Learning to juggle multiple clients and turn a side hustle into a business is something of an art. But if you’re among the lucky ones who are really making money off of your passion, you might need to consider how to set up a business entity as a freelancer. That’s because you’ve probably outgrown your status as a sole proprietor.
Figuring out how to set up a business entity as a freelancer to be either a limited liability company (LLC) or corporation is a great way to take your freelance business to the next level—and enjoy other advantages, too. As registered business entities, LLCs and corporations offer you more legal protection and certain tax benefits. Outside investors, small business lenders, suppliers, employees, and customers also tend to take a company more seriously when it’s a registered business entity.
How do you know if you’ve crossed the threshold and it’s time to set up a business entity for your freelance work? Here are six signs that other small business owners saw that helped them know it was the right time to set up a business entity. Then, follow our guide on how to set up a business entity as a freelancer in just a few steps.
Differences Among Business Entities: A Crash Course
There are four main ways that you can structure a business entity: sole proprietorship, partnership, LLC, or corporation. Out of these options, most freelancers start out as sole proprietors, since that’s the default mode of business ownership. If you go into business on your own and don’t register with the state, you’re automatically a sole proprietor.
Sole Proprietorships and Partnerships
As a sole proprietor, you and the business are basically the same—from a legal and tax standpoint, that is. The business’s profits and losses pass through to the owner’s personal tax returns, and the government taxes them at the owner’s personal income tax rate.
But things can get bad if someone sues your sole proprietorship and wins. Since there’s no separation between you and the business, you don’t have legal separation, either. And that means that the claimant could take your personal assets (like your car, personal bank accounts, possibly even your home) to recover the judgment. A partnership with multiple owners works in much the same way.
LLCs, S-Corps, and C-Corps
If that makes you nervous, organizing your business as a registered business entity—an LLC, C-corporation, or S-corporation—allows you to protect your personal assets. Even if you’re the only owner of the business and have no employees, you can set up a single-member LLC or a single-person corporation.
LLCs and corporations are separate legal entities and offer limited liability. (Hence, limited liability corporation… makes sense?) This means that if someone sues your business, they are limited to collecting on the judgment from the business’s assets—your personal assets are safe.
It’s also important to note that LLCs and corporations are taxed in different ways, which we’ll get into a bit more later. For now, what you need to know is that corporations and LLCs guard your personal assets, and sole proprietorships and partnerships don’t.
→Too Long; Didn’t Read (TL;DR): Registered business entities—LLCs, S-corps, and C-corps—offer more legal protection than sole proprietorships and partnerships. If someone sues a registered business entity and wins, they can only take the business’s assets, not your personal assets.
Signs You Should Set Up a Business Entity as a Freelancer
Freelancers set up business entities for a variety of reasons. Sometimes, a business loan lender or an investor you’re trying to raise money from might require you to set up a corporation or LLC. Other times, the drive might be more internal if, for instance, you want to learn how to set up a business entity as a freelancer to make your business more attractive to prospective clients. You also might be looking for more desirable legal protection.
These are some of the situations that should prompt you to consider learning how to set up a business entity as a freelancer:
1. You start generating more income.
You might have started out with a passion project, hobby, or side hustle. In the beginning, you have just a client or two, and this income might just supplement what you make from your day job. In those situations, a sole proprietorship is probably fine.
But then, you start generating more income as a freelancer—and poof! All of a sudden, before you know it, you have a full-blown business that’s your primary source of income.
When your hobby becomes your livelihood, it’s time to think about setting up a business entity as a freelancer so you get more legal protections. No matter what industry you’re in, there’s always a risk that an unhappy client, vendor, employee, or other party could sue you. A registered business entity can save you from financial ruin if this happens.
This is what motivated Ky Trang Ho, public relations consultant and founder of Key Financial Media LLC, to form her limited liability company. “After freelancing for less than a year,” she says, “I decided to get an LLC to protect my assets should—heaven forbid—I get sued. I was emotionally scared after being named in a lawsuit. I saw how often people sue frivolously, or they think the plaintiff has deep pockets. Getting an LLC protects my personal assets.”
Part of making this happen is also making certain that your business and personal finances are separate, too. For that, you’ll absolutely need a business bank account as a freelancer. If you don’t have one, you can open a business checking account and save yourself a few steps. If you don’t separate your finances, you won’t get the legal protections afforded by setting up an LLC or a corporation.
