Which Business Entity is Best for Freelancers:Sole Proprietorship, LLC, or Corporation?

Moderated by Raymond Lee, Founder, UXr Guild
This is an abridgment; view the full video presentation here.

In this “How to Freelance” session, UXr Guild Founder Raymond Lee dives into how to select and establish your business entity, as well as tax strategies, contracts, and collections.

What is an Entity?

An entity is something separate and apart from you; an organization that has legal rights and is created in order to conduct business. 

Does a Freelancer Need a Business Entity?

A natural first question is whether you really need to create an entity as a UXr freelancer. If so, which entity should you choose and when is the best time to create it?

To answer the first of these questions, it’s important to consider the following benefits that an entity can afford you:

• Protection from liability. Whatever goes wrong in your business can cross over into your personal life, taking assets to rectify the problem or compensate those harmed. This can include your home, savings, and cars. Most people are very interested in protecting their personal assets from business liabilities.
• Tax advantages. 
• Elevate the professionalism of your business. 

Ideally, an entity is inexpensive and easy to set up and maintain. Consider the following:

• Will you need to hire a lawyer to help you create your entity?
• What are the maintenance requirements and annual fees to keep it current?

What Business Entities Can a Freelancer Use?

Sole Proprietorship. With a sole proprietorship, you are choosing not to create an entity. You don’t have an entity apart from yourself. What are the aspects of this option?

• You are doing business as yourself.
• You can operate in your own name or a DBA (doing business as another name of your choosing). 
• If you use a DBA, you must file a fictitious business name statement (usually within your county), which notifies the public that you are doing business in that name.

This is the simplest way to conduct business and it is the way most freelancers start. Many researchers start this way and wait to see if they are successful. They create a separate entity only when business volume and conditions warrant. 

Corporation. Creating a corporation is a more complex and formal option. Here are some of the reasons why:

• Corporations are governed by laws that differ from state to state, or province to province in Canada. 
• They generally have a board of directors, the size of which you can determine, 
• Corporations have regularly scheduled meetings, where minutes of actions and assignments are kept
• Bylaws are created to determine how the corporation will operate. 
• The Board must ratify important decisions: such as borrowing money, going public, acquisitions, layoffs, etc.

Publicly traded companies need a robust system of governance. As an individual freelancer, you probably don’t need all of that structure and governance. it is generally more formal and complex than a solo researcher requires. A corporation, with its Board of Directors, has many benefits, one of which is shielding your personal assets from business liabilities. But if a corporation doesn’t hold regular board meetings and maintain accurate records, the validity of the organization, as well as its liability protection, can be challenged.

That being said, in Canada, this is the only entity available to freelancers. Here in the United States, however, there is another option available. 

LLC. This stands for “Limited Liability Company” and is an appealing alternative to Sole Proprietorships and Corporations.

• An LLC offers liability protection like a corporation but is less work. 
• There is no board of directors, meetings, minutes, or bylaws to be concerned with. 
• While LLCs can have many people, even up to 100 individuals, a single-member LLC is very simple and does not require an operating agreement.
• It is a low-cost alternative that is easy to set up by yourself without the need for an attorney. There may be annual maintenance fees, but these will be considerably less than with corporations. 

With all this in mind, when is the right time for a Sole Proprietor to set up an LLC? You could set one up at the beginning, but most independent contractors wait until their business grows before creating a separate entity. It makes sense to match the entity with your business growth.

What Are Liabilities for Freelance UX Researchers?

If you are protecting yourself against liability by establishing an entity, how risky is freelancing as a UX researcher? It is extremely low risk compared to other businesses. The chance of being sued is extremely small. Nevertheless, there are still some exposures that should be considered.

The first is if you’re freelancing on the side, and have an employment agreement that prohibits it, your employer could sue you for violating your non-compete. In this situation, the damages are likely to be small. Generally, the employer will just want you to stop freelancing, however, it could also result in termination.

