Making Sense of LLCs and Taxes for Creative Freelancers
By Derek B. Kellett, CPA
Being a freelance creative has its perks - flexible hours, getting paid for work you are passionate about, letting your individual creativity flourish, and making your mark on the world one project at a time. Let’s face it; wearing a soft t-shirt, grabbing a cup of coffee from your favorite roaster, and sporting the freshest kicks on a business day is pretty fantastic. Not to mention that you get to see awesome places, work with amazing people (who are just like you), and live the life you want, every day! Even though you may have newfound flexibility and a fresh outlook on your professional life, there comes a moment, often in January, February, or March, where you realize your tax situation is quite complicated and overwhelming.
Cue a freelance CPA. Self-employed just like you, but instead his/her hustle is staying on top of accounting, taxes, and handling these areas for creatives and freelancers in other industries.
Below is an example conversation between you and a freelance CPA:
NOTE: For purposes of this article, we are going to assume that each reader is working for themselves and is therefore, by IRS regulations, currently a sole proprietor.
What is an LLC? What can I use it for?
An LLC is the recommended way to legally organize and operate your business and is formed by filing Articles of Organization with your state’s business filing office. Once filed, the LLC becomes its own legal “person” that can do pretty much anything you can do such as own property, manage bank accounts, borrow funds, hire workers. The LLC can also apply for an Employer Identification Number used to obtain a business credit card, and is often required to open up a separate business bank account. An LLC allows you to separate your personal assets from your business assets and activities to create an additional layer of liability protection.
Do I even need an LLC?
Creating an LLC allows you to separate your freelance activities from your personal bank accounts, credit cards, loans, and financial life. LLCs are simple to operate with virtually no changes from how you are freelancing currently, with the exception of the name on the accounts and tax returns. As previously mentioned, with an LLC you won’t be held personally responsible for paying the LLC’s business debts that you haven’t personally guaranteed including routine bills for supplies, equipment, utilities, etc. You will also not be held personally responsible for any injuries or other losses that are suffered by people or entities during your LLC’s business activities (i.e. a photo shoot).
Will I be taxed any differently with an LLC? Do I have any choice in how my LLC is taxed?
An LLC with only one member (single member LLC) does not change how the business is taxed. The IRS refers to single member LLCs as “disregarded entities” and does not recognize them as a separate business for tax purposes. This means that your legal business name is the name of the LLC, but on your tax return the income and activity is reported and taxed the same way as a sole proprietor. This makes it simple and easy to remember if you are used to preparing your return yourself. A single member LLC reports income and expenses on Schedule C of the Form 1040 (individual tax return) and the individual member pays federal income tax and self-employment tax on the LLC’s net taxable income. The LLC is entitled to the same tax deductions as any other business and the same ones available to you as a sole proprietor. As a single owner, you have the option to decide how your LLC is taxed. Whether you want to be taxed like a sole proprietorship or a corporation is up to you. If you do nothing, the IRS will default you to being taxed as a sole proprietorship. If you do some research or consult a CPA or tax attorney, you will learn that you can also elect to be taxed as an S-Corporation for federal income tax purposes by completing IRS Form 2553.
What is Self-Employment Tax?
Self-employment tax is the Social Security and Medicare tax paid by self-employed individuals including single member LLCs that have chosen to be taxed as sole proprietors. The self- employment tax rate is 15.3% of self-employed earnings and consists of 12.4% for Social Security and 2.9% for Medicare. This tax is due in addition to standard federal income tax and offsets the required payroll taxes typically received by the IRS in an employer and employee relationship via W-2 wages. In a single member LLC situation, all LLC earnings are subject to this 15.3% tax. A portion of self-employment taxes are deductible and generally 92.35% of taxable net earnings from self-employment are subject to this tax. For example, net LLC earnings of $40,000 would be subject to a self-employment tax of $5,652 (92.35% x $40,000 x 15.3% tax). For many start-up and lower income freelancers, self-employment taxes exceed their personal income taxes and are often the largest annual single business expense. Sole proprietors and single member LLCs are subject to both personal income tax and self-employment taxes. Even in cases where no federal income tax is owed due to standard deductions and personal exemptions, a freelancer with Schedule C income from a single member LLC would pay self- employment taxes on the LLCs taxable income. For example, if you made $9,000 in freelancing income, you would wind up below the federal income tax threshold and standard deduction, but still be subject to and owe $1,272 in self-employment taxes due to the IRS. Ouch!
What is an S-Corporation? And why would I want to be taxed as an S-Corporation? You just said that corporations don’t make sense for freelancers.
An S-Corporation is a special tax designation granted by the IRS that is available to LLCs (and Corporations) via an election made on Form 2553. It is very useful for small businesses (single member LLCs included) that want to protect their owners (freelancer) from liability and enjoy the benefits of pass-through income taxation. S-Corporation status is often confused as being another type of entity and different than simply being an LLC. This couldn’t be more incorrect. Electing to be taxed as an S-Corporation is a designation for IRS federal taxation purposes only and does not change the LLC’s status for state taxes, the way business is operated, and no changes are ever communicated to clients, customers, suppliers, or other professionals in your network.
The reason to elect to be taxed as an S-Corporation is to free yourself from a large majority of self-employment taxes. S corporations only pay employment tax on employee wages. All other income is paid to shareholders in the form of “distributions” that are not subject to self- employment tax, which makes S corporation status very attractive to many small businesses. In the self-employment scenario, the 15.3% tax is due on every single dollar of earnings for the business. In the S-Corp scenario, only the amount of money that is paid to you as wages is subject to the 15.3% tax.
Let’s use the same example as above in which you have $40,000 of net LLC earnings, but in this case you have elected to be taxed as an S-Corporation and determined that you wanted to pay yourself a salary of $16,000 per year. In this situation, you would pay self-employment taxes on only the $16,000 for a total of $2,448 and the remaining $24,000 ($40,000 less $16,000 salary) would not be subject to self-employment taxes. This would save you over $2,700 in self-employment taxes without including any other factors in each individual tax situation.
As freelance income and earnings go up, self-employment taxes become more and more significant, and the S-Corporation strategy offers legitimate tax savings year after year. Two things to note with S-Corporations is that they require a separate business tax return to be filed, the Form 1120S, and since the business now has an employee, payroll needs to be processed and taxes paid via a payroll provider or software. Even with additional compliance and time requirements, the S-Corporation for freelancers with a single member LLC offers tremendous tax savings opportunities that can set a freelancer up for ongoing success.
Thoughts and Disclaimers:
In each of these hypothetical question and answer scenarios, it was assumed that the freelancer is currently operating as a sole proprietor and does not have any business partners. Each individual’s tax situation is unique and there are often exceptions and limitations. This article makes some broad assumptions to answer the questions clearly and concisely. It’s always best to check with your tax professional or read IRS guidance before making any decisions or filing a tax return, IRS form, or registering a legal business entity.
Derek is a Certified Public Accountant, small business advisor, and the founder of https://riverandiron.com/.