2. You need a business loan or are trying to raise money from investors.
As your freelance business grows, there’s a good chance you’ll find yourself in need of a small business loan at some point. Lenders and investors prefer working with corporations and LLCs because they’re less likely to default on loans, and corporations generally have higher success rates compared to sole proprietorships and partnerships. Sole proprietorships have fewer legal protections and are therefore more likely to fold if they lose a client or have a bad year.
And you’ll want to apply for any small business loan with the business profile that presents the lender with the lowest picture of risk. That’s why this could be a good time to consider shifting away from your sole prop or partnership status, and figuring out how to set up a business entity as a freelancer.
3. You want to partner with larger companies.
For the same reasons that banks and investors prefer to work with registered businesses, so do larger companies. If you’re hoping to land a major client or become a supplier to companies like Walmart, Target, or Home Depot, be aware that they prefer to work with corporations and LLCs. The risk that your business will fold and interrupt their supply of goods is significantly lower when you have the legal protections that come with being a registered business entity. And these companies definitely know that.
Comedian Dan Nainan organized his business as a corporation for this reason. As a producer who works with famous comedians, Nainan found that “When booking venues such as the Apollo Theater, they needed to deal with a corporation, so I had no choice but to form one.”
4. You want to hire aggressively.
If you’re looking to add employees to your business, you should be thinking about how to set up a business entity as a freelancer. Again, this all goes back to liability.
If an employee gets injured on the job and sues you, they can recover the money out of your personal assets (like your home, car, and personal bank accounts) if you’re a sole proprietorship. With a corporation or LLC, the employee can only seek recovery from the company’s assets.
5. You want to issue stock.
Issuing stock can be a great way to raise money for product development, expansion, hiring, marketing, and more. You don’t have to be Google or Facebook to issue stock. Even small businesses can sell stock. If this is something you want to do right now or in the near future, you’ll need to convert to a C-corp or S-corp. Those are the only entities that can issue stock.
6. You want to enjoy certain tax benefits.
Last but not least among the reasons to form a business entity—the tax advantages. The Tax Cuts and Jobs Act—which you might also known as the Trump tax plan—has brought significant changes to business taxation.
Long story short, Congress has tried to level the playing field by cutting corporate taxes for C-corps, and giving pass-through entities like S-corps, LLCs, and sole proprietorships a large deduction.
But there’s still some variation in tax treatment among the different types of business entities. As a sole proprietorship, you must pay self-employment taxes (Social Security and Medicare taxes) on all of the business’s income (up to a limit, which changes annually). With a corporation, you don’t have to pay self-employment taxes on distributions (or dividends) from the business. You only have to pay these taxes on the salary that you pay yourself. If you organize as an LLC, you can choose to have it taxed as a corporation so you can get the same advantage.
These tax advantages are what led Kali Hawlk, owner and financial writer at Going Beyond Wealth, to create a business entity. Hawlk said she “was actually able to save money on taxes and pay less by filing as an LLC. An LLC also gives me the flexibility in the future to file in a way that’s most tax efficient should tax laws continue to change (or as interpretations of the new tax laws become clearer).”
→TL;DR: Learning how to set up a business entity as a freelancer can give you more legal protections and get customers to take you more seriously. Or you might have to make the switch to get a business loan, raise money, sell stock, or enjoy certain tax benefits.
How to Set Up a Business Entity as Freelancer: Step-by-Step Instructions
Now that you know when to set up your business entity as a freelancer, time to actually get it done. Most people think that setting up an LLC or corporation is just about filing a form or two with the state. But there’s more to it than that. Setting up a business entity as a freelancer starts with form filing. There are other things you need to do to maintain your business entity and protect yourself legally, too.
Here’s what goes into forming a business entity as a freelancer:
Step 1: Draft and file formation paperwork.
The first step to setting up a business entity is drafting formation papers. For freelance LLCs, the main document is the Articles of Organization, and for corporations, it’s the Articles of Incorporation. These documents contain basic business information, such as the company name, address, formation date, and the purpose of the company.
Your state’s secretary of state office should be able to give you a copy of these documents. Alternatively, online legal companies like IncFile and LegalZoom have fill-in-the-blank forms. Their form wizards will walk you through each section of the form. Once you’re done, they will file the documents for you with your secretary of state’s office—usually for a fee of $50 to $150.
The state will assess its own filing fee, which typically varies somewhere between $100 and $500 depending on which state you’re registering in. After processing the forms, your state will send you a certificate confirming that your business entity officially exists.
Filing your formation papers is fairly straightforward, particularly if you get online legal help. However, if you face complications along the way or just want the peace of mind, you can always hire a business lawyer to help you.
