[Credit: NBC’s Parks and Recreation]
(For a quick list of common entities and some Pros and Cons, check out this post.)
In the four months since I started as a freelancer, I have built a stable roster of good clients and have grown my little writing practice to the point that I don’t really have to worry whether I’ll make enough money to pay rent each month.
But despite this bit of success, my business is still relatively immature from a legal standpoint in that I have not yet registered it with New York State. As a result, I do not have access to a dedicated business bank account and, if anything were to go wrong on the job, someone could sue me — personally — for everything I am worth.
And so, to borrow from Jay Z the time he pretty much destroyed Kanye on his own dang song, it is time for me to cease being a businessman and evolve into a business, man. Not only that, but I’ll have to decide how I want to register my business — either as a sole proprietorship, a limited liability company, or as a corporation.
Even without doing any legal paperwork, all freelancers are considered by the government to be sole proprietors, meaning that they are the only owner of a small business in which there is no legal distinction between the owner and the business they operate. As a result, sole proprietors pay income taxes personally and all of our non-business income is potentially on the line if something we do during the course of business gets us sued.
At the very least, it makes sense for virtually every freelancer to level-up his or her sole proprietorship by registering the business name with either their state or local government (each state has different rules as to which branch of government you need to register with. You can click here to find out what the deal is where you live).
To do this, you need to obtain what’s called either a “certificate of assumed name” or a “doing business as (DBA) certificate,” which in New York costs about $100. In exchange, you get two major benefits: the right to legally do business under a name besides your own (i.e. “Aaron’s Very Good Writing Services” instead of “Aaron Taube”) and the opportunity to open a business bank account.
You may be wondering, as I once did, why you should have a business bank account. Since all of the money from my sole proprietorship is ultimately coming back to me, I reasoned, why would it matter whether it is first deposited in a bank account I’m only using for business purposes — especially if my minimal expenses make it easy for me to keep track of everything?
Fortunately, Team Benny’s favorite accountant, Nick Sher, was able to set me straight. As he explained, a major benefit of a business bank account lies not in what you can do with it, but in how it is perceived by others, particularly those who work for the Internal Revenue Service.
By running all of your business income and expenses through a separate bank account, you are creating the narrative that your sole proprietorship is a bonafide endeavor and giving more credibility to the expenses you mark off as tax deductions. Meanwhile, if you have the business expenses you’re deducting right next to the extra Candy Crush lives you bought from iTunes in your personal account, you run the risk of piquing an IRS agent’s interest under examination.
However, one thing a DBA certificate won’t get you is legal protection of your personal assets if something were to go wrong in the course of business. For instance, if you’re a sole proprietor home contractor with a DBA certificate, and one of your employees were to damage someone’s house while she was working on it, the homeowner could sue you and potentially be rewarded with your personal assets as well as the money you have in your business.
On the bright side, you (the home contractor from last paragraph’s hypothetical situation) could possibly shield your personal assets if you were to register your business as a limited liability company (LLC). How much legal protection you can get from an LLC varies from state to state, so it’s best to consult a lawyer to get a better handle on how much of a benefit an LLC might be to you.
A single-member LLC is similar to a sole proprietorship in that you pay taxes personally as opposed to on behalf of your business, but it can be more expensive to register an LLC with your state. According to Sher, getting signed up as an LLC in New York can vary between $800 and $3,000, depending on the county in which you publish notice of your LLC. This estimate includes state formation fees, newspaper publication fees, and the fees charged by an attorney to make all of this happen. The cost of forming an LLC varies by state, and many states don’t require people to publish notice of the entity they have formed.
The other thing to consider with an LLC is how it looks to your customers. For one thing, it makes you appear more professional. For another, it provides long-term clients with a greater degree of assurance that you will not try to claim that they have misclassified you as an independent contractor when you should be getting the benefits of full-time employment. If you’re not sure how your customers feel about this issue, you can always ask them. All things being equal, clients generally feel better issuing a 1099 to an LLC under an employer identification number — which comes with either a DBA or an LLC — than to an individual using his or her social security number.
Ultimately, I decided against registering an LLC for several reasons: I have few outside assets that could be at play in a lawsuit, none of my clients has asked whether I am registered as an LLC, and, right now, I’d really just prefer to have that $800.
The last option at your disposal is to go all out and turn yourself into a corporation. This isn’t really a good idea unless you are planning to build a business with big revenues and a bunch of employees, but sometimes people do it anyway. By registering your business as a corporation, you create a separate legal entity that will be responsible for paying a corporate tax on any profit it makes. As (presumably) the company’s only shareholder, you might have to pay taxes on both the company’s profits and on any dividends you choose to pay yourself. An additional way to pay yourself would be to take a salary from the organization, which requires the cumbersome process of setting up payroll. Either way, if you’re a freelancer looking to service clients, a corporate structure is not the path of least resistance.
However, people may also choose to get rid of this double layer of taxation by electing to turn the corporation into what’s called an S Corporation (otherwise known as an S Corp). By doing so, you eliminate the corporate layer, and all income is then taxed at the individual level, except for in New York City, which does not honor the S election.
Hypothetically, you could earn tax savings by taking a salary that is smaller than the amount of profit your business is generating, but IRS rules require that people take a “reasonable salary” commensurate with the portion of the business’s profits that they are responsible for.
Sher says that a talented accountant can set up an S Corp in a way that optimizes your tax savings each year, but the funds you’ll have to devote to paying that accountant would probably make the whole thing a wash at anything below six figures of income. Add in all of the time and effort you’d have to spend making sure you were in compliance with the law, and it just doesn’t make sense.
Ultimately, the best bet for most freelancers will likely be to get a DBA certificate or to register as an LLC. While both options are good ones, it’s up to you to consider the pros and cons and determine what’s right for your business.
*Written by Aaron Taube on behalf of Benny*