Self-employment is a great choice for people who want more flexibility, autonomy, and control in their work. But with that added freedom comes added responsibility and risk. Many people just starting out ask themselves common questions like “What tax forms do I need to know about?” and “What legal risks do I face?”
If you don’t form a separate legal entity, the law and IRS will assume you’re acting as a “sole proprietor.” While this doesn’t require any work on your part to set up, it allows the government to assume that your business and personal assets are all one, which can put you at increased legal risk.
As a result, lots of self-employed people form a Limited Liability Company. An LLC gives you additional legal protection and reduces your liability. Here are of some LLC pros and cons that should help you decide.
What are some pros of forming an LLC?
1. Better legal protection. Forming an LLC creates a separate legal entity. So if a client or creditor tries to come after you, they will only be able to target the assets of the LLC (like your business bank account) and not your personal assets (like your home).
2. More choices for taxes. When you form an LLC, you can choose from a few different methods of taxation. Most individuals choose to be a “single member LLC,” meaning that the LLC’s activities are reflected on the owner’s federal tax return. However, you can also explore some more aggressive tax strategies, like electing to be taxed as an S Corporation, and taking part of your earnings as a salary and part as a distribution. The salary is subject to income tax and self-employment tax, but the distribution is only subject to income tax. There are some important limitations and other requirements, so discuss this option with a tax professional.
3. Benefits to your brand. Most customers associate LLCs with a higher sense of professionalism, which is great for your personal branding if you’re providing professional services.
And the cons?
1. Additional costs and paperwork. Setting up an LLC requires some initial paperwork. This can cost a few hundred dollars (more, if you hire an accountant or lawyer), plus any state filing fees. There are also annual renewal requirements and fees, as well as additional franchise taxes or capital values taxes.
2. Some unresolved legal issues. LLCs have only existed for a couple decades, so there isn’t a lot of case law yet. While this isn’t necessarily a con, it does mean there might be changes to this type of entity (for example, exactly what legal protection they provide, or in what cases individuals might be held liable at the personal level).
Is forming an LLC worth the trouble?
The answer, as it is with many tax and legal questions, is: it depends. It may be worth getting a professional to help, since the paperwork can be complex, and you might want to discuss the specifics of your situation (for example, which taxation method you should choose). A lawyer or accountant who is knowledgeable about LLC law might be a valuable resource, though costs can add up quickly.
The initial cost of forming an LLC is usually below $1,000. Again, this can vary widely by state (California, for example, requires LLCs to pay a franchise tax, which is typically a percentage of profits or $800—whichever is higher).
The pros and cons above are not an extensive list, but are a good starting point. But if you’re looking to reduce your liability, an LLC might be right for you. If you’re interested in learning more, we’ve made a tool to help determine if setting up an LLC makes sense for your business.