You quit your job and became a full-time freelancer to be free from the clutches of the corporate world. Congratulations! But now, you’re asking how to incorporate your freelancing business. Ironic isn’t it?
When I first started freelancing I had the exact same question about whether or not to incorporate. Unfortunately, the resources available online are few and far between, spread out, and not comprehensive enough.
Consider this your comprehensive guide to incorporation as a freelancer. Please note that this best-suited to individual freelancers based in the United States who are freelancing full-time.
In this article, I will go through:
- The right time to incorporate and the pros and cons of doing so.
- The business entities you can choose from for your freelancing business
- How to incorporate your business
- What you need to do after you incorporate (accounting, business expenses, taxes)
This is the resource that I wish I had access to when I first started freelancing. So let’s get started.
Section 1: Should You Incorporate Your Business?
You Don’t Have to Incorporate If You Don’t Want To
First things first. There is no legal requirement to incorporate as a freelancer. You can continue working for yourself without being afraid of breaking the law.
This is called a sole proprietorship. In fact, 70% of US businesses are sole proprietorships and they do just fine.
However, there are a few reasons you might want to consider incorporating:
- Limit your liability
- Simplify your taxes
- Look more professional
- Larger companies prefer to work with other businesses
- To fundraise
Reason #1: Reducing Your Legal Liability
The main reason to incorporate is to separate your personal and business assets from any liability.
As a sole proprietor, if your business can’t pay its bills or gets sued, you will be personally liable for any debt. This means that your personal assets, including your money and house can be taken in a settlement.
In a sole proprietorship, there is no legal difference between you (the owner of the business) and the business itself. In the eyes of the law, you are the business.
Incorporating will allow you to legally separate yourself from the business. Now when a client sues you they can only go after your business assets. Yay!
Another thing you can do to reduce your legal liability is to make sure you write a contract for each client project you do. Your contract should explicitly state the deliverables of the project and the responsibilities of each party.
In my contracts, I also include a section titled “Limitation of Liability”, where I state that I am not responsible for anything if the client project doesn’t lead to desired results. This serves as a deterrent so that clients don’t sue you. But it’s not foolproof.
I’ll cover contracts in a future post so don’t worry about this for now.
Aside: Liability Insurance
Even if you’re incorporated and get sued, you will still need to pay legal fees. So whether you incorporate or not, you should consider getting liability insurance to help minimize your legal costs.
Full disclosure, I don’t have liability insurance. The reason I don’t is because I don’t feel that this is important to me at this point in time. I would consider it in the future if I started getting larger clients and made over $100,000 a year. But right now it’s an unnecessary expense.
Here are 4 articles that go more in-depth on liability insurance. I highly encourage you to educate yourself on this subject so you can determine if now is the right time for you to get liability insurance.
- Liability Insurance for Freelancers 101 | Adam Cecil (PolicyGenius)
- Everything Freelancers Need to Know About Liability Insurance | Freelancer’s Union
- Professional Liability Insurance | Pat Pohler
- What Freelancers Need to Know About Liability Insurance | Hiscox
Reason #2: Simplifying Your Finances and Taxes
As mentioned previously, incorporating separates your personal and business finances. This is helpful for bookkeeping because it allows you to easily keep track of your business inflows and outflows.
As a business entity, you’ll only need to file taxes once a year. Compare that to the quarterly taxes you need to file as a sole proprietor. It’s a lot less time and money.
If you freelance part-time, I would not recommend incorporating just because you probably don’t generate enough freelancing income for it to matter very much.
If you freelance full-time, I would encourage you to incorporate. Once freelancing becomes your main source of income, you should separate your personal and business finances.
Reason #3: Boosting Your Credibility with Clients
Being a business entity can be helpful when you market yourself to potential clients. By using your business name, you can sell yourself as something bigger than what you are.
For example, I incorporated my freelancing business into an LLC named Tandem Designs LLC. That allows me to sell myself as a design agency instead of just a single freelancer.
If I had no ethics, I could tell clients that I manage a team of 10+ web designers and developers. And they wouldn’t know any better!
