by Jonathan Medows, CPA

For many talented individuals, starting a freelance business can be a very rewarding way to use their skills. However, many new freelancers eager to begin doing the work they love tend to avoid researching some fundamental aspects of establishing a business such as the type of legal entity they should form and their respective tax obligations.

With this in mind, the following was created to help those new to self-employment start out on the right foot when establishing their business and reduce their risk of owing significant dollars in back taxes or worse, yet, facing an IRS audit.

1) Explore Your Entity Options. Usually one of the first and the most important decisions that a self-employed individual must make is selecting the type of entity through which their business will operate. There are several options to choose from, each with their own specific characteristics as outlined below:

● A sole proprietorship is the simplest form of entity in terms of set-up and tax payments. As a sole proprietor you are responsible for claiming the profit and loss of the business as your income. You also must pay self-employment taxes. The drawback of a sole proprietorship is that the individual is personally liable for any damages or credit issues that arise from their business operations.

● A corporation is an entity which is separate from its owner. The corporation is formed under the laws of the state in which it is operating, with Articles of Incorporation. Choosing to establish a business as a corporation limits the liability of the individuals participating in it and, from a branding perspective, it may also provide additional credibility to the business.

● A subchapter-s corporation (or s-corp) is a corporation and the owners are considered employees. The entity is required to pay these employees a reasonable salary. Profit or losses of the entity flow through to the individual shareholders. Any salary paid is subject to traditional employer and employee payroll taxes. The remaining profit flows through to individual shareholders and, while subject to income tax, it is not subject to payroll taxes and is considered passive income. In order to maximize the tax benefit of an s-corp, it is key that the owners find the balance between wages and profit distribution.

● A limited liability company (LLC) is not a corporation, but it has the liability protection of a corporation. Single-member LLC entities pay tax like a sole proprietorship. Multiple-member LLCs can also be formed which pay taxes like a partnership.

Equally as important as choosing the right type of entity is making sure that the entity is set up correctly—a step that can be confusing to individuals who have no experience in this area.

2) Know Your Geographic Tax Obligations. Most individuals are aware that federal and state taxes must be paid, yet they may underestimate how much is actually owed. The place where it is common for newly self-employed individuals to overlook their tax obligations is at the local tax level.

It is important for business owners to know what taxes they may be responsible for in the city where they are conducting business. This information can usually be found on the website of the city where a freelance business is based or by engaging a local CPA firm to help in the business start-up phase. A tax professional will be able to advise on geographic-specific tax considerations that may not be apparent to those outside of the tax profession. For example, in New York City, there are taxes for sole-proprietors, partnerships, LLCs, corporations and s-corporations.

3) Be Prepared to Track and Pay Taxes Regularly. Unlike working as an employee of a business, self-employment requires that an individual proactively pay tax on any income earned. One of the most serious mistakes that the owner of a freelance business can make is failing to pay quarterly estimated taxes (including federal, state, and local personal and business related taxes) and, if the business has employees, not keeping up with payroll taxes.

It is extremely important for freelancers to organize their accounting and keep detailed records to ensure they know what their revenue and expenses are and how much profit their business is making. This information is essential to be able to make the appropriate estimated tax payments that are required of self-employed individuals. When estimated payments are not made on a regular basis, the amount of money owed to the IRS can quickly add up and become a real burden to business owners. In addition, if quarterly tax payments are not made, freelancers can be subject to IRS fines and penalties.

In addition, self-employed and small business owners should monitor new tax rules to ensure their business is fulfilling its current tax obligations and taking advantage of any available tax credits or exemptions. For example, this tax year, the Affordable Care Act (also known as Obamacare) introduced a new 3.8% Medicare surtax which is applicable on all investment income and may affect many small business owners, depending on their net investment income.

4) Get Professional Tax Help If Needed. As many seasoned freelance business owners will attest to, it can be difficult to focus on doing the work that brings income in, while also keeping up on the tasks that will allow you to keep your business operations in good standing from a legal and tax perspective.

Keeping abreast of compliance—especially in the area of taxes where the rules are constantly changing is vital. Therefore many freelance professionals end up relieving themselves of the burden of tax planning and preparation in favor of hiring a tax professional. Seeking the advice of a professional in this area may also be a good idea for those who are just starting out as freelancers to ensure that they establish their business correctly and avoid costly mistakes. For freelancers who choose to go this route, it is vital to select a competent accountant who is well-versed in the nuances of taxation specific to the self-employed.

When it comes to starting a freelancing business and setting up the proper legal and tax structures, the phrase ‘Caveat Emptor’ is particularly appropriate. Often, the excitement of starting a new business can cause some self-employed individuals to jump the gun when it comes to setting up a new entity under which to do their work, which can complicate tax issues further. Not only should new freelancers ensure that the entity that they are establishing is appropriate for the type of business they are running, but they also need to take responsibility for ensuring that they understand their tax obligations and establish good practices for meeting them.

Jonathan Medows is a New York City based CPA who specializes in taxes and business issues for consultants across the country. He has a resource section with how-to articles specifically for the self-employed at his self-employed website, www.cpaforfreelancers.com.