Forming an Entity

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Forming an Entity

The mind is for having ideas, not holding them.David Allen

At some point in your freelance career, you’re going to ask yourself this question: should I start a business?

When it comes to what people call your business and how the IRS will treat it, you have a few options. If you don’t have any partners, you’ll likely be choosing between an S Corporation, an LLC, or a sole proprietorship. A sole proprietorship is just you asking your clients to write checks to you personally (or your parents’ bank account). This is sometimes also called a DBA, meaning you’re an individual Doing Business As some registered business name.*

The factors to consider when choosing how to proceed: your tax burden, your liability, and your overall professionalism. I’m not a tax professional, but I have a brilliant one on retainer, and she helped me write this next part.

In my view, if your freelance work isn’t just a passing phase and you plan to make a real go of it, it almost always makes sense to form a business entity. The reasons for doing so have shifted with the tax law (and probably always will, so stay in touch with your CPA), but if you can afford the few hundred dollars it costs to form a business entity, and the subsequent tax ($800 per year in LLC tax or 1.5% tax on net income for your S Corporation), the tax savings will likely more than make up for it. Why? Because businesses are generally taxed at a lower rate than people are.

Here’s a tidy breakdown of what forming and maintaining the two most common entity types (LLC or S Corp) will cost you on an annual basis (picking California, one of the higher-tax states, as an example):

  • One-time costs

    • Formation: $500–$1,500
  • Annual costs

    • California Tax: $800–1.5% of net income

    • California LLC fee (gross revenues $250,000–$499,999; doesn’t apply to S Corps): $900

    • Tax Services (CPA): $500–$2,500

    • Annual (or Bi-Annual) Statement of Information filing fee: $20–$25

    • Bookkeeping software (yes, you need this): $300–$840

    • Bookkeeping service (yes, you need this): $2,400–$7,800

    • City Business License: $1.01–$4.50 per $1,000 of gross revenues

    • Payroll processing (only applies to S Corps): $540

So it costs roughly $5,000 annually in taxes and professional service fees to run your business entity. (Actually less than that, because even if you don’t form an entity, you’re still required to keep your books and file your taxes). Sounds like a lot, but remember, all of those costs are tax-deductible and a good CPA is trained to help you identify all the ways to offset (or more than offset) those costs.

Nuance applies to all of the above, so call your CPA—or go hire one now!—to see what’s right for you. My CPA actually wanted to go into more detail here in this book, but I wouldn’t let her, because your eyes would glaze over. If your questions go beyond what this book offers, you should be seeking the advice of a money professional. If you have no idea where to start, a free consultation is pretty standard. Free personalized professional knowledge is as good as free money, so take advantage.

If these costs are a deterrent for you because you aren’t currently pulling in that much money, let’s work on changing that. The moment you can reasonably project that you’ll earn enough (and deduct enough) to offset that rough $5K figure I mentioned above, form your entity. If you’re quibbling internally about whether you’re going to make $63K or $68K next year, you’re thinking about this wrong. Instead, plot a path to $150K (or some number that feels the right combination of thrilling, scary, and feasible) and build your entity accordingly. You plan to grow, right? No reason to delay this.

Aside from the financial reasons to form an entity, here are two more:

  1. Professionalism. You want to attract money from clients. Businesses want to send electronic payments to other businesses, not send a Venmo to someone’s cousin.

You’ve spoken to your CPA to determine what type of entity is best for you, and what it will cost—a good lawyer can handle the rest. Personally, I use CPA Collective for all tax advice (they specialize in small businesses and freelancers) and Better for my entity formation needs, but there are many options for both. For more legal protection, may also want to consider liability insurance, especially if you’re a sole proprietor. State laws vary, but a few Google searches will or a recommendation from your CPA will set you straight.

Recap: if you can afford to formalize your business as an entity, do it now. If you can’t afford it now, use this book to get yourself to a place where you can. If you have no intention of growing your business to a size that would necessitate the bare minimum outlined above, then I love you but this isn’t the book for you.

Banking, Collecting, and Saving

We live in a fantasy world, a world of illusion. The great task in life is to find reality.Iris Murdoch

Once your entity is formed, you can take that paperwork to your bank of choice and open a business account. Put your new account number, routing number, SWIFT code, and bank branch address on your invoices. Now your clients can send electronic payments.

One hack I discovered years ago via Ramit Sethi’s book is that many banks will allow you to open multiple savings accounts, nickname them, and link them together. As a person, this helps you save for different goals—car, wedding, vacation, house. As a freelancer, this helps you organize your income, most importantly by setting aside for taxes.

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