Business Entity Pros and Cons Freelancers Should Know

Business Entity Pros and Cons Freelancers Should Know

As a freelancer, it’s easy to ignore the importance of business administrative tasks. You spend most of your time, energy, and focus on doing work for your clients. But, managing your business is also essential to your success. When I began as a freelancer, I learned that the way you choose to structure your business as an official entity can shape your freelancing business in many ways.

I am not a lawyer, accountant, tax professional, or financial advisor. None of the information presented in this article is financial, tax, or legal advice. This article is intended to get you thinking about the way that your business is currently structured and to pose the idea of the different structures that may generally be available for freelance businesses. The information in this article is based on my non-professional understanding, and may be out of date or inaccurate.

Operating a freelance business as the wrong type of entity could cost more money on annual income taxes, or worse. If a freelancer doesn’t have the proper business entity protections, they could lose their car, house, and personal assets due to their business’s legal or financial liabilities.

This article provides a general overview of the pros and cons of the five most common business entities in the United States from a layman’s perspective. To identify the type of business entity that is right for your freelance business, contact a licensed professional. It is also worth noting that each state’s laws are different, so be sure to consult a local attorney so they can explain your state’s rules and regulations to you before making a decision.

5 Business Entities You Should Know About

Do freelancers need to register as a business entity?

Freelancers on Upwork are already operating as a business, even if they haven’t officially registered a company. A new business is considered a sole proprietorship by default. However, it’s crucial that freelancers make an intentional decision about their business structure because it could influence everything from taxes to operations to personal risk.

Benefits of business entities

Below are seven reasons that freelancers may want to register their freelance business as a specific business entity:

1. The freelancer may want to receive certain tax benefits and deductions associated with a specific business entity.

2. Some clients may require confirmation that a freelancer operates as a business before starting a contract.

3. Registering as some business entities may provide additional legal and financial protection for its owners.

4. Business loan applications from some banks require a business to be registered.

5. A freelancer may want to raise money from investors or bring in a co-owner.

6. Being a registered business may make it easier to partner with other companies.

7. Any freelance business that intends to operate using a business name other than the freelancer’s name must register as a business.

The pros and cons of the five most-common business entities

When considering the different types of entity options for freelance businesses, it’s crucial to weigh the pros and cons to determine what’s best for an individual business’s situation.

Sole proprietorship

A sole proprietorship is the most common business structure for freelancers. Simply put, a sole proprietorship is a single individual operating a business.

Pros:

  • Filing federal income taxes is easy for sole proprietors. Sole proprietorships are known as “pass-through” entities, which means any earnings made by the business are simply declared on a separate form (Schedule C) and entered into the individual’s Form 1040 (however, self-employment and estimated taxes still need to be paid).
  • The overall tax rate is also the lowest among all business entities.
  • Equipment that is used for the business belongs to the individual alone.
  • A sole proprietorship requires minimal or no paperwork, and the business may not need to be registered.
  • As a sole proprietor, you may be able to give your business a different name for marketing purposes, known as “doing business as” or DBA.

Cons:

  • There is no legal separation between a freelancer and their business as a sole proprietor. The owner may be held personally responsible for all financial and civil liabilities.
  • If a creditor seeks to have debts repaid, all of the freelancer’s assets could be at risk, including their personal bank account, personal property, real estate, and other assets.
  • It can be harder to raise money for the business because a sole proprietorship has no mechanism for raising capital as a company.
  • Banks often see sole proprietorships as less credible than the other business structures, and as a result, banks may be more hesitant to lend money to the business.

Partnership

A partnership business structure is a straightforward entity. Partnerships offer business owners the ability to share ownership responsibilities, liabilities, and successes amongst multiple people. When two or more individuals go into business together, they can form a partnership.

Pros:

  • Usually, partnerships are easy to start without substantial government filings or registration, and minimal paperwork. While it may not be required, it’s good practice for partners to have a written agreement that outlines each individual’s roles, responsibilities, and the division of profits and losses (and some jurisdictions may require it).
  • Business losses generally are shared between partners and can be deducted on their personal tax returns.

Cons:

  • The tax liabilities of the business may be passed through to the partners. This makes all owners’ personal assets susceptible to creditors when settling unpaid debts or judgments of the business.
  • Each partner may be personally liable for other partners’ negligent actions or behavior.
  • Disputes among partners can be detrimental to the business’s success and growth (though drafting a substantial partnership agreement can help you avoid this).
  • It may be difficult for a partnership to get a business loan, land a big client, or build business credit without registering the business as a more formal entity.

C Corporation

From a legal standpoint, a corporation is a different “legal person” than the person or people who created it. A corporation can own property, accrue its profits, and be responsible for its debts and civil liabilities. The corporation is owned entirely by its shareholders, and the shareholders have a say in the corporation’s overall direction. Some jurisdictions have additional requirements, but generally, a corporation is formed when its articles of incorporation are filed with the Secretary of State.

