Should an Independent Contractor Form an LLC?

An independent contractor is a person who runs a one-owner business. Most independent contractors are sole proprietors who personally own their business and its assets. But an increasing number of independent contractors are forming single-member limited liability companies (SMLLC) to own and operate their businesses.

What is a Single-Member LLC?

A single-member limited liability company is a type of business entity owned by one person. You form an LLC by filing a document called articles of organization (or something similar) with your state's business filing office. In most states, this is the Secretary of State's office. For details, see "How to Form an LLC."

Like a corporation, an SMLLC is a separate legal entity, meaning that it can:

• own property
• open bank accounts
• hire employees
• borrow money
• enter into contracts
• sue and be sued, and
• do anything else in the business world that a human can do.

The owner of an SMLLC runs the business and manages the LLC. But the owner is ordinarily not an employee of the SMLLC. Rather, he or she is a self-employed business owner--the same as a sole proprietor. This means the SMLLC doesn't have to comply with the payroll tax, labor law, and other legal requirements for employees.

What Is the Difference Between an LLC and a Single-Member LLC?

All states allow LLCs to be formed, owned, and run by just one person. LLC owners are called members; thus, one-owner LLCs are called single-member limited liability companies, or SMLLCs for short. Any independent contractor can form an SMLLC to own and run a one-owner business.

Independent Contractor vs. LLC

In the eyes of the law, a worker is either an independent contractor or an employee. However, an independent contractor is not a type of business entity.

Business entity types include partnerships, sole proprietorships, corporations, and LLCs. If you're working as an independent contractor and you do not file formation paperwork with the state, you automatically have a sole proprietorship. Alternatively, you can take steps to form a business, such as a corporation or an LLC.

What Are the Benefits of a Single-Member LLC?

Forming a single-member LLC can provide an independent contractor with some important advantages over being a sole proprietor, including:

• limited liability protection
• tax flexibility
• tax savings, and
• heightened credibility.

Single-Member LLCs Provide Limited Liability

When you're a sole proprietor, you are personally liable for all your business debts and other liabilities. This means that a person or company to whom you owe money for items you use in your business can go after all your assets, both business and personal. This may include, for example:

• your personal bank accounts
• your car, and
• your home.

Sole proprietors are also personally liable for business-related lawsuits. For example, if someone slips and falls in your office, you can be personally sued for damages.

In contrast, when you form a single-member LLC you obtain limited liability. In fact, an SMLLC provides its owner with the same limited liability as a corporation. "Limited liability" means that the SMLLC owner is not personally responsible for paying debts incurred by the SMLLC business. Instead, only the SMLLC's money and assets can be taken to pay for such debts. An SMLLC's creditors can't touch the owner's personal funds like his or her personal bank account or personal property like a home.

However, there can be a big exception to the general rule of no personal liability. SMLLC owners are often asked to personally guarantee bank loans and other SMLLC debts. When they do this, they lose the limited liability achieved by forming an SMLLC.

Also, even if you form an SMLLC you remain personally responsible for your own individual wrongdoing. For example, an independent contractor who forms an SMLLC remains personally responsible for damages due to his or her own professional malpractice, negligence, or fraud. For this reason, even if you form an SMLLC, it's important to have adequate liability insurance.

Single-Member LLCs Provide Tax Flexibility

Single-Member LLCs have another attribute that is often underappreciated: great flexibility in deciding how a business will be taxed. The default form of taxation for an SMLLC is as a "disregarded entity." This means the IRS ignores the SMLLC and treats it the same as a sole proprietorship for tax purposes.

The SMLLC's owner files IRS Schedule C to report the business's income and expenses. Any profits (or losses) are passed through the business to the owner's personal tax return. The owner pays tax on the profit at his or her individual tax rates.

However, single-member LLC owners have the option of having their business taxed as a regular C corporation or S corporation. This is easily accomplished by filing a document called an election with the IRS. Once this is done, the SMLLC is treated the same as a corporation by the IRS. The SMLLC files the same tax forms as a corporation and is subject to all the corporate tax rules. Independent contractors who are sole proprietors do not have this option.

Potential S Corporation Election Tax Savings

Independent contractors who are sole proprietors must pay Social Security and Medicare taxes on all the profit they earn from their business. This is a combined 15.3% tax up to an annual ceiling.

