Like many freelancers, you many have started out doing business “on the side” to either supplement the income you derive from your full-time “day” job or to test the waters before making the plunge into full-time self-employment.
In this situation, claiming the money that you make freelancing as additional income on your personal tax return is fine. However, once you decide to pursue freelancing full-time, or you have reached a critical mass in your business, you should take the formal step of establishing a legal business entity. Selecting the right business entity will protect your personal assets from any liability you may incur as a business owner and it may also offer you some significant tax advantages.
Sounds simple enough, doesn’t it? However, the issue that many first-time, would-be business owners face as they make a move to formalize their freelancing activities is related to how they should structure their new entity. Entity selection is an important process that should be thoroughly considered when you start to organize your business, and it can be somewhat confusing given that each type of entity has its own legal and tax benefits. Three of the most common business structures for freelancers are the sole proprietorship, the limited liability corporation (LLC), and the S corporation (S corp).
To provide some context, let’s look briefly at the tax advantages and disadvantages of each entity type:
A sole proprietorship does not offer protection against personal liability that is incurred through your business activities, and this is an important consideration, especially if you are planning to freelance as your full-time job and you have significantly more exposure than you did when your freelancing was on a part-time basis. However, from a tax perspective, a sole proprietorship, like a single-member LLC, allows you to take a more streamlined approach to tax filing. This is because a sole proprietorship is considered by the IRS as a "disregarded entity." This means that your income from your business is reported on your personal tax return (Form1040), instead of on a separate business return.
A single member LLC offers the major legal advantage of protecting your personal assets from the creditors of your business. By setting up an LLC, you also avoid paying both personal and business taxes on your freelance income. As a "pass-through entity" all the income and expenses from your LLC get reported on your personal income tax return as the business operator.
An S corp, like an LLC, protects you personally from any business liabilities you may be involved in from a financial perspective. Establishing an S corp also helps you avoid paying both personal and corporate taxes. However, S corp owners, unlike owners of sole proprietorships and LLCs, pay themselves salaries and receive dividends from any additional profits the business may earn. This adds another dimension of complexity to the tax situation and required tax filings that S corp owners must comply with. Most notably, S corp owners must file business returns, rather than using their personal return to file their business taxes.
It is worth noting that under each scenario you would be allowed deductions on pre-tax expenses, such as travel, computers, phone bills, advertising, promotion,car expenses, and health care premiums. You may also be able to deduct home office expenses, if you work from home.
What's better for taxes?
Now, let’s focus more closely on the tax implications of establishing an LLC vs. an S corp, the two more common kinds of entities that full-time freelancers might establish.
Using the hypothetical example of Fred Freelancer who lives in New York City and generates $75,000 in revenue and has $15,000 in expenses the following chart shows the tax implications for Fred, based on whether he decides to establish a single member LLC or an S corp (sole-proprietors would have the same tax liabilities as a single-member LLC less $25 annual LLC filing fee). Please keep in mind that these calculations do not take into account any formation, legal or accounting services costs or payroll tax requirements if Fred happened to have employees. We have also structured this example to include Fred paying himself a $30,000 salary should he choose to establish his business as an S corp.
From this example, you can see that Fred is relatively indifferent as to entity structure because the self-employment savings would be counter-balanced by an increase in NYC business taxes as well as Unemployment Insurance. It is also important to note that while this example details the local and state taxes specific to the New York area, which includes business taxes on both of these entity types, if Fred lived elsewhere, he would be subject to the specific taxes in that area, and he would be wise to seek professional advice before determining which type of entity he should select.
In addition to tax implications one also has to weigh the filing fee and other requirements for entity formation. New York imposes a publication requirement on the formation of LLCs which can be cost prohibitive for some individuals.
Another key point to keep in mind that merely incorporating in another state would not reduce your tax burden in your home state as tax is determined based on where the business is operated and not merely incorporated. So forming the entity in Delaware when 100% of your work is done in New York City would not eliminate your tax obligation to New York.
The moral of this example is that selecting the right type of entity for your new fully-fledged freelancing business is a decision that deserves thoughtful analysis and should be done with the help of a qualified financial professional to avoid potential tax issues in the future.
Note: Materials in this article are provided for informational purposes only. Please seek appropriate tax and legal counsel for assistance.
Jonathan Medows is a New York City based CPA who specializes in taxes and business issues for freelancers across the country. His website, www.cpaforfreelancers.com, has a resource section with how-to articles and information for freelancers. Jonathan is happy to provide an initial consultation to freelancers. To qualify for a free consultation you must be a member of the Freelancers Union and mention this article upon contacting me. Please note that this offer is not available Jan. 1 through April 18 and covers a general conversation about tax responsibilities of a freelancer and potential deductions. These meetings do not include review of self-prepared documents, review of self-prepared tax returns, or the review of the work of other preparers. The free meeting does not include the preparation or review of quantitative calculations of any sort. We are happy to provide such services but we would need to charge an hourly rate for our time.