Here Are Important Considerations If You’re an Independent Contractor and Why It Might Make Sense to Create an LLC.

The difference between an independent contractor and a sole proprietor is incredibly small. When it comes down to income, taxes as well as your liability management it’s important to know the difference and also consider other forms of business organization.

Both independent contractors and sole proprietors are self-employed people who haven’t set up formal business entities, like limited liability companies or corporations. They file business taxes using a Schedule C and have to pay self-employment taxes.

The difference between the two designations is how they earn income:

• Independent contractors do specific tasks for clients for a set fee.
• Sole proprietors may do contract work, but may also have other revenue streams, like selling their own products to customers.

You really don’t have to choose between being a sole proprietor and an independent contractor; many people fall into both categories. The more important decision is when to formalize your business, which can become necessary as it grows and based on your goals for the future.

What is a sole proprietor?

A sole proprietorship is a one-person business that hasn’t registered with the state or the IRS as a business entity, such as a corporation or LLC. If you earn income from your business, you’re a sole proprietor.

A sole proprietor might do work as an independent contractor and receive a 1099 tax form from their clients at the end of the year. In that sense, they’re also an independent contractor.

If you’re a sole proprietor, the IRS considers whatever business income you earn to be your personal income. You’re personally responsible for any debts the business incurs, too.

What is an independent contractor?

An independent contractor does work for one or several companies on a contract basis. The person who hires an independent contractor can tell them what to do, but not when or how to do it. Many freelancers, like IT consultants, graphic designers and web designers, are independent contractors.

If an independent contractor hasn’t created a separate business entity, they file a Schedule C, like sole proprietors.

Companies that hire independent contractors don’t have to withhold income tax, Social Security or Medicare payments, so independent contractors usually need to make estimated tax payments throughout the year to cover income tax and self-employment tax.

You don’t have to choose one designation or the other. Lots of self-employed people are sole proprietors and independent contractors, depending on the type of work they do.

For example, a musician might earn money from performing shows, teaching lessons and selling merchandise. If they haven’t set up a formal business entity, they’re considered a sole proprietor because they’re earning business income.

If that musician agrees to compose original music for a corporate video for a fee, then they’re also earning income as an independent contractor.

Both sole proprietors and independent contractors have to:

• Fill out Schedule C when they file taxes.
• Pay self-employment taxes, which cover the Medicare and Social Security taxes that an employer would normally withhold.
• Make estimated income tax payments to the IRS and their state government if they’ll owe $1,000 or more in taxes when filing their return.

When should you create a business entity?

It really depends on your long term goals and vision. If currently you are an independent contractor or a sole proprietor because you are in between jobs and your ultimate goal is to obtain another job with benefits from an employer down the road, it may not make sense at this point to form an LLC or any other business structure.

However, if your long term goal is to be in business for yourself and to be able to grow your income as large as you want it to be based upon your own vision of success while having several ways to potentially reduce taxes and limit your personal liability, forming an LLC or some other business structure such as an S corporation or a C corporation makes a lot of sense.

The larger your business becomes, the more important it is to create a formal business entity. Here are some signs that it’s time to move from being a sole proprietorship or independent contractor to a different business structure, like an LLC or corporation:

You want more separation between your business and personal finances. It’s important for business owners of all sizes to separate their business and personal finances. Sole proprietors have access to some important tools, like business bank accounts and business credit cards. But with a business entity, you can take steps like developing a business credit history and credit score, which limits lenders’ reliance on your personal credit.

To get help setting up your own LLC learn more here.

You want more protection for your personal assets. Neither sole proprietors nor independent contractors have business entities that separate their business assets from their personal assets. While business insurance can help if you’re sued or face another unexpected cost, creating a separate business entity can provide extra protection.

You need additional funding. Sole proprietorships tend to have trouble raising money from traditional sources, like small-business loans. Having a separate business entity can make it easier to get financing.

You want more control over your taxes and the potential to reduce taxes. When it comes to taxes setting up your company in order to get the best tax advantage takes a little bit more thought and work but can be worth it in the long run.

Why an LLC can help you reduce taxes as well as personal liability

One of the most popular ways to organize a business is creating a limited liability company, otherwise known as an LLC. The true advantage of an LLC over other business entity types comes in the form of tax benefits. LLCs give business owners significantly greater federal income tax flexibility than a sole proprietorship, partnership and other popular forms of business organization.

If you own a small business or are starting one, or, if you’ve been “hired” as a Independent Contractor or Sole Proprietor, it’s important to make sure your tax planning is done right.

You can talk to a business coach, financial advisor, tax specialist or business attorney to help you through the entire process and determine which business formation is right for you.

To get help setting up your own LLC learn more here.

 

What Is the Main Tax Benefit of an LLC?

The key concept associated with the taxation of an LLC is pass-through. This describes the way the LLC’s earnings can be passed straight through to the owner or owners, without having to pay corporate federal income taxes first. Sole proprietorships and partnerships also pay taxes as pass-through entities. These businesses pay no federal income taxes themselves. Instead, their earnings are passed directly to their owners, who pay taxes on them at their individual income tax rates.

This is different from standard C corporations, which are subject to double taxation. More specifically, the corporation must pay taxes on its income. Then, any distributions to its owners are also taxed as individual income. Clearly, avoiding double taxation can save significant money in the long run. That’s one of the main tax benefits of an LLC.

