Independent Contractors: Should You Form an LLC?

Do you have an online business? Or are you a 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. 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.

The following article provides a brief overview of forming an LLC as an independent contractor.

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What Is an LLC?

A limited liability company (LLC) is a legal entity that combines the benefits of a corporation and a partnership. 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.

If you're an independent contractor with your own business, a single-member LLC (SMLLC) may be right for you. One person owns this type of business. You still report your business income on Schedule C, but as an LLC owner also you get personal liability protection. This means if your business has debts or legal issues, your personal assets are usually safe. For LLC taxes, you're considered a “disregarded entity," which simplifies filing taxes. Most independent contractors form SMLLCs.

Professional LLCs are for licensed professionals like doctors, lawyers, or dentists. In California and other states, certain entrepreneurs must form this special type of LLC. It's like a regular LLC but designed for professional services. Members of a professional LLC get the same liability protection and tax advantages as other LLCs. If you provide a professional service, check if your state requires a professional LLC.

Advantages of an LLC

There are several advantages of forming an LLC that independent contractors should consider.

Limit Liability Protection

The main reason independent contractors form an LLC is to protect their assets. An LLC separates your business liabilities from personal assets. If someone were to sue your business for negligence, they could only go after the assets in your company and not you personally. Liability protection is critical if you own a home, have a significant net worth, or have other assets. LLC owners enjoy this shield against personal lawsuits, which is great for small business owners.

Pass-Through Taxation

An LLC also helps with business taxes. This is because LLCs usually don't pay taxes themselves. Instead, business income passes through to your personal tax return. You report profits and losses on your personal tax forms. This pass-through taxation can be a big tax advantage, especially for small businesses. 

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. Double taxation is common with business entities like C corporations (C corps).

Self-Employment Taxes

LLCs also allow independent contractors to avoid paying self-employment taxes (FICA) on their earnings. Any wages a sole proprietor pays to themselves are subject to the self-employment tax. As of 2023, the self-employment tax is 15.3%. The tax allows 12.4% for Social Security and 2.9% for Medicare, so independent contractors 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 Internal Revenue Service (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. You'll track business expenses, income, and tax deductions more efficiently.

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:

1. Choose the business name of your LLC. Check with your state that the name is available.
2. Designate a registered agent. You can serve as the registered agent or name someone else.
3. Draft articles of organization. File them with the state and pay a filing fee.
4. Draft an LLC operating agreement. This document is similar to corporate by-laws.
5. Apply for EIN (Employer Identification Number). The EIN is similar to a social security number for the business.
6. Apply for business licenses or permits under the LLC name.

An LLC is simple to maintain as well. 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 to avoid double taxation. Create an LLC yourself in minutes, or seek legal advice from a local business attorney to find the best structure for your business.

Getting Legal Help With Forming an LLC

Forming an LLC can be complex, especially if you're new to it. It's wise to get legal help. A lawyer can guide you through the process, ensuring you meet all legal requirements. They can help with your articles of incorporation, operating agreement, and can advise on whether a C corp or an S corp is right for you. Legal help can also be invaluable for understanding tax deductions and how to manage taxes as an LLC owner.

Speak to a local business attorney about forming an LLC today.