Point being, a business name will always sound more impressive than a person’s name. Of course, you can just call yourself something other than your name. But in legal documents, you will either you your legal name (if you are a sole proprietor) or your business name (if you have incorporated).
Reason #4: Larger Companies Prefer to Work with Businesses
Larger companies may prefer to work with corporations and LLCs instead of sole proprietors. There are a few reasons for this:
- Larger organizations can’t afford to take risks. Working with an established business entity gives corporations a peace of mind.
- There are tax implications when corporations hire a sole proprietor as a contractor. The IRS monitors businesses to make sure they classify their workers properly as full-time employees or contractors.
Reason #5: Raising Money for Your Business
In order to raise funding to grow your business, you may need to be incorporated. Depending on the type of funding you’re looking for, investors may require that you be incorporated. Just remember that any debt you accrue as a sole proprietor will only increase your personal risk.
Section #2: The 3 Types of Business Entities for Freelancers:
- Does not offer protection against personal liability
- Streamlined approach to tax filing.
As we discussed earlier, a sole proprietorship does not protect your personal assets. Instead, your personal and business assets are lumped together.
A sole proprietorship is also considered to be a disregarded entity by the IRS. This means that your business income is reported on your personal tax return. This simplifies things from a tax perspective.
Limited Liability Corporation (LLC)
A limited liability company (LLC) is a business structure that combines the pass-through taxation of a sole proprietorship or partnership with the limited liability of a corporation.
This means two things:
Firstly, an LLC allows you to be taxed the same way a sole proprietorship is taxed. 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. This means that you will have to pay self-employment taxes. In contrast to corporations, you avoid paying both personal and business taxes on any freelance income.
Secondly, an LLC separates your personal and business assets. For freelancers, an LLC offers the best of both worlds when compared to sole proprietorships and corporations.
In-Depth Look: Self-Employment Taxes
The LLC does have one problem: self-employment taxes. In addition to your income taxes, LLC members are required to pay self-employment taxes to the IRS. The self-employment tax rate for business owners is 15.3% of net income up to an annual threshold and then 2.9% for income above the threshold amount.
For complete information on how LLC’s are taxed, read Nolo’s in-depth article:
S Corporation (S Corp)
Similar to an LLC, an S Corporation protects you from business liabilities and helps you avoid paying both personal and corporate taxes. However, S corps are way more complicated than LLCs.
Here’s what I mean. S corp business owners pay themselves in two ways: through salaries and through distributions.
- Salaries must be paid through W-2 forms and incur payroll taxes. In other words, you are paying yourself as an employee of your own company.
- Distributions are dividends from any additional profits the business may earn. They are not taxed.
This adds another dimension of complexity to the required tax filings. In addition, S corp owners must file business returns and cannot use their personal return to file their business taxes.
Corporations require way more paperwork than LLCs. In my opinion you are much better off keeping things simple as an LLC and spending your time building your business.
A Popular Strategy: Forming an LLC and Being Taxed as an S Corp to Reduce Self-Employment Tax
Earlier I mentioned that LLC members are subject to self-employment taxes. One popular strategy to minimize self-employment tax is to form an LLC or corporation and then elect to be taxed as an S Corporation.
Don’t worry, the first time I heard this I had no idea what people were talking about.
The idea with this strategy is that you’re able to pay yourself in both salary and distributions. In this case, only your salary is subject to self-employment tax.
Your salary is your monthly wage that you earn from the business. Whereas distributions are additional amounts of money that you may receive from the business profits.
You need to be careful when splitting your salary and distributions. The IRS monitors to make sure that business owners are paying themselves a fair salary for the work they do and aren’t just getting paid in distributions. So don’t be the person that pays themselves $1 in salary and the rest in distributions.
It has been said that an LLC taxed as a S corp is the best possible small business structure. This is because it combines the simplicity and flexibility of an LLC with the tax benefits of an S-corporation.
Personally, I choose to keep things simple as a regular LLC. My thought process is that if I focused on building the business and making money, none of these little things would matter in the end. Plus, if I am doing well financially I can always hire an accountant to take care of these details for me.
Which is Cheaper When it Comes to Taxes?
