Incorporate Your Freelance or Consulting Business?

Ordinarily, the prime motivator for setting up a corporation or limited liability company is the desire to achieve personal liability protection. If something happens in the course of business, creditors and injured parties can only look to the business to satisfy their claims; the owner’s personal assets are protected.

However, independent writers, photographers, Web designers, illustrators and others who work on a freelance basis, along with consultants and subcontractors--a group that the U.S. Department of Labor estimates to be more than 7% of the U.S. workforce--may be overlooking an opportunity to capitalize on another benefit from incorporation: Tax savings and reduced audit risk.

Your entity choices
 As a freelancer who is the sole owner of the business, you are automatically a sole proprietor and need not take any formal steps to establish you in business.

Optional steps:

• File with your city or county to adopt a business name other than your own, a process called filing a “dba” (doing business as).
• Obtain a federal tax employer identification number (EIN). While you are not required to have one and can use your Social Security Number (SSN) for tax filing, you may wish to use an EIN as an identity theft protection measure--give the EIN rather than your SSN to parties you perform services for; they will use the EIN on annual tax reporting on Form 1099-MISC. You must use an EIN if you have any employees or set up a qualified retirement plan. Your bank may require an EIN for setting up a business bank account.
• Taxwise, as a sole proprietor you report your business income and expenses on Schedule C of your personal income tax return, Form 1040. If you are profitable, you also owe self-employment tax on your net earnings. Self-employment tax is a combination of the employee and employer shares of Social Security and Medicare taxes, only half of which is deductible on your personal return.

Limited liability companies. A limited liability company (LLC) is a legal entity formed under state law. An LLC can be used even though there is only one owner. This legal status gives you personal liability protection; any business creditors can only look to the assets of the company to satisfy their claims.

Taxwise, an LLC with a single owner is taxed just like a sole proprietorship, with income and expenses of the business reported on Schedule C of your personal tax return. Because you are the only owner (member) of an LLC, you are viewed under the federal income tax law as a “disregarded” entity. You may also be liable for self-employment tax. An LLC owner (technically called a member) is essentially treated the same as a sole proprietor for purposes of self-employment tax. Payments from the business to the LLC owner, usually called a “draw,” have no impact on liability for self-employment tax.

Incorporation. A corporation is a separate legal entity set up under state law that fully protects the assets of its owner (shareholder) from the claims of creditors. Incorporation automatically makes you a regular, or C corporation, which is a separate taxpayer. The corporation files Schedule 1120 to report its income and expenses for the year and pays its own tax at its own tax rates. The owner of the corporation only pays tax on payments from the corporation to him/her, such as wages, dividends, and taxable fringe benefits.

Becoming a corporation does not mean the corporation must be a separate taxpayer. You can immediately elect to have the corporation taxed as an S corporation by filing simple forms with the IRS and with your state, if applicable. The result: profits, losses and other tax items pass through the corporation to you and are reported on your personal tax return (the corporation does not pay tax). The S corporation files a return, Form 1120S, which acts as an information return, telling the IRS about the business’s income and expenses. You, as the owner, report the net amount on your personal return, as well as any payments, such as salary, made by the corporation to you. An S election can be made even though you are the only shareholder of the corporation.

Medical coverage
The cost of medical insurance today can be staggering, especially for freelancers and others who work alone. Some have seen their premiums shoot up 28% or 32% in a single year! As a result, more than one third of self-employed people have no health coverage at all.

One of the ways in which freelancers and consultants can afford health coverage is to put the cost on a business-deduction basis. For a C corporation, all medical insurance premiums are a deductible business expense. For any other business, the owner can deduct the full premiums, but only as a personal expense--the premium for the owner is not treated as a business expense.

For example, say a freelancer with an annual net income of $100,000 pays $10,000 for health coverage for herself and a dependent. As a sole proprietor, the $10,000 is deductible as a personal expense; it is an above-the-line deduction, which can be claimed even if other personal expenses are not itemized. But the premiums do not reduce her net earnings from self-employment, the figure on which she pays self-employment tax.

If she had incorporated, the C corporation could have reduced its net income by $10,000. She would receive the $10,000 health coverage as a tax-free benefit and would only pay income tax on the amount of salary paid to her by the corporation.

Typically, in solo corporations, the taxable income is “zeroed out,” meaning an amount is paid to the owner as salary to bring taxable income down to zero so no tax is paid at the corporate level. This is especially so for consultants because, under a special tax rule, any taxable income in their C corporation is subject to a flat 35% tax rate.

In addition to the unique treatment of insurance coverage for a C corporation, this type of entity can adopt a medical reimbursement plan to pay for all expenses not covered by insurance. This strategy can be especially helpful when projected medical costs may run high. For example, Lindsay Auden, an energy procurement and efficiency consultant in Ossining, New York (www.energywiz.com), incorporated his consulting business so he could take advantage of a medical reimbursement plan through his C corporation. Having suffered a childhood illness that has lifelong consequences, the medical reimbursement plan protects his pocketbook.

Let’s take an example. For a family of four, out-of-pocket medical expenses can run to tens of thousands of dollars annually, to pay such costs that are not covered by insurance, such as orthodontia, mental-health services, and eye glasses. By having a medical reimbursement plan, these costs can be placed on a business-deductible basis. If they are not paid through a medical reimbursement plan, the cost can be deducted personally by the business owner, subject to limitation. The itemized medical deduction is limited to amounts in excess of 7.5% of adjusted gross income—someone with adjusted gross income of $100,000 cannot deduct the first $7,500 of unreimbursed medical expenses. And what is deductible only gives a tax benefit at the owner’s tax bracket (e.g., a $1,000 deduction by someone in the 28% tax bracket yields only a $280 benefit).

Audit risk
Today, even though the risk of being audited by the IRS is relatively low, business owners have cause for concern that they might become a target. One reason for this concern is the $345 billion “tax gap,” which is the spread between what the government thinks it is owed and what it actually collected. The government believes that a sizable share of the tax gap can be traced to self-employed individuals who may omit income or inflate deductions, so audit rates for those filing Schedule C are much higher than for other businesses and may even rise in the future.

For example, for the government’s 2006 fiscal year ending September 30, 2006, the audit rate for sole proprietors reporting gross receipts of under $25,000 was 3.8%; for those with gross receipts of $100,000 or more, the rate was 3.9%. For C corporations with assets under $10 million, the audit rate was only 0.8%.

Cost of incorporation
While operating a business through a C corporation offers several important benefits, do not overlook the cost of having a separate business entity. The added cost results from:

• Initial formation. This one-time expense is usually a few hundred dollars, depending upon the state in which you incorporate and whether you do it yourself or use the services of an attorney. Note: Incorporation costs up to $5,000 can be deducted in the year you pay them.
• Annual tax filing. You must file a federal tax return and, where applicable, state income tax return each year for the C corporation, in addition to the owner’s personal return. If you use a paid preparer, this can be as much as $1,000 or more; this cost is fully deductible.
• Annual meetings. Corporations must have a board of directors that meets annually to conduct certain business matters, such as electing corporate officers. If you use outside paid directors and/or an attorney to update corporate minutes, this can be an additional deductible business expense each year.

This cost of forming and being a corporation, however, is usually less than the benefits obtained.

This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex, and the U.S. Small Business Administration.

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