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.
2. Partnership
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.
Thanks for this article! The timing could not be better for me. I’m curious to know if there are any drawbacks to taking a stepped approach. For example, I’m about to start my first blog-related business, and if things go the way I planned (as they so often do), I’ll be launching a few more businesses in the near future. Eventually I’d like to have a single business entity as an “umbrella” over the individual products, if it makes sense.
So in a nutshell, do you see any potential problems with starting as a Sole Proprietorship, and eventually moving to an LLC, or S Corporation?
Thanks again Kelly, for the great posts, and thank you Darren for this wonderful resource!
LLC all the way; I need to get around to doing that filing here in sunny California.
Sole Proprietorship leaves me too exposed for my tastes.
Luke,
I’m glad that you enjoyed the article.
There’s nothing wrong with a stepped approach – you can always elect s corporation down the road if it were something that you wanted.
Keep in mind that the appeal of some of these entities – like an LLC – is the flexibility. You can be a single member LLC or you can be a huge LLC (like a little something called AOL LLC).
As to your umbrella approach, that is classic business planning – good thinking! It’s not for everyone but it makes a lot of sense for high risk businesses or when it’s necessary to segregate assets (real estate comes to mind). It’s also a good idea if you have a valuable asset that you could detach for purposes of tax planning (I mentioned this in the comments in part 1).
While in Samara Costa Rica I decided to set up an Internet business dealing with that region. Any suggestions on whether to set it up as a U.S. business or Costa Rican Internet business?
Good stuff, thanks for sharing.
I should incorporate mainly because I do a lot of freelance development work and it would be good tax wise (writing stuff off). It also looks much more professional in my opinion.
The problem is, at least in Canada, is that it takes much longer to go through this process than it does to just be yourself. This is why I haven’t incorporated yet.
it is a valuable info especially to those interested in business.thanks..
Good summary. I think it would be important to review the different implications for US versus non-US owners.
While an LLC is a very convenient and low-cost way for Americans, a C corporation would give the best benefits if you want to establish a US presence.
Also, would be nice to talk about the differences between states in terms of taxation. If you’re not an American, choosing the right state would be very important for the corporation to pay minimal taxes and lower operating expenses.
I chose an LLC over an S corporation because in delaware there are fewer reporting requirements which makes my life easier.
While I found this article to be good at covering basics there are some inaccuracies, or perhaps lack of telling the whole story I noticed. First, I would argue that a S corporation is not itself a type of entity. An S corporation is simply a C corporation where an election to be treated as a S-Corp was filed with the IRS. There is no seperate set of state law that deals with forming S-corps for example. All s-corps start out as C-corps (albeit maybe only for a very short period of time until the S-corp election is made).
Also, its certainly not wrong when the author suggests that most C corporation have “Inc” after their names, however, that is true of any corporation (chapter C or S). Indeed most state laws require a corporation to use the words “Company”, “Incorporated” or an abbreviation thereof in the name of their entity.
The author also makes reference to LLCs and corporations helping to limit the business owner’s liability, which is certainly true, however, the author leaves out the fact that generally speaking an individual is always going to be legally liable for their own negligent actions no matter what type of business structure they are operating under.
So an individual blogger running their own site can set up John Doe, Inc., however, if John Doe breaks the law the fact that he did so working for a corporation will not serve to protect his personal assets at all.
Thanks for the article, everyone needs to know this kind of information (as tedious as the business side of things can be) in order to make sure they can take their business to the next level.
Jeff,
Thanks for your attempts to clarify some of my points. It’s difficult to completely summarize entire volumes of tax and business law in a few paragraphs which is why it’s important, as I recommend, to check with your own tax or legal professional.
That said, and I understand that you face the same challenge in the comments, your comments attempt to draw some distinctions that aren’t entirely correct – or fair.
Yes, an s corp may start out in most states as a c (though not always, keep reading) – for a few seconds – until the s election is made, which is usually filed simultaneously. The s election is a tax election, true (and the focus of this series is tax) – but it definitely extends beyond federal law. There are entire chapters in most state codes which define s corporations both in terms of tax and structure (including the number and types of shareholders). I would always draw a distinction between an s and a c corporation because, elected or not, the differences are wildly significant.
Additionally, it is increasingly the case in many states that a PC or LLC may also elect s status – hence, no lengthy explanation about Inc., Ltd., or Company in my article. It is extremely fact specific.
Your reference to “negligent actions” is not exactly true. I echo what I said in part 1 of the series that incorporation doesn’t give you carte blanche to do what you want. However, depending on the exact nature of the actions and business entity, it is more likely that the actions be willful and outside the scope of the corporate purpose to reach personal assets. This is an important legal distinction.
Again, this is meant to be a quick overview of incorporation and taxation – there are lots of nuances in federal and state law. I appreciate your efforts to correct what you view as oversights. I would, however, again stress that I think it’s important for folks to arm themselves with a general understanding of what’s *out there* and check with a professional for specific details.
Kelly — In addition to those six conventional types, you might want to add the relatively new innovation– the B Corporation. (http://www.bcorporation.net)
(Quoting from myself) “In the past year, a new legal form of organization has been developed that makes authenticity easier for organizations who seek simultaneously to make money and make a difference. This new organizational form is the B Corporation (where B stands for beneficial).
What’s unique about the B Corporation is that being for-profit and being for-purpose are both defined into the B Corporation’s identity through their articles of incorporation. By legally defining itself as both for-profit and for-purpose, a B Corporation can pursue both for-profit activities and for-purpose activities and think of itself as a for-purpose organization and a for-profit business, without experiencing a conflict between identity and actions.
