Should an Independent Contractor Form an LLC?
Do you have an online business? Or are you are freelance writer or consultant? Maybe you clean houses or sell real estate? If so, you might be an independent contractor.
In the newly developing gig economy, many people work as independent contractors. They want to control their hours and be their own boss.
As an independent contractor, your default business structure is called a sole proprietorship. A sole proprietor is someone who individually owns and operates an unincorporated business.
The primary benefit of a sole proprietorship is that it is simple to run your business. You report all income on your business on your personal income tax return. And you don't have the corporate filings or paperwork of a formal corporate entity.
However, the main drawback is that you are personally liable for any claims against your business operation. Therefore, if you are self-employed, you want to protect your personal assets from your business activities.
In that case, you may consider instead forming a limited liability company (LLC) for your business.
What Is an LLC?
An LLC is a business entity used to separate your business operations from you as an individual. So unlike a sole proprietorship, if there is a lawsuit, only the LLC's assets are in jeopardy. Any claims do not attach against you personally.
Single Member LLC
An LLC owned by one member is a single-member LLC (or SMLLC). Most independent contractors form SMLLCs.
Professional independent contractors such as accountants, lawyers, or dentists can form a professional LLC or PLLC.
Advantages of an LLC
Limit Liability Protection
The main reason independent contractors form a limited liability company (LLC) is to protect their assets. Again, an LLC separates your business liabilities from personal assets. Therefore, if someone were to sue your business for negligence, they could only go after the assets in your company, not you personally.
Liability protection is critical if you own a home, have significant net worth, or have other assets.
A limited liability company also helps with business taxes. For example, LLCs allow pass-through taxation where the profits or losses of the business pass through to the owner's individual income tax return.
Pass-through taxation avoids double taxation. Double taxation means the business owner pays taxes on revenue and then pays taxes on the business owner's proceeds.
LLCs also allow independent contractors to avoid paying self-employment taxes.
Any wages a sole proprietor pays to themselves are subject to the self-employment tax. In 2021 the self-employment tax is 15.3%. The tax allots 12.4% for Social Security and 2.9% for Medicare. So an independent contractor must withhold 15.3% of their earnings to pay when filing their personal tax returns.
The independent contractor can instead form an LLC and, for tax purposes, elect to be an S-corporation by filing IRS Form 2553.
Promote Professional Image
As a business owner, your image is essential. Potential clients are more impressed with a name brand rather than an individual. For example, Eco-Friendly Cleaning LLC sounds like a more professional operation than just one person operating a cleaning service.
Furthermore, filing your LLC business name with the state registers that name. So you do not have to file a "doing business as" (DBA) or fictitious name for your company.
Organize Business Accounting
As an LLC, you open a business bank account to receive income and pay business expenses or business debts. The bank account separates your business operations from personal finances. Thus, your accounting is more organized at tax time.
Appeal to Business Clients
Businesses that hire independent contractors want to ensure the IRS does not consider them employees. Otherwise, the companies are liable for benefits and tax-withholding.
One of the IRS's tests of an independent contractor is if you are in business for yourself. An LLC is a separate business entity, so there is proof that you are in business for yourself.
Disadvantages of an LLC
Compared with a sole proprietorship, an LLC business structure costs money to create and maintain. Therefore, if an independent contractor is not making much money in their venture, the costs of the LLC outweigh any potential benefits of liability protection.
Additionally, if there is little inherent risk of a lawsuit, it may not justify forming an LLC. For example, freelancers writing as a "side hustle" have low liability exposure. However, working as an electrician carries a more significant risk of a lawsuit.
How to Form an LLC
Forming an LLC is easy to do. There are six steps to setting up an LLC:
- Choose the business name of your LLC. Check with your state that the name is available.
- Designate a registered agent. You can serve as the registered agent or name someone else.
- Draft articles of organization. File them with the state and pay a filing fee.
- Draft an LLC operating agreement. Similar to corporate by-laws.
- Apply for EIN (Employer Identification Number). Similar to a social security number for the business.
- Apply for business licenses or permits under LLC name.
Furthermore, an LLC is simple to maintain. You file an annual report to the state and pay a fee.
An LLC is a good choice for independent contractors wanting liability protection and avoiding double taxation. However, seek legal advice from a local business attorney to find the best structure for your business.