Should You Incorporate Your Freelance or Consulting Business?
by Caron_Beesley, Community Moderator
- Created: October 26, 2011, 7:40 am
- Updated: March 2, 2012, 4:14 pm
If you are a consultant or freelancer you’ll be familiar with this often asked, yet perplexing question: “Do I need to incorporate?”
Legally, the answer is no. The truth is over 70 percent of U.S. businesses are owned by sole proprietors, and operate successfully without incorporating.
So, if you can legally operate and be successful without it, why would you want to incorporate your business? Here are some reasons why:
You may not think now that you need protection against liability but what if a client holds you in breach of contract? Can you afford to put your personal assets at risk to satisfy any claims against your business? As a sole proprietor there is no legal distinction between the owner and the business, this means that you are personally liable for all business losses and debts.
Business incorporation can limit your liability as a business owner, essentially putting your personal assets off limits if anyone brings a judgment against you.
There are multiple types of corporations, many of which can offer tax benefits. S Corporations, for example, are a popular choice for small business owners and can reap payroll tax savings. How does this work?
Well, let’s compare a sole proprietorship and an S Corporation, both of which make $80,000 in sales a year. The sole proprietor might expect to pay $9,000 in federal income taxes as well as state taxes. However, the sole proprietor also will pay 15.3 percent in employment tax (for social security and Medicare) on the $80,000, equal to $12,240.
In the case of the S Corporation, assuming it is owned by a single shareholder, only earnings paid to the owner as a salary are subject to employment taxes. Any money left in the business for reinvestment or distributed to the shareholder as a dividend is not subject to self-employment tax. So, going back to our example, the S Corp owner might choose to take $35,000 in salary and take the remaining $45,000 as profit through a distribution. Because S Corporations only pay employment taxes on salaries, the owner is only liable for $5,355 in taxes – a lot less than the sole proprietor!
That being said, the tax savings of the S Corp come at a price. S Corps require scheduled director and shareholder meetings, minutes from those meetings, adoption and updates to by-laws, stock transfers, and records maintenance.
Another popular incorporation option is a Limited Liability Company (LLC). However, the IRS does differentiate LLCs from sole proprietorships. Instead LLC owners are taxed much like sole proprietors are on the entire net income of the LLC.
If you incorporate you can also expect your tax preparation costs to go up. If you’re a freelancer, a $1,000 tax preparation fee is a significant chunk of change that you need to be aware of.
So in summary, you can gain tax benefits through incorporation, and it is one of the biggest drivers for doing so. But it’s not the same for each type of incorporation, and a tax advisor would be your best bet for advice on this matter.
If you are hoping to expand your consulting business, raising capital as a sole proprietor can be tricky. You can get a loan but it would be considered a personal loan since sole proprietorship is not a separate business entity apart from you. Registering as an LLC, rather than a corporation, is a low-cost way to incorporate and separate your personal and business assets.
Increase Your Credibility
Whether you are looking to grow your business or hire employees, having “Inc” or “Corp” after your business name brings with it a lot more credibility than a sole proprietorship does.
How to Incorporate
If you have chosen to incorporate your company, you will need to pursue the process directly with your state. Read more about the steps involved in incorporating your consulting business in SBA’s Business Incorporation Guide. This informative blog also explains some of the pros and cons of the two more popular forms of business incorporation: Should My Company be an LLC, an S Corp, or Both?
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