Set up your own LLC learn here.

What Are Tax Benefits Considerations of an LLC?

An important feature of an LLC is that the Internal Revenue Service (IRS) allows business owners to choose the way their business will be taxed. They can choose to be taxed as a sole proprietor, a partnership, an S corporation or a C corporation. You choose how you’ll be taxed by filing IRS Form 8832.

There are some limitations on the preceding choices. An LLC with multiple owners can’t choose to be taxed as a sole proprietor, for instance. The IRS will automatically tax an LLC as a partnership if it has more than one owner. You can learn more about rules for taxing LLCs from the IRS backgrounder on Form 3402, covering the taxation of LLCs.

Consider the following four common methods to pay taxes for an LLC:

Sole Proprietorship    If you choose to set up your LLC as a sole proprietor, you’ll have to report whatever profit or loss the business generates on your personal tax return. You will file a Form 1040 individual tax form along with, usually, a Schedule C business profit or loss form for the LLC.

S Corporation LLCs set up as S corporations file a Form 1120S but don’t pay any corporate taxes on the income.

C Corporation If you elect for your LLC to be taxed as a C corporation, you’ll file the Form 1120 corporation tax return. Instead, the shareholders of the LLC report their share of income on their personal tax returns. This avoids double taxation. The corporation will have to pay a tax on profits. Members will report any of this income that is passed on to them on their individual tax returns as dividends or interest and, once again, pays taxes on it. Note that if the C corporation doesn’t pass some or all of its income through to members, they won’t have to pay tax on that income.

Multi-Owner Partnership The LLC will file a Form 1065 partnership return. Each owner will pay taxes according to his or her share of the profits or losses, reporting this on Form 1040 and a Schedule K-1.

Starting a Business? Get help setting up your own LLC here.

 

Tax Limits of an LLC

It’s important to keep in mind that organizing as an LLC doesn’t mean you won’t pay any taxes. You’ll still have to pay taxes on income from the LLC at your ordinary individual tax rate. LLCs, depending on how you set them up, may not have to pay business taxes at first.

Unlike wages received from an employer, income from an LLC isn’t subject to withholding. In turn, you’ll have to file quarterly tax payments of your estimated federal income taxes. Some state taxing authorities may get involved as well by taxing LLC income directly. On the other hand, some charge fees for LLCs.

While you may be able to deduct the cost of forming an LLC and capital expenditures such as materials and equipment that are used by the business, there are some limits to what you can do when it comes to deducting other expenses. Specifically, you may not be able to deduct benefits like health and life insurance, which you might be able to do if you organize as a C corporation. If your LLC provides you with these types of benefits, you may have to pay taxes on them. If you pay for these benefits outside the LLC you may be able to deduct them. Talk to your TAX advisor for more on this.

Tax Considerations for an LLC

When deciding how you want your LLC to be taxed, it’s important to consider all of your possibilities to make an informed decision. The right tax method for you might change based on what your biggest need is and how that need is treated for taxes. Here are the most important tax considerations when you form an LLC:

Double Taxation: Some tax treatments (C-corporation) allow for your business to be taxed for income and then that same money is taxed again when it passes to the business owner. This may or may not be a dealbreaker for you depending on what your other needs are but it is something that should be considered.

Tax Rates: Depending on your tax treatment for your LLC, your tax rate might fluctuate. For example, if your business is considered to be a disregarded entity then those tax obligations will fall to you. This can drive your personal tax rate up. However, if you’re taxed as a corporation then the business itself must file a tax return and your personal taxes won’t be impacted in terms of your rate with anything other than your ordinary income.

Capital Expenditures: With an LLC, there is a possibility of you being able to claim a deduction on your capital expenditures for purchases of equipment that the business uses.

Business Expense Deductions: Some tax treatments will benefit you more than others when it comes to deducting business expenses. The type of business expenses that you pay the most will depend on which tax treatment is the best. For example, a C Corporation is typically more beneficial for medical expenses.

Generally, if you’re going to start a business as a independent contractor or a sole proprietor oftentimes it makes sense to take the extra step to set yourself up as an LLC due to the potential to benefit from a further form of limited liability as well as the potential for reduced taxes. It takes a little bit of extra legwork in order to do this but oftentimes the benefits outweigh the costs and the time.

To get help setting up your own LLC learn more here. Then go to Start a Business

 

Here’s how an LLC’s limited liability protection can help protect you personally

When you form an LLC, you establish a new business entity that’s legally separate from its owners. This separation provides what is called limited liability protection.

As a general rule, if the LLC can’t pay its debts, the LLC’s creditors can go after the LLC’s bank account and other assets. The owners’ personal assets, such as cars, homes, and bank accounts, are safe. An LLC owner only risks the amount of money he or she has invested in the business.

But, as with most things, there are exceptions.

Owners are still liable for debts that they have personally guaranteed. They may be liable for unpaid payroll taxes. They may be liable under a so-called “alter ego” theory if they have failed to properly operate their LLC.  And they are liable if they are sued for their own wrongdoing.

Even with these limitations, liability protection is a valuable feature of LLCs and plays an important part in your asset protection strategies.

Want to learn more and set up an LLC? Learn more at LifeByDesign360.com

 

 

Contributions for this article came from;

SmartAsset: What Are the Tax Benefits of an LLC?

NerdWallet: Sole Proprietor vs. Independent Contractor: Which Is Right for Your Business?