“How should I set up my business?”
It’s an age-old question of freelancers everywhere. Should you incorporate or not? If you do, what form? And as a business owner, what kind(s) of insurance should you have?
There is no one right answer to these questions, but we can explain a few basics. Be sure to consult with your attorney and accountant before deciding, so you can get a full understanding of what would be best for you personally.
Common Business Entities for Freelancers
Sole Proprietorship
Many freelancers start out as sole proprietors, because it’s the simplest way to do business. Some later decide to incorporate, but others remain sole proprietors due to the convenience.
A sole proprietorship is an unincorporated business. If you’re the only owner of your business, you’re automatically a sole proprietor until (and unless) you formally incorporate.
One major benefit of this business form is that there are none of the expenses of forming a corporation. Sole proprietorships don’t require any filings, tax identification numbers (TIN), or anything like that. Instead, you and your business are generally treated as one entity. You’ll report all of your business income and expenses on your personal tax return.
A big downside, though, is that sole proprietors are personally responsible for the debts and obligations of the business.
Corporation
Unlike a sole proprietorship, a standard corporation (sometimes called a “C” corp) is a separate legal entity from its shareholder(s). (That’s you.) This means the business itself is liable for its debts, obligations, and activities. There is no personal liability.
Setting up a corporation generally entails registering with your state and filing various forms. Each state has its own laws and rules that must be followed. Most corporations also get a TIN for federal tax-filing purposes. The upkeep on all of this can be costly in terms of both time and dollars. Many people who form corporations outsource the task, adding another layer of expense.
A major downside of corporations is that they’re doubly taxed. First, the corporation itself pays taxes on its profits, though certain things are taxed at a lower rate than personal taxes. Then the shareholder gets taxed on the after-tax profits that are distributed. So your corporation would pay its own taxes, and then you would pay personal taxes as well on whatever you take as a distribution.
S Corporation (“S” Corp)
As you may have guessed, many people don’t appreciate the double taxation aspect of C corporations, but like the fact that a corporation shields them from personal liability. If this describes you, an S corporation may be the ideal solution.
With an S corp, there’s no taxation to the corporation itself. Instead, profits and losses pass through to your personal tax return, so you’re paying only once. And though you have to pay personal taxes, many expenses can be written off as business expenses, which are tax-deductible. (Expenses are tax-deductible regardless of what form your business takes.)
To take advantage of the benefits of an S corp, the IRS requires that you pay yourself “reasonable compensation.” Otherwise, additional earnings beyond fair market value may be classified as wages and taxed differently.
Another tricky thing with S corporations is that they’re treated differently from state to state. Most states treat them as the federal government does, taxing the shareholder but not the corporation. Yet some states tax S corps beyond a certain dollar threshold. Still others don’t recognize S corps and tax both the corporation and the shareholders, as with a C corporation.
If you decide you want an S corp, you’ll first form a C corp and then convert it to an S. Your attorney and/or accountant can help you with this.
Partnership
As a freelance writer, you may not have a business partner. But if you do go into business with someone else, you might form this type of entity. Each partner (there can be more than two) contributes to all of the aspects of the business, and each shares in the profits and losses.
There are a few kinds of partnerships:
- A general partnership typically divides everything equally among the partners.
- A limited partnership will limit at least one partner’s liability and possibly their managerial input. How the limits are defined often depends on the partner’s financial contribution.
- Joint ventures are similar to general partnerships but are often for a limited duration or purpose (like a specific project).
Partners enjoy the benefits of bringing various skillsets to a business, and the shared financial commitment to the business’s success. At the same time, drawbacks include disagreements among the partners and unlimited liability—not just for your own actions, but for everyone else’s, too.
Limited Liability Company (LLC)
LLCs are special partnerships that limit liability. The business is not an entity for tax purposes, so only the partners are taxed individually.
Because LLCs are partnerships, they require more than one person. Some states don’t even allow for the formation of a single-member LLC, and at the federal level, they’re taxed as sole proprietorships.
Liability? Gulp…
You’ve noticed the word “liability” popping up repeatedly in this article, which might make you think of insurance. What types of insurance might you need for your freelance business?
General liability insurance. If you’re a solo freelance writer, you might need to have this, if you have some large corporate clients who require it for all their vendors. Otherwise, you probably won’t need it, unless you have clients visiting you at your office.
Errors and omissions insurance. Though this insurance will (generally) protect you if someone files a lawsuit due to mistakes in your writing, you don’t necessarily need it. A less-expensive approach would be to make sure all your project agreements include an indemnification clause, which transfers the risk from you to your client. After all, inaccuracies on your behalf will probably be due to some information your client has passed on to you, or neglected to catch when they approved your project for publication.
Bottom line? Save the money on insurance if you can and use it to incorporate or otherwise invest in your business—though your accountant can help you decide for certain.
Dealing with these types of matters can be dry and time-consuming. The good news is once you decide how to handle them, you really don’t need to think about them again, unless you want to change something. So take the time to proactively make a decision—and then get back to what you really want to do… write!
Disclaimer: While every effort has been made to ensure the accuracy of this information, it is not intended to provide legal or financial advice. Each situation is different and should be discussed with an expert and/or lawyer.