Designing purpose and profit into the B Corporation’s identity. The B Corporation is a clever innovation on the legal identity of the traditional C Corporation. The legal form of the B Corporation asks an organization “to incorporate stakeholder interests into (their) corporate DNA” by adding legal language that expands the responsibilities of the corporation beyond financial interests and takes into consideration the interests of all stakeholders, not just shareholders.” http://authenticorganizations.com/harquail/2008/05/01/b-corporation-identity-an-opportunity-for-organizational-authenticity/
The fun thing about establishing ones blog/business as a B Corporation is that you get to clarify and set goals against social issues (if these matter to you…) and participate in a bit of a movement. What do you think?
I run a couple of businesses, one is an LLC for my consultancy and and my medical garments company is a Delaware Corporation. IMHO, incorporating in Delaware in very easy and reporting is minimal. When I needed a “good standing” report for my bank when I applied for a merchant account, all I had to do was fill out a sheet and sent $30. Super easy.
B-Corporations are not a legal entity. Nor are they an entity for tax purposes. Even their website says, “It’s less a legal designation than a certification system that will allow businesses to define themselves as socially responsible to consumers and investors.”
Legally a B-Corporation is incorporated as another form (S or C-corp or LLC) and operates as that form. The only difference is some fancy language in their articles of incorporation (which may or may not be legally binding) and a fee from “B-Lab”.
So, no different and it costs more. – No thanks.
LLC allows you to Live Like a Ceo without tedious hassles.
@ Amir Helzer – our company provides incorporation services and we get that question a lot.
The two best states to incorporate in are Nevada and Delaware, Nevada given a slight edge.
Nevada corps have never had their corporate veil pierced (in other words, provides the best protection for you). Nevada also has no state tax, no franchise tax, and a no sharing agreement with the IRS.
Going back to another commentator’s question about protecting assets, keep in mind by combining different business structures with living trusts you can provide excellent asset protection.
It sounds like a B-corporation is a half-done cooperative. Seems better just to be a cooperative and reflect all your members’ interests (money, principles and more). Contact your local ica.coop member for information and advice if you need it.
LLC is the way to go! From my understanding, there are benefits to filing in other states, for instance Nevada or Delaware.
LLCs can also be an estate planning mechanism too.
Be warned – In the UK, and I assume in the States, a partnership is a dangerous business entity to consider, particularly with people you doin’t know well.
You can end up with the responsibily of paying off all debts incurred for the business by the partner. So if a person takes on a series of loans, buys a load of technie goods and then skips the country to Brazil – all debts linked to the business you are liable.
It can also be dodgy if you are in a legal partnership with a romantic partner as if you split up the costs of the business can be linked up with the cash flow of the business.
If you are thinking partnership then in most cases you need a limited liability company. If all goes pear shaped you can you walk away and the bankrupt company is liable – not you. You will still own your house, car and shirt.
Again I don’t know about US legislation, but in the UK we do have a strong cooperative movement, which is usually linked to a non-profit limited company. All profit being shared by the members.
Cooperatives have a good track record as they harder to start up, but the procedure forces the members to face up to a lot of business decisions. It is a good format say for a team of web developers and programmers.
Small correction: cooperatives are not “usually linked to a non-profit limited company” – they are often for-profit, but use part of their profits for social purposes. Sometimes that part is 100%, but it’s not always. The largest UK cooperative, the Cooperative Group (owner of the high-street retail stores, incorporated as an Industrial and Provident Society IIRC) donates some of its profits to the Cooperative Fund and other groups, but not 100%.
Cooperatives are only slightly harder to start up now because you can have LLP cooperatives (and I agree that you almost certainly want to go LLP rather than simple partnership), but most people have to do some thinking and learning to understand how to work as a cooperative and that is part of what makes it a good format. If you set up a limited company, it’s often treated like a personal sandbox, which is a problem when your poop gets in the way of someone else’s foot – with a cooperative, you have members looking in and joining most cooperative organisations will mean letting someone else verify your business model and agreeing that it’s cooperative.
I don’t want to sound like a broken record but… make sure that you consult with a tax or legal professional before making the decision to incorporate in another state. It’s important to realize that the law that controls may not be the state where you incorporate – yes, it sounds weird. For example, in PA (where I live), you are subject to tax based on where you perform the services irrespective of where the company is located. The tends to affect bloggers since the services are generally performed from an office or home. Even if I were to incorporate in a “no tax” state like DE or NV, I would still be subject to tax in my home state of PA.
Tax is a complicated area (which is what makes it so much fun!). Be careful when planning – those things that sound too good to be true probably are…
This is very detailed post which is almost the same as we read while doing my graduate in commerce…
Thanks for the informative article. I’m researching the steps required to get up and running with my blog and this is a topic that I haven’t found much on. So thanks and yes I’ll consult my local tax/legal professionals!
thanks for good information….increasing my basic knowledge
When structuring my business I chose to go with LLC and I would recommend it to anyone else. When you consider that most businesses fail before the end of the first year LLC is a no brainer. When starting a business one has to lease a space to do business out of which usually involves signing a contract for at least 1 year. If you don’t make it through the year and are iether sole proprietor or partner you are personally liable to the fulfilment of the contract. If the LLC fails before the year is up the LLC is liable so you merely dissolve the LLC and you are never personally liable for anything. LLC aford all the protections of a corporation and all of the benefits of a private company. Its a no-brainer