Laura answers a question about creating a business entity when going from employee to self-employed.
Laura answers a question about creating a business entity when going from employee to self-employed.
Find a transcript here.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today’s topic comes from an anonymous voicemail caller, who says,
“I’m switching from a W2 job to being self-employed and need information on how to set up my own business. Do I need to create an LLC, and what professionals should I talk to so I know what to do?”
Thanks for your question, anonymous caller, and congratulations on becoming your own boss! When you start a part-time or full-time business, one of the first tasks you should do is choose a business entity. This post will review essential considerations when creating a business and getting help from the right professionals.
Welcome back to episode 950 of Money Girl–I appreciate you downloading the show! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, and founder of The Money Stack, a Substack newsletter.
You can learn more, ask questions, and sign up for the Money Stack at LauraDAdams.com. Newsletter subscribers automatically receive my Money Success Toolkit with the exact templates I use to manage money.
Choosing a business entity
Choosing the right legal entity for your business is crucial because it comes with significant financial and legal considerations, so it’s not something to take lightly. Plus, you need to know your business name and entity before accomplishing other tasks like getting a business bank account, buying business insurance, and filing a tax return.
You typically register your business entity by filing documents and paying an annual fee to a state agency, such as the Secretary of State. However, choosing a business entity can also be a passive decision, where you take no action. If you don’t register your business, you’ll automatically be a sole proprietor, which I’ll explain more about in a moment.
Each business entity has different pros and cons, including the complexity of formation, your potential liability, and annual paperwork and requirements. Some entities, such as a C corporation, are separate from their owners for tax purposes and must file business tax returns.
Several business entities allow income to “pass through” to the owner and get reported on your individual tax return. So, there isn’t one best business entity, and it’s not a binding decision. As your business needs change, you can always change your entity.
However, the most common entities for solopreneurs and small businesses are a sole proprietorship and an LLC. So, we’ll focus on their pros and cons in this post.
RELATED: Solopreneur success–tips for running a one-person business
What is a sole proprietorship?
A sole proprietorship is the simplest business entity, and it can be owned by one person or co-owned by a married couple. As I mentioned, you don’t have to comply with specialized government requirements or submit any paperwork to be a sole proprietor. That allows you to focus entirely on launching your venture and creating revenue.
If you earn income on the side as a freelancer or contractor, you may have a sole proprietorship and not even realize it. The simplicity of a sole proprietorship can make it a good starting point for solopreneurs, especially if your industry or trade has few legal risks.
Here are some advantages of a sole proprietorship:
While the simplicity of a sole proprietorship sounds great, it comes with the following disadvantages:
RELATED: How to budget with irregular income–6 steps for freelancers and self-employed workers
What is a limited liability company (LLC)?
The anonymous caller asked about creating an LLC, which stands for limited liability company. An LLC is a business entity that exists separately from its owner or owners, who are called members. You can have a single- or multi-member LLC, and there are different sub-types.
An LLC and its members have liability protection from legal claims against the business. They’re typically set up with an operating agreement that defines the company's membership, management, and income distribution. But it can be a simple document and doesn't require a formal annual meeting or minutes, as with a corporation, so record keeping is easier.
Interestingly, you can choose how you want to be taxed as an LLC. You can pay tax as a corporation or as a "disregarded entity," which allows you to include pass-through income on your personal tax return. That means your business doesn’t pay taxes on its profits, and you include them on your individual tax return.
Here are the main pros of having an LLC:
The main con for having an LLC as a solopreneur or small business owner is the administrative and registration costs, which vary depending on where you do business. You must register an LLC with the state and file a report with a fee every year. I live in Florida, with a one-time formation fee of $125 and an annual LLC fee of about $150.
Also, separating your business and personal finances is important to simplify reporting and tax preparation as an LLC. The easiest way to do that is to have a business bank account. No matter your business entity, I highly recommend having a good system where you can easily track your business income and expenses. That helps you stay organized and claim every legitimate business tax deduction.
LISTEN ALSO: How can I get an affordable self-employed benefits package?
Should your business be a sole proprietorship or LLC?
Whether your business should be a sole proprietorship or LLC depends on factors like your industry, potential risk of getting into a lawsuit, expected income, and business goals.
If you’re a solopreneur with no employees, being a sole proprietor with business insurance can provide you with some peace of mind. But it's wise to create an LLC from the start if your business exposes you to risks. For instance, if you work in healthcare, sell edible products, or work with the general public.
The anonymous caller didn’t mention the type of work they do or the business they’ll create. So, I recommend consulting a business attorney or tax professional, like a certified public accountant (CPA), to discuss the issues that should affect your business entity, taxes, and insurance decisions.
A CPA can help you:
A business attorney can help you:
This isn’t a complete list of items to consider when setting up a business, but it’s a good starting point, especially for a solopreneur who might be doing consulting or various service work.
The needs of every business owner are different, and the tax and business laws vary by state. Therefore, it’s wise to consult with legal and financial professionals to discuss the issues that should affect your business entity, taxes, and insurance decisions.
For more information about becoming your own boss, managing business finances, and building a self-employed benefits package, check out my latest book, Money-Smart Solopreneur–A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Holly Hutchings is our director of podcasts, Morgan Christianson is our advertising operations specialist, and Nathaniel Hoopes is our marketing contractor.