Freelancers are an integral part of the modern workforce. They bring flexibility and expertise to projects that may not be available in-house, such as creating a website or designing a logo. If you want to be successful as a freelancer, as well as make freelancing your long term career, then you should know how to set up your business structure. It may feel strange to think of the services your offer on a contract basis like a business, but it most definitely is one. Failure to structure and treat your freelance operations as a business will undoubtedly lead to minimal success, which we’re sure isn’t what you’re looking for.
In this article, we’ll explore some common business structures you can apply to your freelance business. Keep in mind, however, that you should always do your research and consult with both a tax and legal professional when making tax or legal decisions.
Why Do You Need a Business Structure as a Freelancer?
First and foremost, creating a business structure is essential for freelancers because it will provide you with some legal protection, tax benefits, and help you wrap your head around financials when that clear separation exists. You can’t operate without creating some sort of legal structure, and you’ll want to make sure the one you choose is the right fit for your goals.
There are three general types of structures that freelancers should consider using: sole proprietorship or limited liability company (LLC). Many jump to utilize an LLC because they feel this structure grants them more protections than a sole proprietorship, however, it might not make sense to have the extra costs and paperwork for this structure if you’re not generating enough revenue per year.
Let’s break down these two structures so you have a better understanding of each.
A sole proprietorship is the simplest type of business structure and can be created without any legal filings in most states. As the name suggests, it’s owned by a single individual who is responsible for all debts and liabilities incurred by the business. The biggest benefit of a sole proprietorship is that there are no required formalities such as annual meetings or record keeping – you can simply run the business as you see fit. Depending on which state you live in, you may have to register your sole proprietorship with your county or at least create a DBA (doing business as), which will allow you to create a bank account under your freelancing brand name.
It’s very important to have a business banking account set up, so that you can clearly track revenue and your ROI for your business. We’ll discuss more on accounting for your freelance business in later articles.
One major downside to the sole proprietorship structure is that the owner is personally liable for all debts and liabilities of the business. This means that, if your freelance business goes bankrupt or gets sued, you could lose everything – including your personal assets such as your home or car.
Keep in mind that all of your client projects and relationships should have contracts involved that serve to protect you as you offer services. If you’re just starting out, especially on the side, it’s often highly unlikely that a major liability matter will arise. That being said, you just never know and it always depends on the kind of work you’re providing. Always get a legal consultation when deciding your business structure and do additional research.
Limited Liability Company (LLC)
An LLC provides limited liability protection for its owners in the event that the company gets sued or goes bankrupt. This means that the creditors cannot go after the personal assets of the LLC’s owners, which is a big plus. Additionally, an LLC offers tax benefits such as pass-through taxation, meaning profits and losses are “passed through” to individual members and are taxed on their individual income tax returns.
However, creating an LLC requires significant up-front costs and ongoing formalities such as the filing of annual reports with your state’s Secretary of State office or online service . These expenses might outweigh the benefits if you’re just starting out on a part time basis – especially since there are no guarantees that creditors will not come after your personal assets even though you have created this structure.
You’ll also need to account for additional payroll taxes when creating an LLC because many freelancers don’t realize they should be paying themselves “reasonable” wages before applying any other deductions (such as business related ones). Keep in mind these rules vary depending on which state you create your LLC within! Lastly, some clients may request contracts signed by both yourself and your LLC.
Creating an LLC as a new freelance business owner is highly dependent on whether or not you can afford creating one and maintaining it throughout the early stages of your career. If you don’t have any assets yet, then creating an LLC might be overkill – especially if you’re going after small clients who may not want this structure in place anyways. However, knowing about the benefits of having an LLC for freelancers with more complex businesses could definitely help you make better decisions down the road!
When it comes to structuring your freelancing business from a tax perspective there are many factors that come into play including but not limited to: revenue size/amount per year, required filing fees/annual state requirements, type of work you do, and creditor protection. Again, always seek counsel from a legal and tax standpoint to determine which structure is best for you.
Understanding Taxes When You’re a 1099 Contractor
When it comes to taxes, most people think about filing their annual income tax return in April after having worked all year (hopefully) paying quarterly estimated federal taxes throughout the year. But if you’re getting paid under contract with clients who hire you for specific tasks they need accomplished – then things get a little bit tricky!
As a W-2 employee of a company, your taxes are pretty straightforward – the employer takes out money for Social Security and Medicare taxes (called FICA) and then sends that amount to the IRS. You’re also responsible for paying federal income tax on what’s left of your paycheck after those deductions have been made.
However, when you work as an independent contractor or freelancer and receive payments from clients, Uncle Sam considers you a “self-employed” individual. This means you’re considered self-employed for Social Security and Medicare purposes AND you’re responsible for paying both the employee AND employer side of FICA taxes!
Depending on how you structure your freelance business and whether you’re working for yourself as a 1099 contractor, then you will need to set aside taxes for everything you make. A good rule of thumb is to set aside around 20% of everything you make as a 1099, just to be on the safe side and make sure you don’t owe anything major at the end of the year. When in doubt, always consult with an accountant or tax professional to make sure you’re doing everything correctly! And be sure to keep track of all your income and expenses throughout the year – this will help come tax time.
In certain states, it makes sense to file your taxes monthly or quarterly to reduce what you end up owing at the end of the year. You may also have various deductions and expenses you can write off that you absolutely need to keep separate from your personal checking and savings account.
Bottom line: As a freelancer, it’s important to be aware of the different tax implications and structures associated with running your own business. By setting money aside each month for taxes and being mindful of what can be written off at the end of the year, you’ll be well on your way to building a successful freelancing business.
Be sure to bookmark the Melbee Academy website and stay tuned for more articles in this series on how to become a successful full-time freelancer!