Sole proprietor vs Corporations: Determine your freelance design business structure

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Each week at GDB, Dan Sweet provides priceless tips and helpful secrets to make your freelance design venture a success. You can connect with Dan on twitter or at dansweetdesign.com.

You’ve done it! So you’ve made the decision to embark on the tumultuous journey that is starting your own freelance design business. Now what? Hopefully you’re working on developing a foolproof business plan, and you’re excited about getting to work doing what you love.

Before you get too far, though, it’s really important to determine what business structure you’ll register your business as (and once you do, actually register it!).

Sole Proprietorship

If you’ve been doing any business for yourself, you may already technically be a Sole Proprietor. It’s definitely the simplest of all business structures, and the easiest to set up and maintain. In a nutshell, a Sole Proprietorship is an unincorporated business that you own by yourself. You’re personally responsible for all of the business’ financial obligations and the money your business earns is taxed as your money.

From the IRS:

“A sole proprietor is someone who owns an unincorporated business by himself or herself.”

Pros: Easy to set up, inexpensive to start and operate, and you report your income (or losses) on your personal tax return.

Cons: You’re personally liable for any debts you may incur, or legal action. So if you are to get sued or accrue massive debt, your personal property (house, car, computer) could potentially be seized.

Partnership

Very similar to a Sole Proprietorship, a Partnership is a simple business structure with multiple owners. If you’re going into freelancing alone this obviously won’t apply, but you may have a sidekick that does half the work, and if they expect to make any money a Partnership might be the way to go.

From the IRS:

“A Partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.”

Pros: Like an SP, easy to set up, inexpensive to start and operate, and you report your share of income (or losses) on your personal tax return.

Cons: Also like an SP, you (and your partner) are personally liable for any debts you may incur, or legal action. So if you are to get sued or accrue massive debt, your personal property (house, car, computer) could potentially be seized.

LLC (Limited Liability Company)

The LLC is a newer class of business, and a sort of hybrid between the simpler Partnership/SP structure and the more complex corporation structure. Like a Partnership/SP, you’re subject to “pass-through” taxation (taxing business income as personal income), but you have the advantage of limited liability (you’re protected from being personally responsible for business debts or legal claims) like that of a corporation.

From the IRS:

“A Limited Liability Company (LLC) is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a Partnership, providing management flexibility and the benefit of pass-through taxation.”

Pros: Personal liability against debts or claims. You’re able to choose between being taxed as a Partnership or as a corporation. Profit or loss can be allocated differently than ownership interests.#

Cons: More expensive to start. Sometimes there are conflicts between state and federal laws for LLCs, so be sure to check into your particular state’s structure. Also, if you have trouble with your personal taxes from a regular job, taxes for your LLC aren’t going to be a walk in the park.

Corporations

As a freelance designer, you probably won’t have to worry about forming a corporation. They’re expensive to start, difficult to maintain, and complicated to run. You’re required to set bylaws and issue stock certificates to each shareholder, or initial owner, and keep record of who owns how much. Corporations are seen legally as their own entity, separate from those who run them, so whoever is managing it isn’t personally responsible, and a corporation can enter into legal agreements as itself.# For more info on Corporations, check out Nolo’s article on “Corporation Basics.”

From the IRS:

“In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock.”

S Corporation

S Corps are going the way of the buffalo, being largely replaced by LLCs. Similar to an LLC, profits are “pass-through”, so you’re taxed on your personal tax return, and there’s no income tax for the corporation. There’s that fancy corporate limited liability for business debts and claims, but unlike an LLC, you don’t have to pay self-employment tax.

From the IRS:

“S corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes.”

My Solution

When I was starting my business, I had a hard time deciding between a Sole Proprietorship and an LLC. In the end it came down to the following:

  • I figured the chances of legal action against me are slim (maybe short-sighted on my part, we’ll see…);
  • I didn’t have much up-front cost as I already owned my equipment;
  • My business expenses aren’t too high so there isn’t much chance for me to go into debt;
  • And mostly, I didn’t want to pay the fees to register an LLC

…so went with a Sole Proprietorship. I do all the accounting and taxes myself and don’t plan on hiring anyone in the near future, so I thought for starters this would be the way to go.