Step 2: Get an Employer Identification Number.
An Employer Identification Number (EIN)—also known as a Business Tax ID—is a unique nine-digit number that the IRS uses to track your business for tax purposes. All corporations must have an EIN. Single-member LLCs don’t need an EIN (unless they want to be taxed as a corp), but if you have employees or plan to hire soon, you’ll need an EIN.
Even if you don’t need to get an EIN, you should consider getting one because it lowers your personal risk as a freelancer. Without an EIN, you might need to provide clients or suppliers with your personal SSN, putting you at risk for identity theft.
It’s free to apply for an EIN on the IRS’s website and takes less than 10 minutes. Steer clear of online legal services that charge a fee to get an EIN on your behalf. They’ll ask you for the same information that you’ll have to provide to the IRS anyway.
Step 3: Open a business bank account.
Like we mentioned above, having a separate bank account for business transactions is a necessity for all business owners, but it’s particularly important if you have an LLC or corporation. In fact, if you don’t have a distinct business bank account, you might involuntarily be exposing yourself to personal liability if someone sues you.
Using a business bank account also makes you look like a more committed small business owner. Put yourself in the shoes of an employee or customer—would you rather have your salary or payment come from the official company account or the owner’s personal checking account?
Plus, a separate business bank account makes payroll, bookkeeping, and tax filing easy since you don’t have to go through every transaction and determine if it was business-related.
Step 4: Purchase business insurance.
As we’ve already mentioned, registering as a business entity comes with additional legal protections that you don’t have as a sole proprietor. However, you can get an added layer of protection by purchasing business insurance. Business insurance can protect your company from losses due to fire, earthquakes, flooding, theft, data breaches, or terrorism.
Most small business owners just need a comprehensive general liability insurance policy, which an insurance agent can help you with. Many states also mandate businesses with employees to purchase workers compensation insurance.
Step 5: Make your first tax payments.
Small business owners aren’t subject to ordinary tax withholding like regular employees. If you’ve been freelancing for a while, you’re probably already aware of this. The IRS considers all business owners self-employed, and you have to pay quarterly self-employment taxes and income taxes.
Every quarter, you pay estimated federal taxes, and when you file your tax return in the spring, you either pay an additional amount or receive a refund if your business’s actual income varied from your estimates.
State tax rules and deadlines vary, so make sure you consult your state tax authority and mark your calendar because late tax payments come with fines and penalties!
Step 6: Follow state laws to maintain business entity status.
When you decide to set up a business entity as a freelancer, your state’s secretary of state office is your main point of contact. They can provide guidance on the rules and regulations that apply in your state to maintain your status as a business entity.
For instance, almost all states require corporations to draft bylaws, hold board and shareholder meetings, and keep records of meeting minutes and resolutions. Some states also require LLCs to hold formal meetings and keep notes. Make sure you understand what’s required or recommended in your state and follow through so you can maintain your status as a business entity.
If you register your business entity in a state other than where you’re doing business, you’ll have to follow laws and pay taxes in both states. For this reason, most freelancers find it easiest to create an LLC or corporation in the state where they live or conduct the most business.
→TL;DR: Forming a business entity starts with filing formation paperwork with the state. Then, you have to take steps to maintain your corporation or LLC, such as opening a business bank account and purchasing business insurance.
How to Set Up a Business Entity as a Freelancer When You’re Ready
Many freelancers outgrow their time as sole proprietors and look to create a corporation or LLC. Now you have the tools to know if your time has come, and how to set up a business entity as a freelancer when you need to.
- Think about registering a business entity when you start generating more income or if a lender, investor, or client prefers working with a business entity.
- There are also big freelancer legal protections afforded to LLCs and corporations—and you might even want these before the freelance business is your main source of income.
- Business entity formation starts with filing paperwork with the state, but doesn’t end there.
- You need to take other steps to maintain your LLC or corporation, such as opening a business bank account and obtaining business insurance.
When you’re finishing establishing your business entity, don’t forget to take a moment to celebrate. This is a big milestone for your business, and fortunately, something you can accomplish fairly easily with this how-to guide.
- Money.USNews.com. “Turning Your Small Business into a Corporation“
- Entrepreneur.com. “How to Sell Shares Without Going Public“
- Forbes.com. “Freelancers, Here’s How to Protect Your Personal Assets from Liability“
- Bench.co. “When Are Taxes Due? 2020 Filing & Extension Deadlines“
Priyanka Prakash, JD
Priyanka Prakash is a senior contributing writer at Fundera.
Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.