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Should Freelancers Form a Business Entity?

Deborah Sweeney
Deborah Sweeney

Freelancers inhabit a nebulous grey area of employment. They don't exactly work for someone else, but most freelancers wouldn't call themselves their 'own boss' either. I work with a lot of freelancers, and the most common question they ask is whether or not they should form a business. The answer, of course, is that they are already had. The minute they started selling their services as a freelancer, they started a small business -- at least in the eyes of the IRS. Any income earned as a freelancer is reported as business income, and freelancers are responsible for self-employment taxes. Since freelancers are already entrepreneurs, I often recommend they treat their budding business as any other sole-proprietor would.

Write a Business Plan

Freelancing is unpredictable, and most of the freelancers I've talked to describe their work lives as being feast or famine. They'll be chugging along, working twelve-hour days to stay on top of all of their work, and then, all of a sudden, projects completely dry up. A business plan helps solve this problem because it forces you to look objectively at your company, and ask yourself what you can reasonably handle at any given time. First, identify your target clients. Who do you want to work with? How will you find them? Can you market yourself to them? Then, make a financial plan, figure out your rates and, based on that, determine how much work you have to do each month to stay afloat. That gives you a baseline to stay above. If that baseline looks a bit high, either consider diversifying any sources of income to help pad your freelance work, or look into raising your fees.

Related: Best Free Business Plan Templates

Consider Forming a Corporation or a Limited Liability Company

Seventy-percent of businesses in America are owned by sole-proprietors, with no legal distinction between the business and the person operating it. While a sole-proprietorship is the easiest business entity to form and run, it does leave you unprotected. If a client sues, you could be on the hook for paying the final judgment. Debt collectors can also come after your personal assets to pay for the business's debts. And, while most freelance companies don't have to take on much debt to get started, the thought of debtors coming after your personal property can be a bit frightening. Incorporating or forming an LLC turns your business into its own, separate legal entity, responsible for its own debts. An LLC or corporation is also able to enter into contract, meaning clients hire your company directly, and you sign contracts as a representative of the business.

Limited liability companies are very easy to run. You don't have to have any annual meetings, and all of the income earned by the LLC automatically flows to you, the business's owner, unless you decide otherwise. Corporations, on the other hand, can be a bit complicated to run, so speak with a professional or other expert about your options before forming a separate entity for your business.

Research, and Pay, Your Taxes

The federal, and in most cases state, governments levy an income tax, and becoming a freelancer doesn't make you immune from paying. The government also requires everyone drawing an income to pay social security and Medicare taxes. Normally, the business that you work for withholds these taxes from your paycheck but, when you freelance, that isn't the case. Your clients will consider you a 1099 employee -- an independent contractor. That means it is up to you, not them, to calculate what you owe, and send it in. The IRS has a handy worksheet for calculating what you have to pay, and if you expect to owe more than $1,000 in tax, you will have to send in quarterly estimated tax payments. Of course, if you are a freelancer, you will also be able to claim relevant business deductions when filing your returns. Your travel, medical and home office expenses, including your computer and whatever software you use to freelance, can all be claimed as deductions.

Related: 3 Common Questions About Franchise Tax Answered

You effectively start your own small business the minute you begin earning money by freelancing. Thus you should treat your freelancing as you would any other business, regardless of whether you are just doing it on the side to earn some extra cash, or if you are making a living as a freelancer. Write a business plan and outline what you want your company to do, and how you are going to accomplish that. Then consider limiting your personal liability by forming an LLC or incorporating, and don't forget to pay your taxes! Approaching freelancing as a small business, rather than as just another job, will both help you succeed and keep you on the right side of the law.

Image Credit: Monkeybusinessimages / Getty Images
Deborah Sweeney
Deborah Sweeney Member
Deborah Sweeney is the CEO of MyCorporation is a leader in online legal filing services for entrepreneurs and businesses, providing start-up bundles that include corporation and LLC formation, registered agent, DBA, and trademark & copyright filing services. MyCorporation does all the work, making the business formation and maintenance quick and painless, so business owners can focus on what they do best. Follow her on Google+ and on Twitter @deborahsweeney and @mycorporation.