Set up your own business entity v. continue working as an individual: How to decide
Since it’s every person for themselves, freelancing can be a tough gig. But on your tax return, should you just be yourself (in the legal sense), or should you form some kind of business entity (insert wacky — or meaningful — name of LLC here)? “Incorporating” can offer you important tax breaks (especially after Trump’s new tax cuts), as well as legal protection, but is it really worth the hassle? Alongside Seth Kaplowitz, a professor at San Diego State University’s Fowler College of Business, we’re going to try and help answer the not-always-entirely-smart-sounding questions most of us have on the issue.
Why would I bother to set myself up as some kind of business entity?
The main reasons boil down to two things: First, it enables tax savings and deductions, more so than just filing a personal tax return (partly because of the new tax law — more on that later). The other thing is limiting your legal liability, which corporate entities are designed for by their very nature. In other words, if the company goes belly up, or you get sued, depending on what kind of entity you choose, you and your personal assets can be shielded to varying degrees. In short, the company takes the fall, not you — even if you are the company (assuming you didn’t set up the company to intentionally defraud people and shield yourself from it, of course).
Are there different types of entities?
You bet your ass — so many, in fact, that we can’t get into all of them here, but the main ones are:
- Sole proprietorship: Essentially, this is when you set up a “Doing Business As” fictitious name. It’s the simplest and least expensive as you don’t need an accountant to do your books, and you get to expense benefits and losses. The downside is, you don’t get any of the liability protection you do with the others below.
- Partnership: A partnership is possible when two or more people form a business. There are different types of partnership structures to choose from, depending on your state’s laws, plus whether all the partners want to be equally liable if shit hits the fan, or how much liability protection they’re looking for (from “none” to “some”). Partnerships offer lower taxes than corporations, but also less liability protection. The real benefit to them is that the partnership doesn’t pay any taxes—it’s all passed through to the partners’ personal tax returns.
- Limited Liability Company: This is kind of a happy medium for people or small businesses. It’s taxed less than a corporation, and as the name implies, it offers limited liability protection.
- Corporation: There are two main types of corporations: S corps and C corps. An S corporation is limited to 100 shareholders. The upsides to an S-corporation are that you get the liability protection of a corporation, and as a shareholder, expenses and losses are passed through to your personal tax return, the amounts of which are based on your individual share. A C-corporation — the big daddy of all corporations — is what we think of when we think of “corporate” companies. They get taxed hard, but also have total liability protection, because a corporation is considered by the law as a fictitious legal individual. Corporations themselves are taxed at the state and federal level (just like an individual), then, as a shareholder, you’re taxed on your personal earnings. “As if you’re paying for liability protection,” says Kaplowitz.
Okay, so what happens if I have corporate protection?
You pay your dues, and the corporation doesn’t set your bodega on fire.
Nah. It basically works so that, if the corporation gets sued and loses, only the corporation takes a hit — your personal assets are protected. Likewise, if the company has to declare bankruptcy, shareholders only lose what they invested, nothing more.
And is limited liability the same thing?
Unfortunately, no. As the name suggests, it gives you less personal protection than a corporation, but that’s also why it’s not taxed like a corporation. Basically, if you get sued, says Kaplowitz, you have to prove that your LLC is viable (that is, it can cover judgments against it). If there isn’t enough money in the LLC, the law goes through it — this is known as “piercing the corporate veil.” At that point, it can start to get personal, literally.
Dang. Okay, so say I’m just a regular freelancer working in the gig economy, rather than someone starting their own company. What should I set up?
There’s no true one-size-fits-all answer, unfortunately. “I don’t think there’s one entity that I’d recommend without knowing what they do and what they want to accomplish,” says Kaplowitz. Say you’re a freelance writer for a men’s magazine that rhymes with “NEL,” just to pull an example right out of thin air: A sole proprietorship would be fine — unless you have a lot of assets you want to be covered, or think you might need liability protection, in which case an LLC might be the way to go.
But why not just be me, instead of forming a business, then? I already do business expenses and deductions on my personal tax return.
Because change is gonna come, my friend. Remember that big tax law that passed late last year? Next year, you’re only going to be able to itemize and deduct about $12,000 on your personal tax return, which is extremely restrictive. But if you set up a sole proprietorship (or anything else), all those deductions will appear on a separate schedule on your new tax return, yet will still flow through to you.
Also, the taxable amount for businesses is going to be reduced, giving you more incentive to start a business entity. “The new tax law is business friendly and restrictive personally,” says Kaplowitz. “You’ll see in a few years how it’s going to cost the middle class more money — individuals are going to get screwed over the long run. Businesses will benefit.”
Ughh. Okay then, how do I set one up?
You can always set one up yourself, but Kaplowitz recommends doing it with the help of an expert, like an accountant or tax adviser. “I operate under the rule that he who represents himself has a fool for a client,” says Kaplowitz. “In my opinion, you always need an objective person who’s not involved in the business to help you structure it.”
Fair enough. What’s it cost?
Just a few hundred dollars to set it up and follow regulations — things like publishing legal notice in your local newspaper. Plus, you’ll pay small annual payments to the state attorney general for your license. Partnerships and corporations cost more and take longer to prepare.
I dunno, I’m still on the fence.
Look, this stuff can be complicated, and unless you work for the IRS, it’s probably not the sexiest topic to delve into in depth. But if you’re working for yourself, know this for certain: Our new tax laws are stacked against the individual. So just do it. Set up a company and figure out the very basic skills of how to itemize and pay your bills through it. It just requires some basic accounting competency. Talk with an adviser, come up with a funny or clever company name, and then you can get back to business as usual. You can’t afford not to anymore.