Disclaimer: Please note that this article contains general legal information and doesn’t contain legal or tax advice, and isn’t intended to constitute legal or tax advice. While the author is a lawyer and made every effort to provide accurate information, laws can change rapidly, and court interpretations of laws very often vary. Finally, the presented content may not address your specific situation and may not reflect the most current legal developments in your jurisdiction. All liability for any loss, damage, or inconvenience with respect to actions taken or not taken based on the contents of this article are hereby expressly disclaimed to the fullest extent permitted by law.
You’ve decided you want to join the distinguished community of freelancers – one of the most important steps to now take is to choose which business structure best suits your situation and business plan. It will affect your general responsibilities, accounting, level of personal liability, tax and business arrangements, and the state and federal regulations you must follow. In this article, you’ll find a comprehensive summary of the two most popular types of business structures for small businesses: sole proprietorship and an LLC in the U.S., or its closest equivalent in the UK: a private limited company.
What Are the Differences Between a Freelancer, Sole Proprietor, and an LLC?
At the very beginning, it should be pointed out that a freelancer isn’t a business nor a legal structure. A freelancer is a person who is a self-employed professional, often working on several assignments for multiple clients at once.
When it comes to a sole proprietorship, as the name suggests it constitutes a business structure where the business is owned by one person. Sole proprietorship is the oldest and most common form of business ownership – as of 2016, over 75% of U.S. businesses were nonemployer businesses, with the majority of these being sole proprietorships (link only accessible from within the U.S.).
A limited liability company (LLC) is a hybrid between a corporation and a sole proprietorship where there is only one owner – or a partnership where there are at least two owners. It constitutes a legal entity that combines the limited liability protection of a corporation with the tax benefits of a sole proprietorship or a partnership. As a result, it is commonly favored by small businesses. Owners of an LLC (referred to as members) have operational flexibility and income benefits similar to a sole proprietorship or partnership while enjoying limited liability exposure. The LLC exists as an independent legal entity in the way that it is able to enter into contracts and enforce as well as be subject to rights and liabilities. This contrasts with the sole proprietor’s position, where everything is done directly in the name of the business owner. Furthermore, an LLC can have one or more owners that may include individuals, corporations, foreign entities, and other LLCs.
However, it’s important to stress that in many jurisdictions, the freedom of the owner to choose the legal form of their business may be constrained by external factors. For example, not every business can operate as an LLC – financial and insurance industries are typically prohibited from forming an LLC, while some countries and states also prohibit licensed professionals, such as accountants, architects, attorneys, and physicians, from forming an LLC.
Below, you’ll find a brief summary of the differences and benefits of a sole proprietorship and forming an LLC. It’s worth bearing in mind that although something may be an advantage for one person, it doesn’t automatically mean it’s beneficial to you, taking into account the situation you are in and your current and future needs.
Quick Overview: Pros and Cons of Sole Proprietorship vs LLC
Below is a simplified summary of sole proprietorship vs LLC, with a free PDF download that includes some questions to consider when deciding which path to take. Read on underneath for a more detailed breakdown of the advantages and disadvantages of each.
Download the full PDF for free for a simplified overview of the differences and benefits between a sole proprietorship and LLC, plus some questions to keep in mind. You can also type in your own answers within the PDF to keep track of your thoughts.
Advantages and Disadvantages: Sole Proprietorship vs LLC for Freelancers
Advantages of a Sole Proprietorship
The main advantages of a sole proprietorship in most jurisdictions are in particular:
- Easiest and least expensive establishment – Filing for a DBA certificate or licence, if required.
- Minimum legal restriction – Low level of government requirements and fewer reports to file with government agencies.
- Simple taxation – Sole proprietorship is indistinguishable from its owner, income earned by a sole proprietorship constitutes income earned by its owner.
- Ease of discontinuance – Business can be terminated anytime at the owner’s will.
- Complete control of the entire business – Quick decisions and freedom to do business according to your wishes as the owner.
Disadvantages of a Sole Proprietorship
The main disadvantages of a sole proprietorship are in particular:
- Unlimited & personal liability – Business failure can wipe out personal wealth of the owner and impact future business prospects, i.e. personal assets such as the sole proprietor’s property can be seized and sold to satisfy debts and liabilities.
- Limited capital – Owner’s personal savings and money borrowed may not be enough to expand the business, whereas often banks and other financial institutions are wary of lending to sole proprietorships (or lend minimal amounts).
- Business is attached to owner’s fate – If the owner is incapacitated or worse, business proceedings may be severely interrupted or the business will be entirely closed down.
Advantages of an LLC
The main advantages of forming an LLC in most jurisdictions are in particular:
- Limited liability – LLC members are protected from personal liability for business debts and claims.
- Legal personality – An LLC can commence legal proceedings and enter into contracts.
- Pass-through taxation (no double taxation) – When it comes to the U.S., the IRS doesn’t have a specific tax category for LLCs and it uses tax categories of other business types. It means that the default tax status of an LLC with one owner is the same as a sole proprietorship, while the default tax status of an LLC with more than one owner is the same as a partnership. In both cases, the LLC doesn’t pay taxes directly, but the business’ net income is taxed through the personal tax return of the owner(s).
- Professionalism – In some sectors, compared to a sole proprietorship, forming an LLC gives a business more credibility with customers and other businesses or financial institutions.
- Flexibility – Allows greater flexibility for customizing the structure of the business.
