Should You Start an LLC as a Freelancer? Not Necessarily.

What is an LLC?

LLC stands for "limited liability company". It's a business structure that lets you separate your business assets from your personal assets, protecting them from lawsuits and business debts. 

If someone sues your LLC, your personal assets aren't on the line. Your business's creditors can't go after them, either. This sort of legal separation can be helpful if, for instance, you're freelancing on the side of a day job and don't want to run afoul of a non-compete clause.

How much will an LLC cost me?

Expect to hand over between $40 and $500.

LLCs are formed at the state level, so your actual setup costs will vary — as will the amount of paperwork you'll have to do.

This generally won't be a one-and-done fee, either. In a lot of states, LLCs come with recurring annual expenses, like franchise taxes and reporting fees.

How LLCs compare to other business structures

In the world of business structures, LLCs fall into an interesting niche: they offer more legal protection than a sole proprietorship and more flexibility than business structures like corporations.

Here's how LLCs compare to the two other options for running your freelancing business.

LLC vs. sole proprietorship

As mentioned above, the biggest benefit of the LLC isn't tax-based, it's legal. When you form an LLC, you establish a new separate legal entity. This separation is what provides you with asset and liability protection.

If you own an LLC, you'd only risk the amount of money you have invested in your business. Personal assets  — your house and car, for instance — are safe. (You'll still be liable for the debts that you've personally guaranteed, though.)

If you’re doing business as a sole proprietorship, on the other hand, you don't have that corporate shield to protect your personal assets. With no legal protections or separate business finances, your home and car would be on the line if your business is sued, or if its creditors come knocking.

Setting up a separate entity for your business comes with other benefits. You can apply for an Employer Tax ID (EIN), which you'll be able to use instead of your Social Security Number when you send Form W-9 to vendors.

You can also set up a business bank account. This allows you to keep your business income and expenses separate from your personal finances, which some freelancers find helpful for bookkeeping.

LLC vs corporation

An LLC isn't the only way to form a business entity. The other option for doing that is a corporation. 

Like LLC owners, the owners of a corporation aren't personally liable for business obligations. But the corporation structure offers less flexibility than an LLC, and comes with more compliance requirements. 

At the end of the day, corporations are more suited to business owners who plan on seeking outside investors. For freelancers who simply want to avoid liability for their business's legal and financial obligations, an LLC makes more sense.

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How LLC taxation works

An LLC limits your legal liability. But it won't automatically limit your tax liability.

Say you run an LLC by yourself, making it a single-member LLC. For tax purposes, the IRS will treat it just like a sole proprietorship by default. That means you'll still receive a 1099 and have to deal with self-employment tax.

If you have a partnership LLC — meaning, it's run with someone else — you'll also have to deal with self-employment tax by default. Members of the LLC will each report income and losses from their share of it on their personal tax returns.

That said, LLC taxation is complicated. That's because they don't have their own tax rate classification. Instead of being taxed as either a sole proprietorship (for single-member LLCs) or a partnership (for multi-member LLCs), you can choose to have your LLC taxed as a corporation. In that case, your options are C corporation taxation and S corporation taxation.

When an LLC is taxed as a C corporation

C corporations pay corporate income tax on their net income. Meanwhile, its shareholders pay income taxes on the dividends that they receive. This is called “double taxation.”

Double taxation means C corp taxation isn't a financially sound option for most LLCs. For that reason, it's a pretty uncommon choice.

One pro to C corp taxation is that C corp owners aren't limited in how much they can deduct for benefits like health insurance, retirement plans, and life insurance for their employees. But this isn't likely to be relevant to many freelancers.

When an LLC is taxed as an S corporation

S corporations are favored by small businesses. Unlike C corporations, they aren't subject to double taxation. Instead, their profits pass through to the individual shareholders' income tax returns. That means the shareholders are just taxed just once, on their personal income taxes. 

The lack of double taxation makes the S corp an attractive option when it comes to corporate taxation for LLCs. However, there are certain conditions your LLC has to meet to be treated as an S corp for tax purposes. First, it needs to have 100 or fewer shareholders. Next, none of those shareholders can be corporations, partnerships, or non-resident aliens.

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How an LLC taxed as an S corp can help high-earning freelancers save

Choosing S corp taxation can result in tax savings for freelancers who earn a lot through their businesses. To make this worthwhile, you'd have to make enough to pay yourself a fair salary and have something left over.

With an LLC taxed as an S corp, you only have to pay self-employment tax on the "salary" portion of your income. The rest can be paid to you as a distribution of profit, and it won't be subject to that 15.3%.

Keep in mind: The IRS expects you to give yourself "reasonable compensation." You can't pay yourself a $1,000 salary and call the rest a distribution of profit.

This approach isn't cost-free. If you pay yourself a salary through your S corp, you'll have to withhold income and pay payroll taxes on a monthly or quarterly basis. That comes with service fees, and there are also the S corp tax return fees. 

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Does it make sense to choose S corp taxation?

Most people start thinking about switching to an S-corporation when their net income — that is, minus your business expenses — starts to exceed $30,000. S corp taxation will save you about $2,000 in self-employment taxes with a net income of $30,000 — and about $3,000 with a net income of $40,000.

That said, if your payroll tax services fee is $100 per month — making it $1,200 for the year — and your S corporate tax return fee is $800, your extra costs from switching to an S corp will amount to $2,000. That could very well cancel out your savings from self-employment tax.

At the end of the day, it's all about weighing the costs of S corp taxation against the benefits of avoiding self-employment tax. It's least likely to make sense if all your 1099 income comes from a side hustle, for instance. On the other hand, the higher your freelancing earnings, the more likely it is to be worth it.

FAQ

What is the downside of starting an LLC?

While LLCs do have benefits, there are substantial downsides to starting one, too — especially if you’re a sole proprietor. These include:

• The cost — you should expect to hand over between $50 and $500
• The paperwork — it’s extensive

Does an LLC have its own credit score?

Yes, an LLC has a separate credit score. If you’re a sole proprietor who then creates an LLC, your LLC’s credit score will be different from your personal credit score. Instead of being tied to your Social Security number, it’ll be tied to your business’s EIN (employer identification number).

What does LLC stand for?

LLC stands for “limited liability company.” It's a business structure that lets you separate your business assets from your personal assets, protecting them from lawsuits and business debts.