Pros:

  • Corporations generally are not limited to a specific number of shareholders (1+).
  • Corporations may be eligible for more tax deductions than any other type of business.
  • Corporations can raise funds through the ability to offer and sell company stock.
  • The company’s liabilities generally do not flow down to the owners, or shareholders, beyond the amount of money the shareholder invested in the company.

Cons:

  • The corporation registration and incorporation fee can be as much as $500 or more, depending upon the state.
  • All corporations must apply for a federal tax ID number (also known as an Employer Identification Number, or EIN) from the IRS.
  • Establishing a corporation may require substantial government paperwork and corporations are more highly regulated. Since corporate laws are typically written with large businesses in mind, the burden of paperwork for an individual or small group of people may be significant and outweigh any benefits gained by having the corporation in the first place.
  • Corporations may be required to conduct certain formalities, like having meetings, electing officers, and so forth, depending upon the jurisdiction.
  • Corporations are not “pass-through” entities. Corporations must pay their income taxes on any business profits. Tax considerations for corporations can become quite complicated, depending on the size of the corporation and the jurisdiction it’s in.
  • Distributions made to shareholders may be subject to federal income taxes.
  • Business losses are reported on the corporate taxes, and shareholders cannot deduct the business losses on their personal tax returns.

S corporation

An S corporation offers similar individual liability as a C corporation. However, an S corporation is considered a pass-through entity for tax purposes, which means the profits and losses are divided among the shareholders. An S corporation is governed by Subchapter S of Chapter 1 of the Internal Revenue Code, hence the name.

Pros:

  • S corporation shareholders generally don’t have personal liability for the business’s debts and liabilities.
  • No corporate taxation means that the profits for S corporations aren’t impacted by double taxation.

Cons:

  • S corporations must operate under all the corporation rules and regulations, including the various compliance reports that must be filed and officer roles that have to be filled.
  • S corporations typically face heightened scrutiny from the IRS, looking for S corporation owners incorrectly classifying dividends as wages (or vice versa) to receive better tax treatment.
  • Corporations usually are more expensive for business registration than sole proprietorships and partnerships.
  • There are more limits on issuing stock with S corps than with C corps.
  • S corporations need to comply with corporate formalities, like creating bylaws, a board of directors, and shareholder meetings.

Limited liability company (LLC)

A limited liability company (LLC) is a newer business entity developed in the last few decades to take the positive features from each of the other business entity types. LLCs offer limited liability protection, similar to corporations, but usually have less paperwork and ongoing requirements. An LLC is not a federally recognized IRS tax entity, but is a corporate entity allowed by many state jurisdictions.

Pros:

  • The LLC combines the corporation’s limited liability with a sole proprietorship’s pass-through taxation.
  • An LLC may be established by one or more individuals, who then become members of the LLC.
  • In the case of a single-member LLC, it’s a disregarded entity, which means income is reported to the IRS the same way as a sole proprietorship. If there are multiple members of the LLC, the IRS treats it as a partnership for taxation purposes.

Cons:

  • The appropriate paperwork must be filed with the state Secretary of State, along with a fee to establish an LLC.
  • Renewal fees and miscellaneous fees associated with forming and maintaining an LLC may be higher than those for a corporation.
  • Most jurisdictions do not require an operating agreement for multi-member LLCs, which creates a risk that the LLC members will not draft one and could face issues as a result. Without a clear operating agreement, it may be challenging to know who may enter into a contract on behalf of the LLC or make day-to-day decisions without individuals identified as the LLC officers or directors.

Conclusion

There are many factors to consider when deciding which entity to use for a freelancing business. The breakdown above demonstrates some of the reasons why spending time to choose the right model is a worthwhile investment for freelancers. To reiterate, I am not a tax, financial, or legal professional. This article is not intended to be legal, financial, or tax advice. Consult with a business attorney and licensed tax professional to discuss which type of entity is optimal for you and your business.

The views and opinions expressed in this article represent suggestions and opinions of the freelance author who is sharing their own views based on their experience and is not tax or legal advice, nor does this article address all tax issues for freelancers. As the needs and circumstances of each individual business may differ, the information provided in this article may apply to some businesses and not others. This is written for freelancers in the United States and is only intended as general information for educational purposes. Global applicability may change as well as the landscape changes over time. Upwork does not provide any legal advice, and as always, independent professionals remain responsible for their own compliance with all laws and legal requirements in operating their freelance business.

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Author Spotlight

Business Entity Pros and Cons Freelancers Should Know
Sean Cope
SEO Writer

Formerly a full-time in-house marketing director, Sean Cope began building an SEO and content creation company by freelancing on Upwork. He has enjoyed working with clients in various industries, leading them to achieve their business goals and higher Google search rankings. Sean is passionate about helping new clients in growing their businesses through search engine optimization, content writing, and digital marketing.

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