Your side hustle is rocking and rolling. Good job! Now it’s time to look at what’s best for your business financially, and when tax season rolls around again (which is very soon!) is it best for your business to stay as-is, or should you take the next step and incorporate somehow, or change the incorporation you have now? The answer? Well, it depends.
As someone with a successful, freelance side hustle for the past 14 years, this is something I’ve been considering for years but wasn’t really sure where to start. So, I talked with a couple tax experts to see what I could find out.
“If you own a small business, it’s important to consider the best business entity structure for your small business,” says Mike Slack, manager of The Tax Institute at H&R Block, a tax preparation company. “Your business structure influences everything from your day-to-day operations to your taxes and personal liability. Different structures can affect legal protection and tax responsibility. It’s not a one-size-fits-all decision.”
There are several types of business entities available for self-employed: Sole Proprietor, Sole Proprietor Limited Liability Company (LLC), and S-Corporation. Lisa Greene-Lewis, CPA, and tax expert with TurboTax, a tax preparation software company, gave us a rundown on the pros and cons of each.
Pros: This is the simplest structure, and requires the least amount of paperwork. With a sole proprietorship, you only file one tax return since your business would be reported on schedule C that would accompany your personal tax return. Many think that if they set their business up as a corporation they may get more tax deductions than if they are set up as a sole proprietor but this is a myth. Self-employed people can take many of the same business tax deductions as corporations. As a sole proprietor you may be eligible for the 20% Qualified Business Income Deduction under tax reform, which will be coupled with lower personal tax rates under tax reform. You can also deduct the full expense of business equipment up to $1,050,000 for 2021 in the first year you put the equipment in service and in some cases certain non-SUV heavy vehicles used for your business qualify.
Cons: The biggest con for sole proprietors and the reason self-employed opt for an LLC is the personal and legal liability is 100% your responsibility (say, if you’re sued or your business goes under, your personal assets are fair game for creditors and you assume all legal liability), whereas with an LLC there is partial liability. You will also be liable for the other half for your self-employment taxes, but you can deduct half as an adjustment to income when you file your taxes. You are also responsible for paying quarterly estimated taxes if you expect to owe $1,000 or more.
Sole Proprietor LLC
Pros: The main pro of an LLC is limited liability. As an LLC, you are still able to take business deductions like a sole proprietor. These are, by default, taxed in the same manner as a sole-proprietorship, but have the option to elect to be taxed as a corporation.
Cons: You pay the full FICA tax like a sole proprietor and you need to pay estimated taxes like a sole proprietor.
Pros: The gross income from your small business will go to the S-corp, and then you will pay yourself “wages.” This model generally means you pay less in taxes, and you’ll only pay half of FICA tax.
Cons: There is more paperwork with an S-Corp, and in turn, more expenses since you’ll have to file two separate returns. (One for the company, and one for the wages you pay yourself.) You also would not be able to take the home office deduction like a sole proprietor would. There is also a set amount of state taxes owed, no matter how much money you make. “I have known people starting a business to set up as an S-Corp before they even make any money or know if their business will be successful and they are hit with an unexpected state tax bill,” Greene-Lewis says.
What’s The Right Decision For Me?
Most small businesses will start out as a sole proprietor or LLC. The simplest business structure is the sole proprietorship, which you own completely, with no distinction between yourself and the business. Many small businesses are structured as LLCs because they offer some of the advantages of a sole proprietorship without its obvious disadvantages. As a single member LLC, you’re in charge — you own, manage, and run your business — but without the same liability issues of a sole proprietor. If your business is new, it can be a good idea to wait and see if you start earning money and determine what your future plans are before you make this decision.
“If you’re thinking about starting a business, your business structure will set a framework for your future operations,” Slack says. “If you do nothing, you will be considered a sole proprietorship. There are a lot of factors to weigh, namely legal and tax. For legal insight, you’ll want to work with a legal professional. For taxes, you’ll want to have a good understanding of what tax implications are for certain business entities.”
Whatever decision you make, make sure you have separate business accounts, and a dedicated business checking account to keep expenses separated and establish legitimacy of those expenses when tax time comes. This can also help you judge the financial performance of your side hustle easily.
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