Best Business Structure for Freelancers: What’s Right For You?

As a freelancer or small business owner, one of the most important decisions you’ll have to make is which business structure or entity makes sense for you. This decision will have an impact on how the business is named, how it is taxed, and whether its owners will be personally responsible for financial obligations or legal issues that may arise. While it’s something you need to decide early on, it’s a question to be periodically revisited as the business grows and evolves. 

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What is a Business Entity? 

Simply put, a business entity is an organization created by one or more people in order to conduct business. Local, state and federal governments require individuals or groups of people conducting business to establish a business structure. This allows them to tax and regulate the business appropriately and to assign responsibility for any legal matters that may arise.

Businesses entities are:

• Formed at the state level
• Taxed at both the state and federal level
• Like people, governed by state and federal laws

Note: Freelancers, by default, are small businesses. For tax purposes, the state and the IRS will automatically categorize an individual doing freelance work as a Sole Proprietor. Depending on individual circumstances, this might be great or may be less than ideal.

Types of Business Entities 

There are four main types of business entities. Each has its own set of “rules” about how a business will be managed, taxed, and regulated.

An individual working from home will have very different needs than a large multinational company. Different entities allow different businesses to operate effectively with regard to management structure, how capital will be raised, and whether its owners’ personal assets will be protected. 

Sole Proprietorship 

A sole proprietorship is the most basic form of business entity. It is not a separate legal entity from its owner. Therefore, it does not limit personal responsibility for business debts or legal liabilities. 

A sole proprietorship is a single individual conducting business for themselves, as themselves. This type of entity is established automatically whenever a person is paid to work but is not an employee of a company. Sole proprietorships may hire employees.

Advantages

• Simple to establish and maintain
• Inexpensive to start up
• Taxes are simple

Disadvantages

• Does not limit personal liability for company debts or legal issues
• Traditional loans may be difficult to obtain
• Unattractive to investors
• Taxed both as employer and employee (self-employment tax, 15.3%)

Partnership 

A partnership is a lot like a sole proprietorship, except that it is created by two or more people rather than by a single individual. A partnership is not a separate legal entity from its owners. Therefore, it does not limit personal responsibility for business debts or legal liabilities. 

Advantages

• Simple to establish and maintain
• Inexpensive to start up
• Taxes are simple

Disadvantages

• May not limit personal responsibility for all business debts or legal liabilities
• Traditional loans may be difficult to obtain
• Unattractive to investors
• Taxed both as employer and employee (self-employment tax, 15.3%)

There are three types of partnerships. Each has advantages and disadvantages depending upon how much time, money, and effort each partner will contribute to the business.

 

 

General Partnership (GP)

• Partners share responsibilities, profits, losses, and legal liabilities
• Each partner is expected to contribute

Limited Partnership (LP)

• Limits personal liability for some partners
• Must have one general partner and at least one limited partner
• General partner is responsible for running the business
• Limited partners must contribute but do not participate in running the business

Limited Liability Partnership (LLP)

• Reserved for professional services like architecture, accounting, and law offices
• Limits personal liability for some partners

Limited Liability Company (LLC) 

A limited liability company is a separate legal entity from its owners, called members. This type of entity limits the liability of its owners because the business itself is responsible for financial obligations and legal liabilities, not the members. It is a relatively new type of business entity and shares features of both the sole proprietorship and the corporation. Because of this, it has some flexibility in the way it is taxed, which can lead to significant savings at tax time.

The IRS does not formally recognize LLCs. By default, LLCs are categorized as partnerships, and taxes are filed on the members’ personal returns. However, an LLC may elect to be taxed as an S-corporation which can result in reduced tax obligations. In this scenario, a member is paid a reasonable salary (which is not considered self-employment). This results in a reduction of the amount of Social Security and Medicare tax that the member would otherwise pay.

Advantages

• Limits personal liability for company debts and legal issues
• Flexible tax status can save money
• The business itself can establish credit and secure loans and investment money
• More attractive to investors than sole proprietorships and partnerships

Disadvantages

• More complex and expensive to establish and maintain
• Requires periodic reporting to the state
• May be subject to annual state fees

Corporation

A corporation is a separate legal entity from its owners, called shareholders. This type of entity limits the liability of its owners because the business itself is responsible for financial obligations and legal liabilities, not the shareholders. Corporations are managed by a board of directors that must be appointed or elected. The board of directors is required to meet regularly and must maintain detailed records. For freelancers and other very small businesses, the workload required to maintain a corporation may make it an unattractive option.

Advantages

• Limits personal liability for company debts and legal issues
• The business itself can establish credit
• Ownership structure is most attractive to investors

Disadvantages

• Complex and expensive to establish and maintain
• May be subject to corporate income tax
• Requires significant ongoing record-keeping and reporting

There are two main types of corporations: C-corporation and S-corporation. 

