I'm a freelancer. Should I change my business entity?

The U.S. is home to 76.4 million freelancers, a number that has been steadily increasing every year since 2017. By 2028, some estimates predict the freelance population to grow to 90 million. 

Many of these freelancers start out as sole proprietorships, which is the default business structure. 

“It’s a good place to start for a lot of people,” said Lawrence Sprung, a certified financial planner and wealth adviser. “Depending on what the business is, you may need to progress from there at a later date.”

Moving from a sole prop to another business structure could offer perks, like the opportunity to add partners, reduce your personal liability and even lower your tax bill. Which is right for you? 

Choosing between business entities 

A business entity is the legal structure you choose for your business. This decision affects how you can raise capital for your business, how much you pay in taxes, the paperwork you need to file and your personal liability. When choosing your structure, look at the benefits and drawbacks of each type.

Sole Proprietorship

Best for: A hobby or side business with one owner

A sole proprietorship is a business that’s owned and run by a single person. This is the default business structure — so if you don’t set up a separate LLC or corporation, you’ll automatically operate as a sole proprietor. This entity type is easy to set up and shut down, and you get complete control over the company. 

All income flows through the business to the owner, who reports profits and losses on their personal tax return. That income is only taxed once — a clear advantage over the C corp structure, where corporate profits are taxed once as an entity and then again individually for each shareholder. 

But sole proprietors have to pay both parts of the self-employment tax on all income, whereas S corps can get a break here. You also take on more risk because there’s no legal separation between the owner and the business. Plus, you may have trouble qualifying for business loans, since banks often want to see a formal business structure.  

For all these reasons, sole props are best for less-complicated businesses that are just starting out. “For example, you’re getting revenue from a side gig, and it doesn’t make sense at this point to form a company because there’s not a lot of meat there yet,” Sprung said.

Once you're sure the business will take off, Sprung added, it's typically best to switch over to an LLC or corporation. 

Partnership

Best for: A hobby or side business with more than one owner

A partnership is the default structure for businesses that have more than one owner. So when setting up your business, consider whether it’s the right choice. 

A partnership can help relieve some of the pressures and expenses of being in business by yourself. You also get to share knowledge and divide work based on each partner’s skill set, and the business is easy to set up and shut down. 

But partners take on their own set of challenges, like figuring out how to split profits and resolve internal conflicts. And partners take on more risk compared to LLCs and corporations because each owner is personally liable for all of the partnership’s debts and lawsuits.

Like a sole prop, a partnership is considered a pass-through entity for tax purposes. The business income and losses are passed to the partners and reported on their individual federal tax returns. Those profits are taxed only once, offering an advantage over C corporations.

Limited Liability Company (LLC)

Best for: Companies that want to avoid personal liability and choose their tax treatment

A limited liability company, or LLC, has become a popular legal entity because it combines the limited liability of corporations with the flexibility and tax characteristics of sole proprietorships or partnerships. 

When you form an LLC, the business becomes a separate legal entity (reducing your risk in the process) and owns the business assets.

LLCs also provide more options when it comes to tax treatment. You can choose to be taxed like a sole prop, partnership, C corp or S corp, which means you can be an employee of your business. 

S Corp

Best for: LLC owners who earn enough to pay themselves a salary

An S corp is a type of corporation that’s considered a “pass-through” entity, where profits and some losses flow through to the owners. Avoiding the double-taxation drawback of regular C corps is a major benefit to S corp shareholders. 

Another perk of running an S corp: “Freelancers who are making enough money to pay themselves a ‘reasonable salary’ can avoid paying self-employment/FICA taxes on any additional profits,” said M. Zane Johnson, the founder of MZA Legal, a virtual law firm that specializes in business formation. “This can result in hundreds or thousands of dollars in tax savings.”

If you’re already set up as an LLC, you don’t even have to change business entities to be taxed as an S corp. Instead, you can simply fill out a form with the IRS, which is a much simpler process.

Tips for making the switch

If you’re thinking of changing your business structure, Sprung recommends talking with tax and legal professionals or a financial adviser who has experience with both ends of the equation. They should run an analysis based on last year’s business tax return and discuss the pros and cons of each entity type.

“This will help you see if there are tax savings or legal benefits from making that shift,” Sprung said. “If in the end, you don’t need the protection and there are no tax benefits, you might be better off staying where you are.”

But if you decide to move forward with the switch, here’s a quick overview of what you may need to do:

• Register your business with the state.
• File the appropriate paperwork, such as a formal operating agreement or partnership agreement.
• File a DBA (Doing Business As) form if needed.
• Apply for a new employer identification number (EIN).
• Inform your bank, credit card issuer, vendors, insurance company, and customers of the change.
• Reapply for business licenses and permits if needed.
• Contact your insurance provider to discuss the change and potentially adjust your coverage.
• Create or update your partnership/stock agreement.
• Transfer assets and liabilities to the new business entity. 
• End the former business entity if needed.