Whether you're a new independent contractor who's 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. Independent contractors include freelancers, gig workers, consultants, and other business owners. Whichever term you use, as an independent contractor you're self-employed. So you're 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 don't have a sole proprietorship, but some states make an exception to this rule if your partner is your spouse.
Formation and ongoing legal requirements. You don't file any paperwork with the state to become a sole proprietor. However, if you want to offer your services under a name that's 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.
Personal liability for business debts. While simple to form, the downside is that a sole proprietorship doesn't limit your liability. Any debt your business is liable for, you'll also be liable for. To obtain some measure of liability protection, many sole proprietors obtain business insurance to protect their assets.
Taxes. As a sole proprietor, you'll report your income and losses on your personal tax return, and the IRS doesn't require a separate tax return for your business. You'll enjoy pass-through taxation. But as with other business income, you'll be responsible for self-employment tax.
You form a partnership as soon as you start conducting business with one or more other people.
Formation and ongoing legal requirements. As with a sole proprietorship, you don't 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's best to have a partnership agreement that specifies the terms of the arrangement, such as how the partners will share profits and losses.
Personal liability for business debts. Also like a sole proprietorship, a partnership doesn't shield the owners' personal assets from being used to satisfy the business's debts. However, some states provide the option of forming a limited partnership or a limited liability partnership. 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.
Taxes. 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.
A very common business structure for independent contractors is the limited liability company (LLC). You can form an LLC with one owner, known as a "single-member LLC" or with more than one member, known as a "multi-member LLC."
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.
Formation and ongoing legal requirements. To form an LLC, you must file paperwork with the state and pay a filing fee; however, it's fairly simple compared to forming a corporation. Most states also require you to file reports every one or two years and pay a filing fee.
Personal liability for business debts. The main benefit is that the LLC offers limited liability for all of the owners.
Taxes. By default, the IRS treats an LLC as 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 isn't the appropriate business structure for every independent contractor. The LLC must pay filing fees, and in some states, additional state taxes. If you're hoping to attract investors 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 a professional LLC or a professional corporation. These structures don't 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 corporation, an S corporation, a close corporation, and a nonprofit corporation.
Formation and ongoing legal requirements. To form any type of corporation, you must file paperwork with the state. Depending on your state's laws, you might also be required to submit other documents to the state, like corporate bylaws. As with LLCs, many states require you to file reports every one or two years.
Personal liability for business debts. Like an LLC, all corporations offer limited liability to their owners (shareholders).
Taxes. Corporations file separate tax returns, which can be more complex than the returns you'd file for other business types. A C corporation (the default type of corporation) isn't a pass-through entity and is subject to corporate tax. If you elect to become an S corporation, then you'll be taxed as a pass-through entity. But this election requires you to file paperwork with the IRS.
A corporation isn't 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 recordkeeping. Compared to other business entities, forming and maintaining a corporation can be complex and cumbersome.
Choosing which business structure works best for you will depend on what your priorities are as a business owner. If you only care about which option is cheapest and easiest, then a sole proprietorship or a partnership will likely be the best fit. But if you're fine with submitting little paperwork and paying filing fees every year, then you should consider forming an LLC. An LLC is a great choice because it's relatively easy to form, protects your personal assets, and is flexible in its management and tax options. However, if you're looking to build a business that can attract investors and employees alike, a corporation might be the best way to go.
Whichever type of business you choose, make sure you follow your state and local laws for businesses. You might have to follow rules that apply to businesses regardless of their structure, like licenses and permits, or laws that are specific to your business type. If you ever have questions about your legal obligations, consider speaking with a business attorney.