Incorporation or Sole Proprietorship: Considerations for Freelancers and Entrepreneurs
Should you choose incorporation or sole proprietorship as a freelancer or entrepreneur? Here are things to consider for your growing small business.
Do you see your “gig economy” job as a side hustle, or a career? Do you hope to grow it into something bigger—or are you planning to stay on your own?
If you’re one of the estimated 57 million Americans now doing freelance work, these may be important questions for your financial health. The answers affect your tax considerations both now and in the future, so they’re worth thinking about before any liabilities emerge to upend your professional plans.
Every gig is different, however, and some come with fewer liabilities than others. There are some reasons you might elect to stay a sole proprietor rather than embrace the protections of an LLC, S-Corp, or C-Corp (and vice-versa). Here are a few of the considerations to keep in mind as you decide what’s right for you and your business.
Aligning Status and Structure
60% of current freelancers say they started doing it “by choice” (marking a 7% increase from five years earlier). But even in a strong labor market, the choice to freelance can be influenced by any number of complicating factors—ranging from a person’s job prospects and career goals to their age, health, and personal or family-related circumstances.
It can also be a less-than-permanent choice. Freelancing may help some professionals enter a more entrepreneurial or consulting-driven career path, but only if larger objectives (like launching and growing a company) appeal to them. When it comes to freelancers’ long-term plans, not all intend to start a business of their own or stay solo for good; plenty see themselves as short-term contractors or temporary workers on their way to something more permanent.
A person’s viewpoint about their freelance status—as something they do “for now,” or potentially for the long-haul—is just one factor affecting which legal structure is appropriate for their needs.
Entering Sole Proprietorship
For the “for now” crowd, sole proprietorship tends to be the default structure. Going into sole proprietorship requires no legal documents or declarations (aside from any permits or licenses required by profession, and the annual submission of a Schedule C to the Internal Revenue Service). Essentially, as soon as you take on business as yourself, you begin operating as a sole proprietorship and are taxed as a self-employed person.
Sole proprietorship offers a sense of full control to freelancers as individual owner-operators, and can make sense long-term for individuals who will always “be” their own business, without the need for staff. A key benefit is their low cost to maintain: Operators of sole proprietorships can use one bank account across both business and personal funds (should they want to), for example, and are subject to no formal set-up costs, recordkeeping or filing requirements, unemployment taxes, or annual fees.
These savings are diminished in some cases by their tax considerations, however. Since you and your business are one in the same in a sole proprietorship, there is no “business profit” that can be segmented for tax advantages as it is in other legal structures. Sole-proprietor freelancers must calculate self-employment tax and income tax on all income (less their deductible expenses) and make quarterly estimated tax payments to the IRS.
Tax concerns are not the only complicating issue, either. Sole proprietorship means that the liability for your business rests solely on your shoulders; as the individual owner-operator, you possess no legal protections for your professional or personal assets in the event you are sued, go into debt, or face other financial or legal problems related to your work.
Embracing Further Protections
Even for those individuals who are comfortable “being” their business forever, holding 100% of their professional liability in their own hands can get too complicated over time.
The risks of sole proprietorship grow with each new client and each new project, as you remain personally responsible for any debts or legal obligations of the business regardless (and could have your personal assets seized as restitution or payment in the event of lawsuits or defaults).
Sole proprietors’ audit risk tends to increase over time, as well. It can also be harder for them to secure business-related capital, insurance, leases, or other resources compared to their incorporated peers—and for good reason: Securing an Employer Identification Number (EIN) or “doing business as” name (DBA) for a sole proprietorship can help formalize the operation, but it won’t minimize the risks of partnering or investing in a business that can’t survive without its single owner-operator.
Incorporating or establishing an LLC can help freelancers establish that kind of “survivability,” even if they intend to keep operating without partners or staff. And for those who do intend to build out their operations with employees or co-owners, it’s necessary and recommended to incorporate as soon as those plans are in play.
LLCs and corporations offer protections for an owner-operators' personal assets in the event of lawsuits or debts, and can be structured in ways that create tax advantages. These benefits come with additional requirements and expenses, however, due to formal recordkeeping, registration, and filing policies (which vary by state and legal entity). They also create the need to pay yourself a salary, and to separate business and personal funds through distinct accounts.
For freelancers or “side hustlers” transitioning into entrepreneurship, establishing a single-member LLC can be a smart place to start, as you can choose to structure it as a corporation—typically an S Corp, which does not pay corporate income tax—to help minimize your tax burden. (If you don’t make this election, it’s taxed as a sole proprietorship.) If you take on one or more partners, at some point, the LLC will be taxed as a partnership.
Alternatively, you can set the business up directly as an S Corp or a corporate-tax-paying C Corp.
Notably, if you are an S corporation or an LLC taxed as an S corporation, you will pay Social Security and Medicare taxes (aka, the self-employment tax) only on the salary you pay yourself—not on the rest of your business profits. With a C Corporation, you would pay corporate income tax on your business earnings as well as personal income tax on amounts you take home (as the structure is intended for larger, shareholder-owned entities). It also involves the most formal requirements, such as annual reports and up-to-date articles of amendment, depending on state and other specifics.
Weighing Future Risk and Costs
For many of the 57 million Americans who freelanced last year—who represent a full 35% of the U.S. workforce—creating a C corp is not on their career roadmap. Yet the protections of a legal entity beyond sole proprietorship are worth thinking about for many participants in today’s “gig economy.”
It comes down to balancing the liabilities related to growth with the importance of keeping costs low (and control high). In a rapidly changing job market and economic landscape, there are both benefits and risks to independence. Freelancers and entrepreneurs should keep their long-term plans in mind as they decide whether to treat sole proprietorship like a sustainable path, or to build more “survivability” into their professional plans with a formal legal-entity structure.