The portrait of today’s worker is undergoing a fundamental shift. Fueled by advances in cloud-based, social and mobile technologies, companies are choosing to gain agility and savings by leaning on an always-on virtual workforce of contingent employees.
According to Freelancers Union, there are approximately 42 million Americans who make their living independently—that’s 30 percent of the workforce.
Forget about a traditional 9 to 5 at the office. Workers in this new freelance economy find that they need to become their own marketing experts, accountants, sales and IT gurus. And somewhere along the way, small business providers, contractors and freelancers need to grapple with selecting a business structure.
Forming an LLC or corporation can be a relatively quick and easy process, but most small business owners aren’t exactly experts in tax and business law. There are a bevy of mistakes that can have a significant impact on their business; here are six of the most common.
1. Selecting the wrong business entity
The LLC (Limited Liability Company), S Corporation and C Corporation are the three most common types of business structures in the U.S. These structures have some distinctive features, so picking the right option is important.
An LLC is great for small businesses that want liability protection, but also want minimal formality and paperwork. An S Corporation, like an LLC, is a pass-through entity for federal taxes, meaning that the company isn't directly taxed but that the tax burden is passed on to the shareholders of the business. Lastly, the C Corporation files its own tax report and isn’t appropriate for most freelancers, unless you plan to seek funding from a VC or your tax advisor specifically advises you to choose this entity.
Here are some examples of common mistakes made when choosing a business structure.
A freelance graphic designer forms a C-corp and finds herself paying a significant portion of her income due to double taxation.
- Two partners form an S-corp for their SEO consulting business and soon realize they must share in the income in direct proportion to their ownership (at least when it comes to tax reporting), even though they’ve actually arranged to allocate this year's profits 75 percent/25 percent. They should have formed an LLC instead where they can have more flexibility in dividing the profits.
2. Incorporating in the wrong state
Delaware and Nevada are hot states for incorporation. After all, Delaware offers some of the most developed, flexible and pro-business statutes in the country, and Nevada has become a popular choice due to its low filing fees and the lack of state corporate income, franchise and personal income taxes. However, these benefits are more advantageous to larger companies. If your business has less than five shareholders, incorporate in the state where your business has a physical presence. Otherwise, you’ll be dealing with too many hassles and fees for operating out-of-state, including difficulty opening a business bank account, appointing a mandatory registered agent and fees for operating as a "foreign entity" in your own state.
3. Incorporating without the necessary business licenses
A corporation or LLC is not the same as a business license. Most businesses are required to get some form of local, state or federal license. This can be true even for a freelance writer working from home, so you should check with your local city hall or county office to see what kind of license you may need. Most business licenses are inexpensive to obtain and are much cheaper than having to pay costly fines for operating without a license.
4. Not keeping your corporation or LLC compliant
Your job isn’t over once your applications are in and your LLC or corporation is formed. You must keep your business entity in compliance. If a plaintiff shows that you have not maintained your LLC or corporation, your "corporate shield" can be pierced, making your personal assets vulnerable. This means you must:
- Keep your personal funds separate from those of the business (no commingling).
- Use your business title when signing business documents so that no one can argue that you were signing in your personal capacity.
- Register your company’s “Doing Business As” (D.B.A.) name.
- Send in your annual statement/annual report at the time required by your state of incorporation.
- File for foreign qualification if you’re operating in any state(s) other than your state of incorporation.
- Keep the state up-to-date with any key changes to your business with an “Articles of Amendment.”
5. Believing the corporate veil equals unlimited liability protection
It probably goes without saying, but you cannot use your LLC or corporation to protect yourself if you engage in any kind of fraudulent or unlawful acts. If you break the law, you will be held personally accountable.
6. Not incorporating at all
The biggest mistake is assuming your business is too small to worry about forming an LLC or corporation. In today’s uber-litigious society, it’s wise to separate your personal and business finances. By staying as a sole proprietorship, you’re putting all your personal assets at risk. So, even if you’re putting in 80-hour weeks to drum up new business, make some time to incorporate or form an LLC. You’ll be able to scale your business far more smoothly and securely for years to come.