A second scenario is being accused of violating a non-disclosure agreement where you’ve posted a case study online. Once again, your employer will probably just ask you to take it down, although there might be some other repercussions, including termination.

A final consideration involves proprietary research and participant data that you collect or have access to as a researcher. If, for instance, your laptop is stolen, such data could fall into the wrong hands. This is an area where you need to take real precautions because it’s likely your biggest exposure.

Which Business Entity Saves Taxes for Freelancers?

With a sole proprietorship, you don’t file a separate tax return because there’s no other entity to file a return, it’s just you. For your federal taxes in the U.S., you file a form 1040 and a Schedule C, which is where you put your profit and loss from your business. It’s very simple; you don’t have to have a second tax return. (In Canada, you would use a T1 General plus a T2125, a Statement of Business or Professional Activities). Whether in the U.S. or Canada, you can still write off many business expenses, such as traveling to a conference, buying supplies, or spending money on marketing. Writing off a home office and healthcare premiums are some of the trickiest, so it’s best to consult a CPA to know whether these are allowable in your situation.

With a corporation or LLC, you can be taxed twice, once at the company level and again as an individual, and generally, the company will require a separate tax return. If you want to avoid double taxation (and who doesn’t?), you can make an s-corp election, which allows the income to flow to the corporate shareholders or LLC members without taxation at the company level.  Hiring a CPA to do these returns is a typical expense of freelancing, as are any required annual renewals and fees. If there’s not an offsetting benefit to creating the entity, you probably don’t want to do it or you may want to wait until the benefits exceed the expenses. 

A very attractive option is called a single-member LLC. These are considered disregarded entities by the IRS, meaning they know that you are operating as a sole proprietor, so there is no need to file a separate tax return. You do of course need to keep separate books and know what your business income and expenses are, but those can be listed on a Schedule C of your individual 1040. Avoiding a second tax return can save you $500 or more per year and the taxes may be simple enough to do yourself.

Do Freelancers Pay Self-Employment Tax?

As an employee, you pay 7.65% of your wages in FICA tax which includes Social Security and Medicare. Your employer pays the other 7.65%, for a total of 15.3%. If you are a sole proprietor (freelancer or independent contractor), you are required to pay self-employment tax of 15.3% on your earnings. Because there is no employer, you pay both halves. If you set up an LLC, you can define some of the income as wages, and some as income for the LLC, therefore reducing the amount on which you pay self-employment tax (because it is only paid on wages). 

Here is a sample of what that breakdown might look like under these various entities:

Freelancers Can Save Taxes with an LLC

As an employee, if you earn $150,000 in wages you would pay $11,475 in FICA tax and the employer would pay $11,475.

As a Sole Proprietor, earning $150,000, you would pay self-employment tax of $22,950.

With the same income as an LLC, you could pay yourself $75,000 in wages, and pay $11,475 in self-employment tax. The remaining $75,000 could be income to the LLC, which does not incur self-employment tax, saving you $11,475. The same strategy can be followed with a corporation.

If you have a full-time job and are freelancing on the side making less than $25,000 a year, it may not be worth going to all this trouble to save less than $2,000 in taxes. So, your choice of entity and tax strategy depends on the size of your freelance business. 

Which Entity is Best for Freelancers?

To answer this question, you first need to determine your freelancing status.

• If you are freelancing part-time: a sole proprietorship may be your best option until you have enough income to warrant tax savings and need liability protection.
• If you are freelancing full-time, consider creating an LLC when your income level reaches $50,000 per year. You may also need an LLC to prove that you are an independent contractor, not an employee, in which case you may need to set it up earlier.
• If you are freelancing in Canada, you will need a Federal Business Number from the Canadian Revenue Agency at $30,000 in freelancing income to pay GST/HST, but a sole proprietorship can obtain one. LLCs do not exist in Canada, so the only option beyond a sole proprietorship is a corporation.

Do Freelancers Need Insurance?

