A little bit of legal protection can go a long way.
Whether it’s a day job or a side hustle, working as an independent contractor is becoming more and more common, and that means so are self-employment taxes. But there’s more than one way to operate your independent contractor work.
Limited Liability Companies, or LLCs, are an effective structure for many small business owners. Should you create one for your independent contractor work?
The basics
- Independent contractors are technically small business owners
- An LLC is a versatile business structure that works very well for many small businesses
- Forming an LLC will let you keep doing what you’re doing, just with more legal protection
What’s an independent contractor?
You’re an independent contractor if you perform work for clients on a contractual basis instead of being their employee. This comes with perks like greater flexibility, the ability to take on projects from multiple clients, and control over your own work environment.
Though many don’t think of themselves that way, an independent contractor is technically a small business owner. Even if you haven’t filled out any paperwork to establish a business, you’re considered the owner of a sole proprietorship and taxed accordingly (on Schedule C of your individual tax return).
Wait, really? I run a business?
Yes, all independent contractors are small business owners. When your clients hire you to complete a project, you become a business offering a service. The business income goes on your tax return (via that Schedule C we mentioned earlier) and there is no legal separation between your finances and that of the business. This type of business structure is called sole proprietorship.
At this point, you can either continue on as a sole proprietor, or opt for some other kind of business structure. We usually recommend operating as an LLC.
Why not stay a sole proprietor?
Sole proprietorship works just fine for many independent contractors. You may need to register a business name, but there’s not a whole lot of additional costs or paperwork besides that. You simply put that income on your personal Form 1040 tax return on Section C.
However, we don’t usually recommend sole proprietorships. That simplicity is a double-edged sword – with no separation between yourself and the business, any risk is yours to personally handle. You have unlimited liability for any debts or lawsuits that may occur in the course of your work, and your personal finances and assets are on the table if anything goes wrong.
It’s also not the most advantageous tax situation out there once your profits exceed $25,000 per year. Sole proprietorships can incur some pretty hefty self-employment taxes compared to some other tax structures, like S-corporations.
Consider an LLC instead
We mentioned unlimited liability earlier. Well, the “LL” in LLC stands for limited liability. With an LLC, your independent contractor work becomes a legal entity. Your clients enter into contracts with your LLC, rather than with you personally. This layer of separation can protect your personal assets – like your car or your home – if there’s ever a dispute or a legal problem.
LLCs also offer some additional tax flexibility. You can continue to be taxed as a sole proprietorship, with the extra legal protection of the LLC, or choose a different tax election like an S-corporation (Form 1120-S) that may offer you some savings. Representing yourself with an LLC can even establish some extra credibility for your freelance work.
There are some additional costs associated with forming and maintaining an LLC, with costs in the neighborhood of $400-$3,000 depending on the size and complexity of the business. But the advantages are usually worth it in the long run. For many independent contractors, it’s a safer and more effective way of doing work.
Bottom line
If you’re an independent contractor, you are a small business owner, and by default, that business is a sole proprietorship. That’s fine for some folks, but for some peace of mind and the flexibility to take your business to the next level, it may be better to opt for an LLC instead, even if you don’t plan on changing the way you do business. It’s just safer that way.
Need a little help with getting things started? Our team at DiMercurio Advisors have plenty of experience with business formation and other services, so schedule a call soon!
