The thousand dollar mistake that freelancers make

Enoch Ko - Jul 30, 2019


Working as a freelancer is exciting. Interesting projects, flexible schedule, and remote work. With hundreds of thousands of people joining this self-employed market every year, many suddenly meet with unfamiliar zone — managing your own taxes. If you are lucky, you might just have a friend or an uncle who can help you explain a few things, but if you aren’t so fortunate, you are faced with various responsibilities.

I’m helping many freelancers at Soraban, software-enabled tax-experts for self-employed individuals. There is one place many freelancers mess up (especially when they are handling the taxes themselves) which costs them thousands of dollars: Setting up the right business entity structure.

For some background, most freelancers are either sole proprietor, s-corporation, and limited liability corporation (LLC). They have their own advantages and disadvantages, and knowing which one is right for you is crucial.

Sole Proprietorship

By far the easiest and most popular one to set up for your business. By default, you are treated as a sole proprietor when you start earning income from your clients. This is the most common entity for most business owners. By being a sole proprietor, you get to avoid most of the legal headaches. However just because it’s a popular option, it doesn’t make it a good idea to stay as a sole proprietorship.

Advantages:
  • No corporate board minutes to maintain.
  • No need to file separate income taxes.
  • No legal fees and document filing fees that come along with forming a business entity.
Disadvantages:
  • No asset liability protection

Limited Liability Corporation (LLC)

Now, let’s say that you want to make your freelancing business more formal by setting up an LLC. This now gives you the added benefits of liability protection. In terms of taxes though, Single-owner LLCs are taxed just like sole proprietorships. This is usually a good idea to set up if you are running a business that has some risks.

Advantages:
  • Protection from the liabilities of LLC itself.
  • Relatively easy to operate and costs associated with it — compared to the other forms of businesses.
  • No need to file separate income taxes.
Disadvantages:
  • Need to pay additional fees annually for some states.
  • Some additional paperwork & maintenance requirements compared to the sole proprietorship.

S-Corporation (S-Corp)

S-Corporations are corporations are similar to any corporation, except it was designed to help the small business avoid “double taxation” issue that normal C-Corp would face. S-corporation does not get taxed on the business level, but it gets “passed-through” to the individual return similar to sole-proprietorship, where you have to pay taxes on the individual level.

Here’s the interesting part: S-Corp helps you reduce self-employment tax by classifying part of your income as salary and another part as a distribution. You will still need to pay self-employment taxes on the salary portion, but the rest of the money will be distributed to you without self-employment-tax-free. This means you’ll be paying self-employment tax only on your salary.

Now before you try paying yourself $0/year to entirely avoid self-employment tax, IRS warns that if taxpayers don’t pay themselves a reasonable salary, IRS would make them pay self-employment tax on all of their business net income. It’s critical that you figure out the right amount of salary to pay for yourself. There are a few more things to keep in mind. You will have more paperwork such as filing IRS form 2553, paying yourself a reasonable salary (i.e., payroll), need to also file a business tax return called the Form 1120s, which are usually more expensive than individual tax returns.

Advantages:
  • Lower audit risks compared to sole proprietors.
  • Generally, lower self-employment tax.
Disadvantages:
  • Need to pay yourself a reasonable salary.
  • Need to file a business tax return as well on top of the individual tax return.
  • Need to file form 2553.

Which business entity is best for me?

Generally, if you are making over $40,000 in net income from your freelancing business, you would want to set up an S-Corporation. This is because you would be able to greatly reduce self-employment tax by paying yourself a reasonable salary — which would be the only portion of your business income that needs to pay for “self-employment tax”. Now for many of you readers who are consistently earning significant income from your clients, you might save thousands of dollars from setting an s-corporation.

For example, with $70,000 in net business income:

These calculations are for illustrative purposes only in order to show you how two general scenarios differ on the surface. Always consult a tax professional about how changes might affect your particular tax situation.

As you can see, you would avoid over $4,500 in self-employment tax! If you want to leave your tax side of your business to an expert and interested in how to save more taxes, don’t hesitate to reach out at hello@soraban.com

If you are fairly new to self-employed world or prefer to outsource the tax & accounting side of freelancing, we are offering $25/month off for the first two months for the first 25 customers with the promo code of GRATIFY25.