxes to stay in the IRS’s good graces.
How much should you set aside for your income taxes? Roughly, 30% of your net income to cover your yearly tax obligations when you start freelancing. To save time, estimate how much you’ll owe at the end of the year at the beginning of the year.
Calculate your earnings after the first quarter of the calendar year (January, February, and March). Multiply that number by four, and you can estimate how much you’ll earn this year. Let that number act as a guideline to help you determine what you’ll owe each quarter and at the end of the year.
Failure to fully understand your tax obligations as a freelancer can be costly and land you in the hot seat with the IRS.
Both the legal risks and tax risks of freelancers are why some freelancers decide to protect themselves and their enterprise by forming a legitimate business.
One way to incorporate as a freelancer is a sole proprietorship, a one-person company. This means you are in the driver’s seat, controlling your salary and reporting all earnings and losses on your tax return.
It’s the quickest way to start a business and the easiest from a tax standpoint. As a sole proprietor, you don’t have to file a separate business tax return. Instead, you simply attach a Schedule C to your 1040 and file it with the IRS. Gains, losses, and other items that can be considered business taxes are all combined.
But with simplicity comes risks. With no legal distinction between yourself and your business, business liabilities become personal liabilities. If sued, judgment can come against your personal assets, meaning you risk losing everything for your business.
After a sole proprietorship, an LLC is the next simplest structure to form. Creating an LLC means you are no longer considered the owner of your business, which means your personal assets are completely protected. When creating an LLC, be sure to separate all personal and business finances and never combine them.
Setting up a separate bank account for your company makes it easier to manage a cash balance, deduct business expenses for taxes, conduct proper accounting, execute employee payroll, and even settle necessary legal fees. It also provides better protection if legal action is taken against your company.
Additionally, business bank accounts are historically relevant through the relationship established with the bank. They can provide unrestricted access to long-term funding options, business credit cards, and other financial solutions.
Some freelancers choose to incorporate to limit their personal liability, while others incorporate to gain the tax benefits of LLCs.
For example, in an LLC, you can pay all your taxes via your personal tax return or pay corporation taxes and use the tax return to claim the salary you receive from the LLC. This can be particularly advantageous for freelancers who want to keep their salary in a low tax bracket and pay a lower corporate tax.
In addition, some freelancers choose to form an LLC because they believe it makes them a more legitimate business. Unlike a sole proprietorship, an LLC is an official company with a formal business name and number. This makes some freelancers feel more professional, credible, and respected within the business world.
Incorporating as a freelancer does not have a one-size-fits-all approach. It largely depends on the growth and nature of your business and your circumstances.
Here are some indicators that it might be time to incorporate:
As your freelance business grows, your income might reach a point where remaining a sole proprietor could result in higher tax liabilities. Incorporating as an S corporation can help reduce your self-employment taxes by allowing you to pay yourself a salary and take additional profits as distributions, which can result in significant tax savings over time.
It might be time to consider incorporation if your freelancing work involves a huge amount of liability—such as giving advice, handling sensitive data, or engaging in high-risk projects. Incorporating as an LLC or a corporation can protect your personal assets from business liabilities, especially in the event of a lawsuit or debt.
If your freelance business has grown to the point where you need to hire employees or subcontractors, incorporating can simplify payroll, tax reporting, and labor law compliance. It also offers liability protection in case of disputes with employees or contractors.
Incorporation can be viable if you seek outside investment or enter into partnerships. Investors are more comfortable putting money into an incorporated entity with a formal structure and governance. Incorporation will also make selling shares or equity in your business easier.
Incorporating as a freelancer not only puts a legal shield around you and your business, it makes filing taxes easier and can save you thousands of dollars annually.
Incorporating is the most powerful thing you can do to legitimize your startup. And at IncAuthority.com, our setup LLC services are 100% free. Always. So, don’t wait. Form your new LLC today and enjoy the protection due to you and your business under the law.
If you are unsure about incorporating, consult a business start-up specialist at Inc Authority to determine the best entity for you. Call us at 866-545-1867 for more information.
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