Whether you are a new independent contractor who is just starting out with your business or are looking to change your business structure for legal or financial reasons, an important step is deciding on how to structure your business. Each business structure (from being a sole proprietor to creating a corporation) has its pros and cons, and your decision will depend on your industry and interests. Some business entities are easier to set up and operate, while others offer limited liability and tax benefits.
An independent contractor is a broad term that describes anyone who provides goods or services without being employed by someone else. This includes freelancers, gig workers, consultants, and other business owners. Whichever term you use, as an independent contractor you are self-employed, meaning you are the one responsible for legal and financial decisions like deciding on a business structure.
Business structures, also known as business entities, are the legal names that describe how the owners legally form and operate the business. The major differences among business structures include:
A sole proprietorship is the simplest business structure to form. As soon as you begin operating your business on your own the government considers you a sole proprietor. Typically, if you have a partner you do not have a sole proprietorship, but some states make an exception to this rule if your partner is your spouse.
You do not file any paperwork with the state to become a sole proprietor. However, if you want to offer your services under a name that is different than your own, you might need to file for a fictitious business name or doing business as (DBA) with your state. In addition, you might be responsible for business licenses, depending on your location and type of business.
As a sole proprietor, you will report your income and losses on your personal tax return, and the IRS does not require a separate tax return for your business. You will enjoy pass-through taxation, but as with other business income, you will be responsible for self-employment tax.
While simple to form, the downside is that a sole proprietorship does not limit your liability. To obtain some measure of liability protection, many sole proprietors obtain business insurance to protect their assets.
You form a partnership as soon as you start conducting business with one or more other people. As with a sole proprietorship, you do not need to file any paperwork unless you want to use a fictitious business name or your local government requires additional licenses. To avoid conflict among partners, it is best to have a partnership agreement that specifies the terms of the arrangement, such as how the partners will share profits and losses.
The IRS requires the partnership to file an informational tax return, and the partnership enjoys pass-through taxation. The partners report the profits and losses on their individual tax returns.
Also like a sole proprietorship, a partnership does not shield the owners’ personal assets from being liable for the business’s debts. However, some states provide the option of forming a Limited Partnership (LP) or a Limited Liability Partnership (LLP). These arrangements protect the liability of some or all of the partners. In some states, only the passive investing partners have limited liability, while partners engaged in the day-to-day operations remain liable for the debts of the business.
A very common business structure for independent contractors is the limited liability company (LLC). The main benefit is that the LLC offers limited liability for all of the owners. To form an LLC, you must file paperwork with the state and pay a filing fee; however, it is fairly simple compared to forming a corporation. This entity offers a great deal of flexibility in how the owners, known as members, manage the company and share the profits. The members create an operating agreement to detail how they will manage the company and split the profits.
By default, the IRS treats the LLC is a pass-through entity, taxing it as a sole proprietorship (if it has one member) or a partnership (for two or more members). The IRS also allows LLCs to elect to be taxed as a corporation.
An LLC is not the appropriate business structure for every independent contractor. The LLC must pay filing fees, and in some states, additional state taxes. If you are hoping to attract investors in order to expand your business in the future, you’ll learn that many investors prefer to invest in corporations for tax and other legal issues. In addition, some states prohibit certain professionals, like lawyers and doctors, from forming an LLC. The state might limit professionals to forming Professional LLC (PLLC) or a Professional Corporation. These structures do not limit your personal liability, but might limit your liability for your partners’ misconduct or other business debts.
If you want to structure your business as a corporation, you might have a number of options in your state, such as a C Corp, S Corp, Close Corporation, and a nonprofit corporation. Like an LLC, all corporations offer limited liability. To form any type of corporation, you must file paperwork with the state.
Corporations file a separate tax return, which can be more complex than the returns you would file for other business types. C Corporations are not pass-through entities and are subject to corporate tax.
A corporation is not best for every business. States have a number of corporate laws that specify how to set up and run a corporation, including rules for meetings and record-keeping. Compared to other business entities, forming and maintaining a corporation can be complex and cumbersome.