Have you ever wondered if your business is legit? Is there a way to reduce self-employment taxes? If so, read on to learn more about business structures and freelancing.
By default, you’re a sole proprietorship.
If you’ve never actually chosen a business structure, then your business is a sole proprietorship. As the simplest business structure, the sole prop doesn’t separate your personal and business finances. That means that if your business is sued or can’t pay its debts, you may be required to tap into your personal savings and property.
A lot of small businesses transition to a formal business structure like an LLC or Corporation. These structures will help protect your personal assets from any liabilities of your freelance business. And in some cases, there can be tax benefits as well.
Business Structures: An Overview
Three common U.S. business structures are: the LLC (Limited Liability Company), S Corporation, and C Corporation. Each structure has pros and cons depending on your specific situation. However, in most cases the C Corporation is overkill for a freelancer. For several reasons (including tax structure), the C Corporation is a good option for bigger companies who plan to go public, seek VC funding, or invest profits back into the company.
The LLC and S Corporation are popular choices for the small business/freelancer. Both give you the option for “pass through” taxation where the company doesn’t pay taxes, but all profits and losses are passed on to your personal tax report. That probably sounds a lot like how it works with a sole proprietorship, but there’s a big difference.
If you’re a sole proprietor and pay your taxes on a Schedule C, you’re subject to paying self-employment tax in addition to income taxes. This can leave you scratching your head wondering what happened to your hard-earned money.
However, Bert Seither, Director of Operations at Corporate Tax Network, explains that many freelancers will set up as an S Corporation or LLC that’s taxed as an S Corp in order to reduce self-employment taxes.
“When you have an S Corp or an LLC that’s taxed like an S Corp you can be paid a good portion of your money from the entity to yourself in distributions (think of distributions as bonuses). The distributions are not subject to any self-employment taxes,” said Seither.
“However, keep in mind that you cannot take all of your money in distributions and are required to pay yourself a ‘fair and reasonable’ salary,” he added.
While taxes are typically at the forefront of everyone’s mind, you need to consider other aspects that can have just as big an impact on your bottom line. If you incorporate as an S Corporation, you’ll need to set up a board of directors, file annual reports, hold shareholder’s meetings, etc.
With an LLC, there’s a lot less paperwork and fewer ongoing administrative formalities to follow than a corporation. For some people, the S Corporation can be too burdensome.
Take some time to learn about the different business structures; talk to a tax advisor about your particular situation. It’s easy to set up and you’ll be protecting your personal assets and giving your business more legitimacy.
Editor’s Note: This was originally written by Nellie Akalp for Elance.