I even consulted with GDB’s Preston D. Lee, and he made the good point that it’s much easier to upgrade from an SP to a more complex structure than in the opposite direction, if you change your mind down the road.

Other Factors

So which one do you choose? For the purposes of freelancing, the most common choices are Sole Proprietorships and LLCs, so we’ll focus primarily on those. A few things to consider when making your decision are the potential risks/liabilities involved in your business, the initial expense and business formalities you’re willing to put up with as your business grows, your income tax situation, and if you have any need for investors.

TAXES
With SPs, Partnerships and LLCs, all income taxes are filed and paid as though all income was your personal income (which in most cases, it is).

With any pass-through business structure, you’ll probably find yourself getting hosed by the IRS. Since you’re not an employee of another company, you’re required to pay Self-Employment tax, which is the half of Social Security and Medicare taxes that are normally paid by an employer, plus the half that you normally pay.  Of course, this is in addition to the normal Federal and State income taxes that you have to shell out.

EMPLOYEES
Will you be hiring employees in the future? With an SP or Partnership, you are able to hire as many employees as you want, but your liabilities will increase. It may be a good idea to “upgrade” to an LLC to protect yourself and your business from those malevolent employees.

Calling all Freelance Designers!

As with any business decision, the choice really lies with you and what works best for your situation. Now it’s your turn: what business structure have you set up, or are you planning on using? Why? Did you make the right choice?

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Comments

  1. This article was very interesting. I am considering the LLC for my company. A few years back you were more like to be sued that end up in the hospital (I know that sounds silly, but its the truth). Better safe than sorry.

    – Brandon

  2. Tax savings with S-Corps. I freelance and make a good living.
    The tax savings of being an S-Corp is substantial enough that it covers the cost of retaining a CPA for setting up and handling my annual corporate taxes… plus increasing my take-home by about %8.
    One-man S-Corps don’t pay the payroll taxes on up to half their income because they can take it as a “dividend” instead of salary.
    When I need to hire employees (or contract W-9 help), it’s a no-brainer.
    At least in VA, S-Corps have just about all the liability protections that LLC’s have, plus a substantial tax savings.

  3. great article, thanks for sharing! It’s very helpful information.

  4. Great Advice. When I started my freelance telecommuting Electronic Engineering Services SP in 1996 I basically did every thing this (and other related “You Might Also Like”) article recommended. Being primarily a hardware designer already with 20 years of “how not to do it” experience, a jack-of-all-trades, allowed me to set up a one-stop shop as a temporary extension to any engineering staff, filling in where I could be of greatest help.

    WARNING: The IRS (and my accountant) really doesn’t like it very much when, after accepting only 1099-contracts for years, a SP also mixes in (just for one contract) a temporary employee status with a W2. I highly recommend only doing 1099-contracts (and also building a really good web site to show off your talents and generate new business).

  5. Hmmm…I’m 80% leaning toward sole proprietorship. Thank you for this article, Dan! I needed it!

  6. I am thinking that I am going to do Sole Proprietorship because its just me and like you, I think I can slim down the chances of getting sued. I am glad I found this article to clear it up for me. Good information!

  7. Adeel Saeed says:

    I am 90% sure I will do Sole Proprietorship and it will gave me chance to work on a 1099 , but still I will get an advice through my accountant !!! Great help for me and good information !!!!!

  8. Yes, great article! It may also be nice if you do a second part article(s) on SP vs LLC’s — Rules of business naming or DBA, best tools to use for accounting (as creative person friendly as possible), recommendations on setting up a business bank account and what they would ask you for (LLC’s require articles of incorporation and possibly a operating agreement), etc. Could be lengthy but the devil is in the details and this was explained perfectly.

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