Independent Contractors Guide to Forming an Entity
What is an Independent Contractor?
An independent contractor is a self-employed individual who provides services to clients under a contract, rather than as an employee. Unlike employees, independent contractors are responsible for their own taxes, including self-employment tax, and typically have more control over how they complete their work. They might work in various fields such as consulting, freelancing, construction, or other professional services.
Why would an Independent Contractor want to form an entity?
Liability Protection: Forming an entity like an LLC or a corporation separates personal and business assets. This means personal assets (like your home or savings) are protected if the business faces legal claims or debts.
Tax Benefits: Certain entities offer tax advantages. For example, S Corporations allow for pass-through taxation and can help reduce self-employment taxes on a portion of your income.
Professionalism and Credibility: Operating under a formal business structure can enhance your credibility with clients. It shows you are serious about your business, which can lead to more professional opportunities.
Ease of Managing Finances: Keeping personal and business finances separate simplifies accounting and makes it easier to track income, expenses, and deductions.
Growth Potential: Forming an entity provides a foundation for future growth, whether you plan to hire employees, take on bigger projects, or even sell the business.
Common Types of Entities
You can use the following table to view a clear and concise comparison of the different types of entities, including their definitions, benefits, and drawbacks:
| Entity Type | Definition and Characteristics | Pros | Cons |
| Sole Proprietorship | A business owned and operated by one individual without a separate legal entity. | -Simple to set up and operate. -Full control over decisions. -Minimal regulatory requirements. | -No liability protection. -Personal assets at risk. -Self-employment taxes on all profits. |
| Limited Liability Company (LLC) | A flexible business structure that provides liability protection to its owners (members) while allowing pass-through taxation. | -Liability protection for personal assets. -Flexible taxation options (can be taxed as a sole proprietorship, partnership, or corporation). -Fewer formalities than a corporation. | -Can be more expensive to set up than a sole proprietorship. -Annual state filings and fees required. |
| S Corporation (Form 2553) | A corporation that elects to pass corporate income, losses, deductions, and credits to shareholders for federal tax purposes. | -Avoids double taxation (pass-through taxation). -Potential to save on self-employment taxes. -Limited liability protection. | -Stricter operational processes and formalities. -Limits on the number and type of shareholders. |
| C Corporation (Form 8832) | A legal entity that is separate from its owners, offering strong liability protection and the ability to reinvest earnings in the business without immediate tax. | -Strong liability protection. -Easier to raise capital through shares. -Can attract investors and issue stock. | -Subject to double taxation (corporate income taxed at the corporate level, and dividends taxed at the individual level). -More regulatory requirements. |
If you are still unsure of the correct entity that will be the perfect fit for your business, the following examples may help. These are some case studies that involve common professions and why they might choose one particular entity type over another.
A freelance graphic designer who works independently with minimal risk of liability might choose a sole proprietorship. This option allows for a simple setup, minimal administrative burdens, and straightforward tax filing. Since the nature of the work doesn’t expose the contractor to significant legal risks, the lack of liability protection isn’t a major concern.
An IT Consultant working with multiple clients on complex projects might prefer an LLC. This entity provides liability protection, shielding personal assets in case of client disputes or contract issues. Additionally, the LLC offers flexible taxation options, allowing the consultant to benefit from pass-through taxation or even elect S Corporation status for potential tax savings.
A construction contractor dealing with physical labor, subcontractors, and significant liability risks would likely choose an LLC or an S Corporation. The LLC would protect personal assets from business liabilities, while the S Corporation could offer additional tax benefits, such as reducing self-employment taxes on part of the income.
A marketing consultant aiming to grow the business, hire employees, and potentially attract investors might opt for a C Corporation. This entity offers strong liability protection and the ability to reinvest profits back into the business without immediate personal tax implications. Despite the double taxation, the potential for growth and scalability could make this choice worthwhile.
A health and wellness coach providing services online might start as a sole proprietorship due to the low upfront costs and ease of management. However, as the business grows, transitioning to an LLC could provide necessary liability protection, especially if the coach starts offering in-person sessions or hires additional staff.
Steps to Form and Maintain an Entity
Forming a business entity involves several key steps, followed by ongoing compliance to ensure the entity remains in good standing. Here’s a comprehensive guide:
1) Forming an LLC
- Name Selection: Choose a unique business name that complies with your state’s LLC naming rules. Ensure it’s not already in use by another business.
- Articles of Organization: File this document with your state’s business filing office. It typically includes basic information about your LLC, such as the name, address, and members.
- Operating Agreement: Although not always required, creating an operating agreement outlines the ownership structure and operating procedures of your LLC. This is crucial for multi-member LLCs to prevent disputes.
2) Electing S Corporation Status
- Filing Form 2553: After forming your LLC or corporation, you can elect to be taxed as an S Corporation by filing Form 2553 with the IRS. This election must be made within a specific timeframe, typically 2.5 months after the beginning of the tax year in which the election is to take effect.
3) Other Initial Requirements
- EIN Application: Obtain an Employer Identification Number (EIN). This is required for tax purposes, even if you don’t plan to hire employees.
- Business Licenses: Depending on your business type and location, you may need local, state, or federal licenses or permits to operate legally.
- State-Specific Filings: Check for any additional requirements in your state, such as initial reports or publications.
4) Ongoing Compliance
- Annual Reports: Many states require entities to file annual or biennial reports to maintain good standing. This report updates the state on key business information.
- Taxes: Stay current on federal, state, and local tax obligations. This includes income tax, self-employment tax, payroll tax (if you have employees), and possibly sales tax.
- Record-Keeping: Maintain accurate and organized records of your business finances, including income, expenses, and any significant decisions or changes in your business.
- Separate Finances: Keep personal and business finances separate to simplify accounting and protect liability protections. This includes having a dedicated business bank account and credit card.
Let FormPros Help!
Starting a business can be overwhelming, but FormPros makes it easier. Aspiring entrepreneurs can use our platform for any help starting a business, from Forming an LLC to Starting a Corporation and even acquiring a registered agent. Our platform also helps with a wide range of tax and business-related forms, from EIN applications to essential contracts. Take the hassle out of paperwork and let us streamline your business formation and tax needs. Get started with FormPros today and focus on growing your business, not drowning in paperwork!