Because the risks are relatively low as a freelancer, you may not need it. However, be advised that larger clients may require you to have it. They limit their liability by requiring you to carry insurance for data protection, for example. Liability insurance sometimes referred to as general liability, or professional liability which includes errors and omissions, are the most common policies. The premiums are relatively inexpensive since research is low risk.

Do Freelancers Need a Contract?

A signed contract or agreement is an important part of any freelance engagement. Big companies can be slow to approve contracts and the process can take weeks. With startups or smaller companies, the process can be much quicker. It is generally not advisable to begin working without a contract in place. 

The two most a Fee for Services Agreement (hourly) or a Master Services Agreement (fixed-bid or hourly). 

In a Fee for Services Agreement, you will summarize your hours and bill on a regular basis. The most common frequency is once a month, but billing more often, either weekly or every two weeks is advisable. This agreement may include the following:

• Type of work contemplated
• Roles of the parties
• Terms for billing and payment (such as hourly rate, billing and payment frequencies).
• Hours not disputed within 30 days are approved
• Attorney fee provision, venue, limitation of liability.

With a Master Services Agreement (MSA), you negotiate the master or overriding agreement and write a statement of work (SOW) that covers each project. Typically these are fixed-bid projects.

• The MSA covers all work you will do together
• Each SOW enumerates the scope, tasks, and deliverables in detail
• The total fee for the project, or an hourly rate 
• Payment schedule: typically a percentage of the total fee is paid upon signature of the agreement, such as 25%. The remaining payments are usually tied to certain deliverables, such as acceptance of the research plan, completion of interviews, and delivery of the final report.
• Be aware of the possibility of scope creep, which is increasing the work to be done for the flat fee that was agreed upon. 
• If additional work is required outside of the original scope, specify an hourly rate so that you will be compensated for that work.

With either type of agreement, you can hire an attorney to draft it, or create a custom version of a template. The following website, www.wonder.legal/us, has easy-to-use templates for a nominal fee. 

How to Collect as a Freelancer

While you can’t prepare for every contingency, there are a few things you can do to improve the likelihood of being paid what you are due. The first suggestion is to bill often, preferably weekly or bi-weekly, but at least monthly, and call to collect if the invoice is not paid when due. This is especially important if you are working with a startup or a smaller company with unknown creditworthiness. It takes a bit of time and organization to stay on top of this, (and let’s admit, it’s nobody’s favorite thing to do) but you are more likely to be compensated if you follow up promptly. 

Another option is to require a retainer. A retainer can be a monthly amount that you have the client pay you towards your hours. It doesn’t have to be a fixed bid – you still might be billing hourly. You state your hourly rate and estimate how many hours you plan on working during the following month. Then ask for all or a portion of that upfront. At the end of the month, determine what else they might owe you and bill accordingly. 

When you are not paid as contracted, whether on a retainer or regular invoicing, don’t let too much time go by before checking on what is going on. That’s one way you might discover a problem.

Why would a client not pay? 

• Disagreement about the work
• The client does not have the money (but may insist they will pay when they get it).
• Never intended to pay. 

If it’s a local client, it is more likely that you know them, they know you, and they will pay. But if it is someone you met online, it is possible that they are not ethical. Be prepared and protect yourself.

Is Your Freelance Client Running Out of Money?

• Always be aware that it can happen, especially to start-ups
• If you’re worried, ask for 50% pay in advance or ask for a retainer. 
• Bill weekly and make invoices due in 10 days.
• Stop working if they stop paying. 

If they are not paying for your services, the best recourse is to stop working until you have been paid. This will probably have a greater impact than anything else you can do. This doesn’t happen often, but if you are owed a large amount of money, you may need the services of an attorney. A warning letter from a lawyer is an inexpensive way to get a company’s attention and may get results.

 

Raymond Lee is the Founder of the UX Researchers Guild. You can find him on LinkedIn. This presentation included guest speaker John Thompson, a New York-based freelance lawyer, who deals with freelance contracts and legal issues on a regular basis. You can view John’s full video appearance here.