by Garrett Fisher
May 30, 2012
Incorporating is usually a scary word for freelancers. It conjures all forms of stereotypes – assumptions that it’s terribly expensive, complex and not worth it except for brick and mortar businesses or high revenue firms. Those assumptions date to the 90s and earlier (particularly last rock solid in the 80s) – predicated on the need for an attorney and lack of information readily available to the general public. It was simply easier to spend $1200 on a lawyer than to make a [vain] attempt to do it oneself. Couple the Internet phenomenon with the popularization of LLCs in the mid 90s – and the recipe was born to make incorporation a possibility for most proprietors (a lawyer is not required though can be a good idea in certain instances where large amounts of money are involved).
First and Foremost
Above all, the single greatest benefit of forming a company is liability protection. By and large, the owner of a company is not liable for the debts of the company – so in the event of an unexpected and catastrophic lawsuit, the proprietor’s net worth is not at risk. What about insurance? Liability insurance covers against general injury style events (with some add-ons like false advertising coverage, data breaches, employee liability – check with your agent as this varies by state) such as trips and falls and other events that one simply cannot predict. Since a freelancer does not usually have real estate for the business (owned or leased), then premises liability is non-existent. Injury liabilities are plausible (someone trips over your laptop cord at Starbucks) though much less than traditional businesses (note: it is my disposition that all businesses should have liability coverage no matter how remote the possibility of an accident). The real liability that one could expect is related to services rendered. A freelancer, unlike an employee, is roped into contractual liability. I.e., while in the mind of the freelancer, they are to be paid for hours worked, the reality is that the customer may determine that the freelancer’s work was faulty, caused [possibly infinite] damages and wishes to hold them accountable (this is largely not the case for employees as they are protected in many circumstances). Let’s use an example – someone in the information technology field. The freelancer is hired to perform programming services. In the course of programming the desired application, it is alleged (it does not even need to be what actually happened, just alleged) that the programmer took the server down, wiping out data and causing an interruption in sales. The client now wishes to sue for data recovery fees, lost sales, lost profits and the list goes on. The freelancer now needs to get a lawyer to defend themselves and if the court finds them liable, then damages must be paid. Not a fun proposition when facing the loss of personal assets. In the event a company was formed and was providing the services in question, then the assets of the company are at stake and no more. For freelancers, this is not as damaging as they usually have minimal working capital and long-term assets (read: they have a little cash in the bank, some accounts receivable, and a laptop). Only the aforementioned assets are at stake. Pragmatically speaking, the [presumably irrationally angry] client has the prospect of spending significant sums to recover a judgment against some accounts receivable and a used MacBook (that the freelancer would claim is his personal laptop anyway). If logic prevails, the suit would have no merit.
The bottom line is that contractual and injury claims are usually large, unpredictable and infrequent. Those combinations of attributes makes planning for them a silly concept – spreading unknown liabilities against an unknown period of time not knowing when the first payment would be (it could be never or day 2 of the business’ operations). Further, it is standard business practice to form a company, so the freelancer who chooses to remain unincorporated is welcoming uncharacteristically high risk compared to other players in the marketplace. An entity shields those unpredictable situations and makes it safer to engage in business. (Note: There are occasions where the corporate veil is pierced in court and the shareholders are held liable for certain events. California is notorious. Nonetheless, protection is significantly greater when a company is involved vs a sole proprietorship).
A freelancer who acts as a sole proprietor is advertising their lack of sophistication. It is readily apparent to the client that they are a) small b) likely acting alone c) probably do not have employees or staff and d) have little to no resources. Having a trade name welcomes the [good] stereotypes of a company – sophistication, resources, possibly a group of owners and the like. Also, marketable names may be used and so forth.
Companies can be taxed a number of different ways – at the choice of the owner of the company. The most nimble method is to disregard the entity for tax purposes – that is, the entity is separate from the owner from a legal standpoint (trade names, assets, contracts, etc) except the taxable income/losses are mapped to the owner’s tax return. This is by far the simplest method and can allow for the same tax structure that a sole proprietor is used to.
On the other hand, it is possible to have a company (LLC or Corporation) taxed as an S Corporation (note: an LLC can be taxed as an S Corporation) which allows for allocation of some of the income as owner salaries and the rest as distributions. Generally speaking, this structure is a lower tax burden than others (see my article “S Corps – The Missing Perspective). For many, the tax advantages of this vehicle cover the cost of incorporation.
LLC or Corporation?
For freelancers, 95% of the time it will be advantageous to have a Limited Liability Company. They are simple and don’t require bylaws, Boards of Directors, officers, annual shareholder meetings and the like. One Manager is designated (the freelancer). Operating Agreements are only required if there is more than one owner or if certain bank lending instruments are going to be used. Ownership is tracked in percentages as opposed to shares.
Each state differs in their requirements and fees for entities and requires advance planning.
There is very little reason for a sole proprietor of any sort to avoid forming a company for their business. Unless revenue is absolutely minimal (even then, it’s not a bad idea), forming a company is a sensible basic requisite for any freelancer going into business.