This guest post is part of a two part series (see part 1 here) written by Kelly Phillips Erb, a tax attorney who blogs for b5media at taxgirl.com. You can find out more about Kelly here. For more information about tax and blogging, check out her handy list of prior articles on the subject including Problogger articles!
Once you’ve made the decision to treat your business as a business, you’ll need to choose an entity. Follows is a brief rundown of the most popular forms of business entities for freelancers and bloggers:
1. Sole Proprietorship
The sole proprietorship is the most simple form of business entity. There is no formal procedure to form a sole proprietorship and there are few formal accounting requirements. There are no separate tax forms; you file taxes on your own personal income tax return. You can easily exchange personal and business assets. This is how most bloggers and freelancers operate.
The downside of these “loose” requirements is that sole proprietors are personally liable for debts, obligations and the like of the business, including lawsuits. Personal assets are essentially treated, for liability purposes, as assets of the business.
Additionally, since your business income is reported on your personal return, deductions expenses like medical insurance are limited to the caps and restrictions for individuals. In most cases, these deductions are less favorable to take as personal expenses than as business expenses.
A partnership (sometimes called a “general partnership”) is also a simple form of business entity.
A partnership operates from a tax perspective as a “pass through” entity which means that all items of income and deductions pass through the partnership to the partners according to percentage of ownership or partnership agreement. Those items are then reported on each partner’s respective personal tax return. No income tax is paid at the partnership level (though a partnership may be subject to other state and local taxes).
As a result, personal and business assets are not separate and personal assets can be subject to the liabilities and obligations of the partnership. Additionally, just like with a sole proprietorship, the availability of certain types of deductions are limited to the tax floors and ceilings on your personal income tax return.
3. Limited Liability Partnership
A Limited Liability Partnership (“LLP”) is similar to a general partnership. There is one significant difference: in most states, an LLP may register with the Department of State. The benefit of registration is that each partner is not liable for obligations and liabilities arising from the “negligence, omissions, malpractice, wrongful acts or misconduct” of the other partners. In other words, so long as you observe the proper rules, liability is largely limited to your own actions.
The LLP, like a regular partnership, is treated as pass through entity for federal and state tax purposes. Again, income and losses pass through to the partners either in proportion to ownership or according to your partnership agreement.
An LLP does not offer complete liability protection. Although an LLP has limited liability for “negligence, malpractice, omissions, etc.” there is unlimited personal liability for contractual obligations of the partnership such as, for example, promissory notes.
4. Limited Liability Company
The Limited Liability Company (“LLC”) is probably the best known corporate entity other than a regular corporation. It’s a hybrid entity that offers the liability protection of a C corporation with the tax option to be treated as a partnership or a corporation.
An LLC can be structured to provide for added flexibility, including unlimited members. An LLC also provides ease of operation and possibilities for expansion which makes it attractive for a number of freelancers.
An LLC is govened by an Operating Agreement, which outlines plans for business management. Banks, mortgage companies and other institutions will want to see your agreement when making loans or setting up accounts. The Operating Agreement also allows you to set up the “control” of the corporation and limit the transfer of interests.
Even though the LLC offers pass through tax treatment, liability is limited in much the same way as with a C corporation. This means that so long as you follow the corporate formalities, as well as keep your personal assets separate from your business assets, your liability will largely be limited to your business assets.
5. S corporation
The S corporation is another special form of corporation that operates like a C corporation but is taxed like a partnership. There are strict limitations on the structure of an S corporation including the number and types of shareholders.
The S corporation is considered a good vehicle for small, closely-held corporations. One of the most attractive features of the S corporation is the ability to “slice up” distributions to shareholders and reclassify those distributions. Traditionally, compensation to shareholders who also served as owners was taxable as ordinary income. As compensation for services, it was also subject to self-employment tax, which is the self-employed person’s version of FICA (Social Security and Medicare contributions). The rate for self-employment tax is 15.3% of wages (the equivalent of the employer and employee portion of FICA). This tax is on top of the actual income tax on those wages. The result is a painful hit – the same as operating as a sole proprietor.
Since 1984, there have been a number of tax packages passed that have made the notion of dividends more appealing, especially the legislation passed under President Bush’s first term, which lowered those rates. So practitioners started thinking: what if you paid yourself a dividend instead of a salary? Under the old tax laws, that wouldn’t be a good thing. But under the new tax laws, it may result in tax savings. This is the feature that is most attractive to freelancers; however, you will want to make sure that this is set up properly so that you don’t create a tax, legal or Social Security problem. And oh yeah, it’s definitely worth mentioning that the IRS doesn’t like it…
The S corporation also has a number of restrictions relating to ownership – be sure and check out these ahead of time. If you lose S status due to a reporting or management violation, the time period is generally ten years before you can regain your status. The default is that you would be treated as a C corporation, which likely not a good thing from a tax perspective.
6. C corporation
A C corporation is what most people generally think of when they think of corporations – C corporations are the companies usually followed by “Inc” in their names, as in Coca Cola, Inc.
The advantages of a C corporation are continuous life, clear divisibility of assets between personal and corporate, limited liability among shareholders, freely transferable shares of stock, virtually unlimited options on structuring stock ownership, and favorable tax treatment for certain expenses. All good, right?
The disadvantages of a corporation are increased administrative expenses, compliance formalities and the potential for “double taxation.” Increased administrative expenses are due to more complicated accounting and tax compliance (i.e. filing corporate returns). “Double taxation” is the result of a C corporation being a separate taxable entity and not a pass through. This means that the C corporation pays a tax on its income for the corporate year and the shareholders pay tax on dividends received from the corporation. Additionally, money that is paid out as salary is reported as ordinary income and is subject to FICA (Social Security and Medicare taxes) on the employer and employee sides; in a one person corporation, this is largely the same result as paying self-employment taxes since it’s the same pot of money.
In most cases, a C corporation is “overkill” for a freelancer with no immediate plans for expansion, hiring of employees, etc.
The Bottom Line
Be informed. Research. Know enough to know the direction that you generally want to go. But don’t assume that information that you glean from friends or the internet (even if it comes from a reliable source) is sufficient to make a business decision.
Laws vary from state to state as to how various entities are structured, so check with your tax or legal professional for specifics: I can’t stress this enough. While it feels cheap and easy to simply incorporate online, you may be creating a bigger monster – some states charge annual fees for incorporated entities which can add significantly to your tax bill. Additionally, creating an incorporated entity may subject you to local taxes that you would not have been required to pay if you remained unincorporated.
If you don’t get proper advice, you can also make elections or fail to make elections that can result in serious tax consequences. We often joke that our office is like that Midas commercial: you can pay us now or you can pay us later. Don’t forego important advice to save a few dollars in advance: you may find that you’re really paying for it later.
For more information about tax and blogging, check out my handy list of prior articles on the subject including Problogger articles!
Like any good lawyer, I need to add a disclaimer: Unfortunately, it is impossible to give comprehensive tax advice over the internet, no matter how well researched or written. Before relying on any information given on this site, contact a tax professional to discuss your particular situation. If you have a question, ask the taxgirl.