It depends on a lot of factors. I’ve read many comparisons online and found that there is no clear answer. Don’t believe me? Read the expert opinion of Jonathan Medow’s, a New York based CPA and a partner at CPA for Freelancers, in his comparison of an LLC and S corp’s tax returns:
- Sole Proprietorship? LLC? S-Corp? How to Pick What’s Best for Your Business & Taxes | Jonathan Medow (Freelancer’s Union)
Section #3: How to Incorporate Your Business
By now you have decided on the business entity you want to go with (Hint: An LLC). So how do you incorporate now?
When it comes to incorporation you have three options:
- Do it yourself
- Get a lawyer to do it for you
- Do it online
To do you a favor, I have already removed options 1 and 2. You’re welcome.
The DIY method is a waste of your time. There are many things you need to keep track of as part of your application and it’s not worth the hassle. Plus, if you mess up your application you’ll have to do it again and pay another application fee.
The lawyer option is just too expensive. There’s no reason why you need to hire a human being to do something that can be automated by software.
That brings us to option 3: incorporating online. At first, I was skeptical about incorporating my business online. There’s something about it that just seems scammy. But after going through the process, I can assure that this is the right option.
Your Options for Incorporating Online
To preface, I am not an affiliate of LegalZoom, nor am I interested in acting as a salesman for someone else. I am recommending it because I used it and was happy with the results.
LegalZoom is great because they guide you through the whole process. Simply select the type of business entity you want, and they will ask you a series of questions about your business so you know what information to provide.
Pricing: I Overpaid Online Because I Didn’t Know Any Better. But Here’s How You Can Avoid That
The total cost I paid to incorporate was $1,100.99. And I fully admit that I overpaid.
The reason was not because I was scammed. The reason was because I paid for some additional things that I didn’t need. The goal of this section is to show you exactly what you should pay for and what you should not so you can avoid paying for things you don’t need.
First things first, here is a link to the LegalZoom Pricing page: http://www.legalzoom.com/business/business-formation/llc-pricing.html.
You’ll notice that you have three pricing plans: Economy ($149), Standard ($289) and Express Gold ($359).
As you can see, I went with the Express Gold. The reason I did so was because:
- I needed to have everything done in 2 weeks
- I needed a federal tax ID or employment identification number (EIN)
In the interest of full disclosure I took a screenshot of my LegalZoom receipt:
What is an EIN?
An employer identification number (EIN) is a nine-digit number assigned by the IRS. It is used to identify the tax accounts of employers and certain others who have no employees. The IRS uses the number to identify taxpayers who are required to file various business tax returns.
If you are a single-member LLC, you don’t need an EIN. You can just use your social security number when filing for taxes.
However, if you want to open a business bank account, which I recommend, you will need an EIN.
You Can Apply for an EIN Yourself for Free
I reiterate, you don’t have to purchase an EIN through LegalZoom. You can apply for an EIN yourself .
You Also Don’t Need the Business License Package
I can’t remember what the Business License Package is, which means you don’t need it. When you go through the LegalZoom application process, they will make suggestions for add-ons that you can include in your package for an additional cost. So make sure to only select the things you need to avoid overpaying.
LegalZoom Marks Up the State Filing Fee
One thing I noticed is that LegalZoom marks up the cost of the state filing fee. In Illinois, the filing fee for a new business is around $300, but LegalZoom charged $612. So keep that in mind. Still, this is much cheaper than going through a lawyer, since they mark up their prices even more. An hour of a lawyer’s time could be as much as $100.
Verdict: Get the Economy or Standard Package and apply for an EIN Yourself
I would recommend going with an Economy or Standard package and then applying for an EIN yourself. You can apply for free by going to the following website after you have incorporated your business:
Total Cost of Incorporation
To summarize, I would recommend the following:
- Go with either the Economy or the Standard package.
- Do NOT pay for an EIN
- Do NOT pay for the Business License Package.
If you follow the above, here is what you will likely be paying for incorporation:
- For the Economy package, your total cost should be around: $149 (Package Fee) + $612 (Illinois State Filing Fee) + $6 (Installment Fee) = $768 to incorporate
- For the Standard package, your total cost should be around: $289 (Package Fee) + $612 (Illinois State Filing Fee) + $6 (Installment Fee) = $907 to incorporate
Keep in mind that these prices may change over time and will depend on your state filing fee.