In contrast, an SMLLC owner can save on Social Security and Medicare taxes by choosing to have the SMLLC taxed as an S corporation instead of a sole proprietorship. Here's how it works: by choosing to have the SMLLC taxed as an S corporation, the SMLLC owner works as its employee. The owner's employee wages are subject to Social Security and Medicare taxes just like any other employees.

Here's the key thing to understand: An SMLLC doesn't have to distribute to its owner all the profits the business earns in the form of employee wages. It can pay the owner some of the profit in the form of S corporation distributions instead. These are profits passed through the S corporation and paid to the owner as a shareholder, not as an employee for his or her services.

Such distributions are not subject to Social Security and Medicare tax. The SMLLC owner only has to pay income tax on them at his or her individual tax rate. The savings can be substantial. For example, an SMLLC taxed as an S corporation that earns $100,000 in profit would save the owner over $8,000 in Social Security and Medicare tax if $60,000 was paid as a shareholder distribution.

The larger your shareholder distribution, the less Social Security and Medicare tax you'll pay. If you took no employee wages at all, you would not owe any of these taxes. As you might expect, however, this is not allowed.

The IRS requires S corporation shareholder-employees to pay themselves reasonable employee salaries—at least what other businesses pay employees for similar services. If you fail to do so, the IRS can recharacterize all or part of your distribution as employee wages and require you to pay Social Security and Medicare taxes on them.

Potential C Corporation Election Tax Savings

It is also possible to save money by electing C corporation taxation for an SMLLC. Unlike an S Corporation, a C corporation is a separate taxpaying entity that pays tax at the corporate tax rate on all its profits. As a result of the Tax Cuts and Jobs Act, C corporations pay a flat tax of 21% on all their profits. This 21% rate is lower than all but the two lowest individual income tax rates.

However, the benefits of this low 21% rate are not as great as you might think because C corporations are subject to double taxation. When a C corporation distributes its profits to its owner the money is taxed twice: first, at the 21% corporate rate, and then at the owner's capital gains tax rate, anywhere from 0% to 23.8%.

At all but the highest tax brackets, the combined tax is more than you'd pay on your profits if you were taxed as a sole proprietor (or S corporation). Generally, an independent contractor will save on taxes with a C corporation only if his or her business earns substantial profits--at least $200,000 to $400,000.

Pass-Through Deduction for Single-Member LLCs

From 2018 through 2025, business owners other than C corporation shareholders can deduct for income tax purposes up to 20% of the net income they earn from their business entity. This deduction is available for both sole proprietors and SMLLCs. For example, if the net income from an SMLLC business is $100,000, the owner may deduct up to $20,000 from his or her income taxes.

However, if taxable income exceeds an annual threshold, the deduction is limited to 50% of the amount paid to employees of the entity, or 25% of employee payments plus 2.5% of the value of depreciable business property. Additionally, the deduction is phased out for taxpayers involved in various types of service businesses. This deduction may not be taken by SMLLCs that elect to be taxed as C corporations.

Single-Member LLC Status Provides Credibility

When you're a sole proprietor, you and your business are one and the same. To outsiders, it might look like you are pretty small potatoes. On the other hand, going to the trouble of creating a formal business entity like an LLC shows you're serious about having a real business. Moreover, when you form an LLC, you get to put the letters LLC (or some variant) after your business name so everyone will know your business is an LLC. As a result, potential clients and others may take you more seriously.

What Are the Disadvantages of a Single-Member LLC?

The main disadvantage of SMLLCs is that they cost more than sole proprietorships, which cost next to nothing to form and run. Forming an LLC can cost up to a few hundred dollars. You'll need to file articles of organization and you should also create an operating agreement. You can minimize the costs involved if you do most of the work yourself.

In addition, some states require LLCs to pay minimum annual taxes. For example, every LLC created in California must pay an $800 annual tax for the "privilege" of doing business in the state. This is the highest minimum LLC tax in the country, but many states have similar, smaller minimum annual taxes. No such taxes are imposed on sole proprietors. Thus, forming an SMLLC will cost more than working as a sole proprietor.

Is an LLC Right for You?

If limited liability is important to you, you should seriously consider forming an SMLLC. It is the lowest cost and easiest way to obtain limited liability for your independent contractor business. SMLLCs also come with the added benefit of potential tax savings if you choose to be taxed as a corporation.