C-corporations

• May have an unlimited number of shareholders
• Can have multiple classes of stock
• Are subject to corporate income tax

S-corporations

• Limited to a maximum of 100 shareholders
• May only have a single class of stock
• Are not subject to corporate income tax

A word about DBAs 

A DBA (Doing Business As) — or Fictitious Business Name — is just a name. A DBA is a way for an existing business to legally do business as another business without having to create a new, separate business. DBA is not a type of business entity.

Example: Stella has a graphic design business called Premier Graphic Design. They decide to do video editing under the name EditPro. Stella can either start a new business called EditPro or they can file a DBA so that Premier Graphic Design can legally do business as EditPro.

How to Choose the Right Business Structure 

First and foremost, understanding the business is critical in choosing the right entity. Like people, each business is unique. Without understanding where the business is today and how it might evolve in the future, it will be very difficult to provide it with a suitable structure. Good questions to ask are:

• What is the business or freelancer’s startup and growth strategy?
• How will money be raised for startup or growth?
• What product or service will the business provide?
• Will the owner(s) eventually sell the business?
• Will the business or freelancer hire employees?

Once a thorough understanding of the business has been established, it is possible to compare the different types of entities to determine which is the best fit. When considering each entity type, here are some things to think about:

• Taxes. Each type of business entity is taxed differently. Depending upon the type and size of the business, considerable savings can be realized.
• Legal and Financial Liability. Some entities protect their owners personally against the financial and legal liabilities of the business while others do not. In a Partnership, each partner is responsible for the other partners’ actions, legally and financially. Owners of businesses are legally responsible for employees’ actions while they are on the job. Protecting personal assets from lawsuits and collections is important.
• Financing and Investment. Each entity type uses different methods to define ownership status and to distribute profits. Some entities are attractive to investors while others are not. Banks may or may not lend business money depending on the business structure.

Setting Up a Sole Proprietorship 

Startup Cost Range: $25 – $300

1. Choose a name. If the business is going to use the legal name of its owner, no further action is necessary, and it costs nothing. If the business will be named anything other than the owners legal name, a DBA will need to be filed with the County Clerk’s office and the filing must be published in a local newspaper, usually for four consecutive weeks. 
2. Get a business license from the city where the business operates.
3. Get an EIN (Employee Identification Number) also called a Federal Tax ID Number. This is free and is only required if the sole proprietorship will hire employees.

Setting Up a Partnership

Startup Cost Range: $25 – $2,500+

1. Choose a name. Check with the Secretary of State where the business will operate. General Partnerships are usually by default, named after the partners. If a different name is going to be used, a DBA will need to be filed with the County Clerk’s office and the filing must be published in a local newspaper, usually for four consecutive weeks.
2. Create a Partnership Agreement. This may not be required but is highly recommended. The Partnership Agreement is like a contract between partners that clearly states what each of their responsibilities and obligations will be. It is extremely valuable if the partners later disagree about how the business will be managed.
3. File with the Secretary of State (if required). This varies by state but Limited Partnerships and Limited Liability Partnerships are likely required to file certain documents with the Secretary of State
4. Get a business license. 
5. Get an EIN.

Setting Up a Limited Liability Company

Startup Cost Range: $1,000 – $2,500+

1. Choose a name. 
2. File Articles of Organization.
3. Create an Operating Agreement. This step is not always required but is highly recommended. An operating agreement is like a contract between owners (members) of the LLC. A clearly written Operating Agreement will help settle any disputes that may arise between members regarding each of their duties and responsibilities within the organization. Cost varies between just a couple hundred dollars to several thousand depending on its complexity and whether a lawyer is hired to create the agreement.
4. Get a business license.
5. Get an EIN.
6. Pay the minimum annual tax (varies by state).
7. At tax time, select a tax status. Getting help from a tax professional is recommended.

Setting Up a Corporation

Startup Cost Range: $2,000 – $10,000+

1. Choose a name.
2. File an Articles of Incorporation with the Secretary of State
3. Establish corporate bylaws. This is like a Partnership Agreement or Operating Agreement. They are not always required but they establish the operating rules for the corporation and help legitimize the business. A legal professional should be consulted when establishing corporate bylaws.
4. Appoint directors and hold the first board meeting. This is necessary to finalize the structure of the company. In the meeting, Board Members will make decisions like: Selecting which bank to use, adopting bylaws, and adopting a corporate seal among other things.
5. Issue stock to shareholders in return for financial contributions to the company.
6. File a Statement of Information with the Secretary of State.

Anyone can set up a business. If the legal requirements get confusing or feel overwhelming, remember that the first step is to thoroughly understand the mission of the business and the needs of its owners. From there, choosing the best business structure should be a straightforward process.