- Perpetual succession – A company doesn’t die with the owner, instead it continues until there is an act of dissolution by the owner(s). However, dissolution requires a winding up of the business, which includes the settling of debts and the distribution of ownership to relevant parties.
Disadvantages of an LLC
The main disadvantages of forming an LLC in most jurisdictions are in particular:
- Medium level of government requirements – Easier than sole proprietorship and more complex than corporation – an LLC must file additional paperwork, including the articles of organization. It can also be advised (or in certain locations required) to create a comprehensive operating agreement because of the high degree of variability/flexibility.
- Initial and ongoing fees – It usually costs more to form and maintain an LLC compared to a sole proprietorship. In the U.S., many states charge an initial formation fee, as well as impose ongoing fees. Additionally, some locations require publishing a notice of intent in a local newspaper to create an LLC, for which the fee may be quite high.
- Public disclosure – In most jurisdictions, limited companies are compelled by law to make some information about their business available to the public, such as their accounts or listing the names of directors and shareholders.
- Not allowed for all businesses – Certain types of businesses, depending on regulations in particular jurisdictions, can’t form LLCs. However, licensed professionals may have the option to form a professional limited liability company (PLLC).
As a Freelancer Should I Incorporate?
Let’s start from the beginning: under U.S. law an LLC isn’t incorporated, unlike, for instance, its closest equivalent in the UK and many other jurisdictions – a private limited company. According to U.S. corporate law, an LLC is an unincorporated business organization with at least one member. “Incorporation” refers to the formation of a corporation under state law, which is a different kind of legal entity from an LLC. With the above in mind, the resulting question is: do I need to form a corporation or an LLC to freelance?
It’s crucial to understand that even though in the U.S. an LLC is not incorporated, its owners can still enjoy the protection of their personal assets from business creditors like the owners of a corporation. This is due to the fact that an LLC is a hybrid business structure that combines certain characteristics of both a corporation (such as the limited liability) and a partnership or sole proprietorship (depending on how many owners there are).
In the case of both an LLC and a private limited company, when operating in the UK, the business is treated as an entity separate from both the owner(s) of the company and those who manage it as its directors (if appointed). As a rule, any legal action by an aggrieved client of the company, or a third party, will typically need to be taken against the company rather than against its shareholder(s)/ director(s). However, it’s worth bearing in mind that in the case of serious misconduct, courts in many jurisdictions might put aside limited liability and hold the company’s owners (or directors, if applicable) personally liable for the company’s actions or debts (so-called lifting or piercing the corporate veil). The second main consequence is that the company’s existence continues independently of the identity of its shareholders and directors. Even when there is a complete change of ownership, for example where the company is taken over by another business or where a sole shareholder dies and their ownership is passed on, the company survives.
In the case of a corporation, on top of the limited liability and separate business and personal identities, choosing this business structure might bring you tax benefits (in particular circumstances) and give you the opportunity to raise capital more easily. However, forming a corporation is more complex and connected with higher costs.
Which Business Structure Should I Adopt as a Freelancer?
Before starting a new, solely owned business, it’s crucial to carefully consider your choice of business entity from multiple angles. This particularly includes ownership and control of the business, capital raising, asset protection, and tax implications. Answering the questions below will help you come to a considered conclusion on the most crucial features of your business form, and accordingly decide which of the locally available models is most suitable for your business at this time. Even if you decide to consult the above with a legal or tax advisor (which is highly advisable), you might be asked the presented questions by them to ensure that the business will be operating through the format best suited to your current and near-future needs. Thinking about these matters before the consultation will save you time.
- Where do you see the business in five years’ time?
- Is your long-term goal financial security for you and your family or to maximise profitability with a view to a future sale?
- What are the risks in your business, and how much do you need to be insulated from them?
- Additionally, what is your personal net worth and/or your significant personal assets?
- Do you need to raise funds for your business and if so, from whom?
- Are you prepared to be restricted from combining personal and business property and funds?
- Please note that it generally isn’t advisable to do so, but is legally possible when it comes to a sole proprietorship.
- Are the clients in your sector likely to work with a sole proprietorship?
- Or do you think that becoming a company would enhance the status of your business?
- Do you want the affairs of your business to remain as private as possible?
- Or are you prepared to file information on a publicly available register?
FAQ – Sole Proprietorship vs LLC
Should a freelancer form an LLC?
You don’t have to but might need to. A sole proprietorship provides no legal protection which means that creditors can go after the owner’s personal assets including your house, car, etc. As a rule, as an LLC member (i.e. owner) you will be protected from personal liability for business debts and claims.
Yes. When changing from a sole proprietorship to an LLC, you have to form an LLC according to the laws of your state, including filing the articles of organization, and updating your sole proprietorship registrations and accounts.
A single-member LLC is subject to the tax on net earnings from self-employment in the same manner as a sole proprietorship. For income tax purposes, an LLC with only one member is treated as an entity not regarded as separate from its owner unless the member elects to be treated as a corporation which is also possible.
While there is no legal requirement to hire an attorney or a lawyer to form an LLC, it’s always beneficial to consult with a professional about a decision as critical as the legal structure of your freelance business and the subsequent process of implementation of this decision. It can save you both money and time, especially in the long run.
An LLC is neither a corporation nor a sole proprietorship. However, it combines particular elements of a sole proprietorship and corporation, where there is only one owner.
It usually takes around 5 up to 7 business days to form an LLC. However, the process can take longer in certain cases – in particular when the required documents weren’t filled out correctly.