When and Why Freelancers Should Create a Formal Business Structure

When and Why Freelancers Should Create a Formal Business Structure

Bradley Schnitzer

Aug 19 2020

Many people get into freelancing to control their schedule and income, especially as they become skilled in their field. But a freelancing career is a business — and running a business involves a host of other responsibilities and legal issues. Chief among these concerns is whether or not a freelancer should form a formal business structure.

Still, no two freelancers have the same situation. One freelancer may benefit from a business structure. For another, it may not be worth the time and paperwork at this point in their career. Consider the following if you’re thinking of creating a formal structure for your business.

Why Should I Create a Business Structure My Freelance Business?

A formal business structure offers many legal protections and other benefits that can help you grow your business with less worry.

Most small businesses and freelancers set up a business structure to save on taxes and protect their assets.

1. Liability Protection

First and foremost, all formal business structures shield your personal assets in case your business ever owes money through debt, lawsuit, or another financial obligation. Without a business structure, you and your business are considered one entity for legal purposes.

Let’s look at an example.

Say your business is sued. Without a business structure in place, the court can force you to sell your personal assets to fulfill the terms of the suit. That could mean selling your car — or even your house — if the suit is big enough.

But with a business structure in place, your house and car would be safe. Only business assets — such as savings accounts and equipment — would be at risk of loss.

What About Liability Insurance?

Liability insurance doesn’t protect your assets from use in fulfilling financial obligations. Instead, it covers some of your legal costs when sued.

For that reason, a business structure is generally preferable.

Ideally, you’d have both — especially if you’re in an industry that’s known for liability claims. With that said, form a business structure first to protect your personal assets.

Piercing the Corporate Veil

As a freelancer, it’s easy and often tempting to mix your business earnings and expenses with your personal finances.

But doing so puts your assets at risk — even if you have a business structure. Courts can “pierce the corporate veil” by removing your liability protection. For freelancers, this often happens when you don’t keep business and personal finances separate.

Avoid this by keeping a separate business bank account through which to run your business income and expenses. Don’t write off any expenses incurred on personal cards or accounts as business expenses. Invest in accounting software like Quickbooks to simplify your record keeping and separate business and personal funds.

2. Tax Benefits

Both freelancers and W2 employees pay personal income taxes. However, freelancers pay double the FICA (Social Security and Medicare) taxes.

See, employees and employers split FICA taxes. But since you’re self-employed, you’re responsible for both.

Certain business structures help you reduce your self-employment taxes. These structures have more complex requirements and paperwork, though. Online accounting software, such as Freshbooks, is a good way to keep track of everything you’ll need to ensure your taxes are complete and accurate.

3. Credibility

The benefits of a business structure go beyond legal concerns.

Adding a corporate title such as “LLC”, “Inc.”, or “Corp” after your name conveys credibility and professionalism to current and prospective clients.

Ultimately, clients pick you based on your past work and your sales pitch. But having a formal business structure in place sets you apart from freelancers without one.

4. Raising Capital

The credibility factor extends to business borrowing. Banks are more likely to trust a formally-structured business than a sole freelancer without a business structure.

Types of Business Structures

You’re considered a sole proprietor by default when you’re self-employed. Sole proprietorship is less of a business structure and more of a classification for tax purposes. There’s no business paperwork, and your income and expenses all show up on your personal tax return.

If you want to formally structure your freelance business, you have two viable options.

1. LLCs: Simplicity and Liability Protection

The LLC — used quite often for independent businesses — is the simplest formal business structure for freelancers.

Taxes work the same way as with a sole proprietorship if it’s just you. If you expand into a partnership by adding more owners, you only pay taxes in proportion to your ownership stake.

For example, if you and John Doe each own 50% of an LLC, you’d each pay taxes on 50% of the income.

In terms of liability, an LLC shields your personal assets from loss in case you’re sued.

2. S-Corporation: More Savings, More Paperwork

S-corporation is a special tax status you can elect if you’re an LLC. As an S-corp, you can become an “employee” of your business and pay yourself a “reasonable salary” as the IRS defines.

In doing so, you pay employee and employer FICA taxes only on your salary. You can take the rest of your earnings as distributions, which aren’t subject to FICA.

S-corporations have more paperwork and strict requirements, though. If you don’t meet them, the IRS may remove your S-corporation status and tax you as an LLC.

When to Create a Structure For Your Freelance Business

If you’re dipping your toes into freelancing — perhaps your business is a side hustle — then you may not need to set up a business structure. You have less exposure to liability if your business is a small portion of your income.

Once you take freelancing full-time, you should consider creating your LLC or S-Corporation. If it’s your sole or primary income stream, you want to protect yourself and it as much as possible.

Beyond that, formally structuring your business can help you grow it faster due to the credibility and ability to raise capital mentioned earlier. Clients will take you more seriously — and you might even be able to command higher rates.

Ultimately, you should discuss this issue with an attorney.

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