Freelancer Tips

Sole Proprietorship vs. LLC: Which is Best for Freelancers?

By
Fiverr Team
|
February 23, 2022
freelancers

When you first launch your freelancing career, it’s common to spend all your time looking for work and focusing on your deliverables. However, as your business starts to grow, you’ll have some important decisions to make. This includes deciding whether you’ll put the effort into forming a limited liability corporation (LLC) or if it's best to operate as a sole proprietor.

Both are valid options that come with perks, like being able to take deductions for your home office and other business expenses. They also each have a few potential drawbacks. The following guide will tell you everything you need to know so you can decide which business structure is best for you.  

Do Freelancers Need to Register as a Business Entity?

If you’re doing freelance work for pay, you’re already operating a business – even if you haven’t done anything to officially register it. When you file your taxes, the Internal Revenue Service (IRS) will deem your business a sole proprietorship by default. However, this may or may not be the best choice for you.

Your business structure can impact everything from how you pay your taxes to your personal risk. This makes it important to fully understand your options and make an intentional decision.

What Is a Sole Proprietorship?

A sole proprietorship is essentially the term given to a single person operating a business. For tax purposes, it's considered a “pass-through” entity. This means that when you earn income from doing freelance work, you’ll simply report it on your personal tax return by completing a Schedule C form, then transferring the results over to your 1040 or 1040 EZ.  

While filing taxes as a sole proprietor is quite simple, there are some additional steps you’ll need to take. For example, it’s important to carefully track your business income and expenses or hire a bookkeeper to do it for you. This is common practice for any successful business, and you’ll need this information to complete your Schedule C. Sole proprietors are also required to pay both self-employment tax and quarterly estimated taxes. If you fail to do so, you'll end up in hot water with the IRS.

Top Benefits of Sole Proprietorship for Freelancers

One of the primary reasons sole proprietorships are so popular is that they’re simple and require virtually no effort. Generally, there are no special forms you’ll need to file, and tax reporting is very easy.

In many cases, you may not even need to officially register your business. If you want to give your business a name for marketing reasons, you can simply file a “doing business as” (DBA) form with the state.

Sole Proprietorship Drawbacks to Consider

Since sole proprietorships are the easiest business structure to set up and maintain, it's a common choice for freelancers. However, there are some potential drawbacks to consider.

Financing Challenges

It can be difficult to secure financing for your business when you're operating as a sole proprietor. Lenders often see sole proprietorships as less credible than other types of business structures, so they may be reluctant to approve loan requests. This structure also makes it difficult to work with investors and doesn’t give you any other mechanism for raising capital.

Lack of Personal Protection

Since a sole proprietorship is tied to you as an individual, there’s no legal or financial separation between you and your business. If you are able to borrow money for your business, you’ll also have to personally guarantee the loan. This means that if your business fails, you’ll be personally liable for paying back what you borrowed. This could result in the loss of your personal savings, real estate, and other assets.

If you get sued for creating content that is considered defamatory, causing a security breach, or any other action that creates a loss for your client, you could lose everything you own trying to satisfy your business liabilities.

What Is an LLC?

Freelancers who are looking for extra protection often incorporate by filing as a single-member LLC. This structure allows you to continue operating your business as a solo entrepreneur while also enjoying the legal advantages of a corporation.

The LLC structure typically requires far less paperwork and fewer ongoing requirements than a traditional “C corporation,” making it a feasible option for freelancers regardless of the size of your business.

Top Benefits of LLCs for Freelancers

Registering your business as an LLC allows you to separate your business and personal assets. If a situation arises where you’re sued for something you’ve done in your business, you won’t have to worry about putting your personal assets on the line.

In addition, the structure of an LLC also allows you to add partners to your business. This can give you more flexibility when it comes to raising funds and/or growing your company. While many freelancers begin by forming a single-member LLC, it’s nice to know you have the flexibility to make changes in the future.

LLCs also offer some tax benefits. This is a “pass-through” entity, which allows you to report the income on your personal tax return rather than having to file a separate corporate tax return. For tax purposes, single-member LLCs are treated the same as a sole proprietorship, while multiple-member LLCs are treated as a partnership.

LLC Drawbacks to Consider

While an LLC offers significant protection for business owners, it’s not without at least a few potential drawbacks. Here’s a look at some of the most common concerns.

Initial Filing Requirements

To register as an LLC, you’ll need to file articles of incorporation with your state. This will cost you at least a bit of time and money. To get set up, you’ll need to draft your articles of incorporation, file them with the appropriate agency, and pay your filing fee. Depending on your state, this can cost anywhere from $50 to $500, in addition to the money you may pay an expert to help you through the process.

Ongoing Maintenance

There are also ongoing requirements to keep up your corporate status. Many states require you to complete an annual filing and pay a fee each year. This can cost anywhere from $15 to over $250, depending on the state where your LLC is registered. It’s important to take note of the required filing frequency and deadlines, so you don’t end up having to pay excessive fees or risk losing your LLC status.

Weigh the Pros and Cons. Then Choose the Best Option for Your Business.

When choosing the best structure for your freelancing business, there are many factors to consider.

First, think about whether you’re serious about your freelancing business. If you’re not sure whether you want to take it from hobby status to business status, then establishing an LLC is likely not worth the cost or effort.

On the other hand, if you’re thinking about taking your business to the next level, it may be a good idea to set up your LLC now. When you become a successful freelancer, the public attention can make you more susceptible to liability. By being proactive with your business structure, you can use an LLC to protect your personal assets from the beginning. This is particularly true if you have a lot to lose by failing to do so.

Still not quite sure which is the best option for you? This is totally normal! It often takes some time for freelancers to get a solid grasp on how how much you’ll earn and the amount of liability you’ll face. It’s also normal for freelancing businesses to fluctuate, so what’s right for you today may not be appropriate a few years from now.

The good news is, you can always change your mind. If you find that your freelancing business is going better than you expected, or it doesn’t quite turn out as you planned, you can simply file the necessary paperwork to create or dissolve your LLC.

Pulling It All Together - The Bottom Line

As with all tax, legal, and financial issues, it’s best to consult with an expert before making any major decisions. A qualified business consultant can help you analyze your current and projected income and evaluate your business risks. Then, you can take this information to a legal and/or tax expert who can help you make the best choice and show you how to file all of the necessary paperwork.

While this may seem like a huge task, you’ll likely find that it’s not as intimidating as you initially thought. Taking the time to set things up correctly will give you peace of mind and position you for business growth – and that’s something that's well worth the effort.

Fiverr Team
Whether you’re scaling up your small business or building a brand from scratch, we’ve got the resources you need to keep you informed and at the top of your game.
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