Remember That You Are Paying for Convenience
At this point, I want to make sure you understand that by applying to incorporate through LegalZoom, you are paying for the convenience of not having to do this yourself. If you were to apply by yourself, you would only need to pay for the State Filing fee, which could be as little as $300 (which is the price in Illinois where I incorporated).
If you want to do the DIY option, here is a quick resource to get you started. Make sure to find specific information for the state you want to incorporate in!
Section #4: Things to Do Now You’re a Business Owner
Apply for a Business Bank Account:
Now that you have incorporated, it is very important to keep your personal and business assets separate. The best way to get started with this is to open a business bank account. This will help you keep everything separate and keep a close eye on the most important parts of your business.
Also be sure to apply for a business debit card and perhaps a credit card for your business spending. This way you can easily keep track of your business expenditures.
Here’s some information about business checking accounts:
Use Accounting Software to Keep Track of Your Business Expenses
Now that you have a business bank account, you need to get accounting software. Why? This is so you can:
- Easily keep track and categorize your business expenses by connecting to your bank account
- Invoice your clients and have them pay directly to your account
This just scratches the surface but here’s a great write-up by Sara Angeles of Business News Daily about accounting software:
I use QuickBooks and am pretty happy with it so far. It connects directly to my bank account and automatically tracks all my expenses. It also allows me to send out invoices to clients for easy payment options.
Make Sure You File Taxes On-Time
April 15 April 15 April 15. Don’t forget this. If you are a sole proprietor or a single-person LLC, this is the date you need to look out for.
To file your taxes, you can either work with an accountant or use online software. To be honest, I haven’t filed my first-year business taxes yet so I can’t say which option is better. I incorporated my business in January 2016 so I am due to file taxes by April 2017.
Option 1: Working with an Accountant
If you are working as a freelancer full-time, you should have enough money to work with an accountant. A good accountant should be considered as valuable as an employee because they help you save your hard-earned money.
Since you may only need to work with your accountant during tax season, you can expect to pay around $1,000 to $2,000 a year if you file taxes once per year. This may seem like a large expense, but the savings that your accountant can help you gain (which includes business deductions that we will cover in the next section), may pack back their cost.
Option 2: Using Tax Filing Software
I have been using TurboTax to file my personal taxes for the past two years and I love it so far. They have a modern website that is intuitive and easy to use. Similar to LegalZoom, they ask you a series of questions about you financial records and walk you through each step of the way.
I know they have a business solution that integrates with accounting software so I am planning on using TurboTax come April.
Of course, TurboTax comes with a fee of around $55 for individuals and $105 for businesses, so make sure you take that into account.
Now that you have your business bank account and debit card, it is worth noting that you are 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.
Here is a full list of what you can deduct taken from the IRS’ website:
All you need to do is to make sure that you log all your expenses in your bookkeeping software and to categorize them properly. This way when your accountant comes into play he or she can easily identify what deductions and savings you’re entitled to.
Last But Not Least, Focus on the Business
We’ve talked about a lot of stuff in this guide. But by far the most important thing is for you to bring business through the door! Your job is to ensure the success and well-being of your venture. So make sure you’re always out there selling your product or services and making sure your customers are happy.
If your business is struggling, none of this stuff matters.
What are your thoughts? Let me know if I missed anything!
I wish you the best of luck on your entrepreneurial adventure. It’s awesome that you’re working on your own freelancing business and I salute you for your sense of adventure.
Being your own boss is a wonderful feeling though it does come with its set of unique challenges. For those of you on the fence read my article 10 Things to Know About Working for Yourself.
Lastly, let me know your thoughts. Have I missed anything? Do you have any more questions? Feel free to leave a comment below and I’ll get back to you.
References and further reading:
- Should I Incorporate as a Freelancer? | Matt Brown (Creative Class)
- Myths and Realities About Incorporating for Freelancers | Nellie Akalp (Small Biz Trends)
- Should I Incorporate? | Susan Lee (Freelance Taxation)
- The Better Choice for Entity Selection: LLC or S Corporation? | Barbara Weltman (US Small Business Administration)