The third business model option is to register as an S-Corp. An S-Corp is a corporation. It is stronger than an LLC. I can’t stress enough how important it is to consult with an attorney and an accountant to determine which business model option is the best for you as you get started.
To learn what is required to set up and maintain an S-Corp, be sure to find out your state’s rules and regulations. In most instances, more paperwork is required than for an LLC, but less than is required for a C-Corp – the fourth business model option.
The benefit of an S-Corp status is you can pay yourself a salary as if you are an employee of the business (meaning you must actively participate in the day-to-day activity of the S-Corp). However, this can take up quite a bit of time, and remember, time is money. If you are spending too much time creating invoices, managing payroll, taxes, etc., you may need help from a payroll company. When you move to using a payroll company, you typically go from a 1099 to a W2 status because the payroll company now files the IRS tax forms and creates the paystubs and W2 forms.
As an S-Corp, you need to be able to estimate the year end profit so you are also able to estimate your quarterly taxes throughout the year. This is really hard to determine when first starting out, and why so many choose to go the LLC route. In an S-Corp, the year-end profit, revenue minus expenses, is not subject to self-employment tax, such as that found in option 1 & 2. As the sole person in your business, your business is now paying the other half of Social Security and Medicare taxes. Remember in option 1 & 2, you pay the full FICA amount. When you file taxes now, you have two different forms you file. You will pay self-employment taxes, but now you can take the taxes your company paid on your behalf as a deduction because you are an employee. This leads to a lower overall profit. You can avoid several thousand dollars in taxes each year by not having to pay self-employment tax on that profit, although you are subject to the regular income tax rate.
Definitely something worth discussing with your attorney and accountant because, when first starting out, you may know what is reasonable, but you may not make that much money your first year or two, and the extra cost of the paperwork, tax filings, etc. may not justify choosing S-Corp from the start.
Ok. Hopefully your head is not spinning because we have the final and fourth business model option to go yet.
The fourth business model option is the C-Corp. As either a sole proprietor or in partner with others, a C-Corp is probably not the easiest option to begin with. The C-Corp requires significant investment in paperwork and adherence to regulations at both federal and state level. C-Corp does have many benefits that protect you like the LLC and S-Corp. The downside to the C-Corp, especially a small one, is that the profits are taxed at the corporate rate. So like in an S-Corp, you pay yourself a salary that you must pay taxes on, but you also must pay corporate rate taxes on any profit. An accountant or tax attorney will be able to guide you through what types of losses are deductible against what types of income.
Many people start as an LLC to get a feel for their business, in other words, what type of revenue they will bring in each year. And in some cases, to test the waters as to whether they want to be in business for themselves. If after several years, you see your business consistently growing revenue and you truly love owning your business, then you can always file certain forms with the IRS to elect to be taxed as an S-Corp. This is for you and your attorney and accountant to determine in time.
In conclusion, there are four business model options from which you can choose as a freelancer. You need to determine which is best for you in terms of limiting your personal liability and protecting your personal assets and how you envision the future of your company.
I hope this brief overview of business model options provided you useful information to have a productive conversation with an attorney and accountant about which option is best for you.
In Part 6, I will discuss the need for a website and portfolio prior to opening for business.