As of 2016, freelancers have reached a booming 55 million in the US, which is 2 million more than it was two years ago (in 2014). It would not be surprising if this figure increases even more in 2018, as more people transition from the 9-to-5 to the gig economy. With more people taking the plunge and joining the freelance economy, we can expect to see a rise in sole proprietorships. However, what happens after freelancers have established themselves and are ready to make that transition from sole proprietorship to another business entity? Which should they convert to? Limited liability company (LLC) or S Corporation? Read on to find out. (Plus, learn why you need to conduct a Massachusetts Secretary of State search.)
When Being a Sole Proprietor No Longer Benefits You
What makes a sole proprietorship attractive boils down to its cheap registration cost and how easy it is to register one. However, given that sole proprietors have to dole out around 30% of their income to Uncle Sam, you may want to think twice about staying as one once your income increases. Putting this into perspective, let’s say on year three, you pull in $75,000. Being that you’re a sole proprietor, roughly $22,500 would go in Uncle Sam’s pockets, which leaves you at $52,500.
Why the 30%, You May Ask?
In a nutshell, sole proprietors pay self-employment taxes once as an employer (about 15%) and once as an employee (roughly 15%). While initially, you may be able to grin and bear the large tax, overtime (as mentioned), this may hurt you and your business.
Plus the Lack of Liability Coverage
And then you have to take into consideration that you, as a sole proprietor, don’t get to have limited liability protection, which protects your personal assets from being seized.
Long Story Short
Overall, there are several pros to starting as a sole proprietor but not as many once you become established. This is when you may want to consider transitioning to an LLC or S Corp.
Why an LLC
While still relatively new, limited liability companies provide freelancers a middle ground; they are not quite sole proprietorships and partnerships (although still hold some of the benefits) but not quite corporation (while enjoying liability and tax benefits).
An LLC, if it is single member, tends to still be taxed as a sole proprietor. This may seem like a drawback to those trying to get away from sole proprietorships (especially because of the self-employment tax), however, LLCs provide liability protection that sole proprietorships do not.
This can save you some stress should you receive a cease and desist letter or are involved in a lawsuit—which, according to Forbes, 36%-53% of small businesses are at some point. Since we live in a litigious-friendly country, knowing that your personal assets are protected and that you and your business are separated can save you some sleepless nights.
Despite doing your best to mitigate potential lawsuits (i.e. drawing up, signing, and adhering to contracts), even then it sometimes is the luck of the draw. While you do reap coverage benefits, you still don’t get to bow out of paying self-employemt taxes on distributions—something S Corps have the luxury of doing…
Why an S Corp
Unlike an LLC, an S Corp is 100% corporation, not an “in-between.” While you cannot go public and cannot exceed 100 shareholders (as is the case with a C Corp), one of the biggest advantages of an S Corp—and why so many choose to transition to one—is that you don’t have to pay self-employment tax on your distributions (please know that you must pay it on your income).
Potentially, you can save big by setting aside 60% of business profits as salary and 40% as distributions. However, claiming a higher percentage of distributions—or even, dare we say, claiming all of your income as distributions—will be a red flag to the IRS and, most likely, lead to an audit and financial repercussions down the road.
How Do Freelancers Factor into This Equation?
Ultimately, it comes down to what you want. Since an LLC shares some sole proprietor characteristics, it may be an easier transition for freelancers who are familiar and comfortable being sole proprietors but want more coverage.
For those who would like paying less self-employment tax but don’t mind making a bigger jump into unfamiliar territory, going through a more complicated registration process, and doing a little extra bookkeeping, an S Corp may be the better choice.
If you cannot decide and both sound appealing, you may want to look into an LLC with an S. Corp status. As the name suggests, this business entity fuses characteristics of both. Often times, forming this business structure can be challenging. In which case, we recommend that you reach out to a licensed accountant for help.
The freelance economy is booming and is only expected to get bigger this year. If you have made the jump and have joined and have been a sole proprietor, because of the hefty self-employment taxes and lack of coverage, it may be time to make a change and transition to either an LLC or S Corp.
While LLCs share some similarities, they ultimately provide freelancers with the liability coverage they didn’t get as a sole proprietor, which can be an enormous benefit given how easy it is to sue and be sued. On the other hand, an S. Corp allows for freelancers to pay less in self-employment tax, with up to 40% of business income going towards distributions.
Ultimately, it comes down to which structure best aligns with your business wants and needs; we recommend reaching out to a financial advisor or licensed accountant to help you identify them and, in doing so, choose the business entity that is right for you. If you are a freelancer, which business entity do you have? Did you make the change from sole proprietorship to LLC or S Corp? What has your experience been like? Comment below.