An independent contractor is an individual who owns and operates a construction business in one of the skilled trades. Most of the independent contractors operating across various industries have personal ownership of their business and its assets. Lately, there has been an increase in the popularity of the single-member LLC incorporation structure for independent contractors. The LLC as a form of incorporation is popular for a range of services including framing, painting, bricklaying and roofing.
An independent contractor will form an LLC (limited liability company) to
- Limit the liability of their personal assets in the case of a lawsuit.
- To open a business account.
- Apply for a business loan.
Keep reading to find out why the LLC has many advantages over the sole proprietorship for an independent contractor.
What Exactly is a Single Member LLC?
LLC stands for limited liability company. An individual can form an LLC by filing articles of organization with their respective Secretary Of State. In general, LLCs should be formed in the state where you conduct the majority of your contract work.
All states in the U.S. allow the formation of LLCs. The individual who forms an LLC can own and operate it single-handedly. The owners of an LLC are referred to as members. An LLC owned by an individual is called a single-member LLC or SMLLC for short. Any independent contractor can form an SMLLC to own and operate a single-owner business.
An SMLLC is a legal entity, much like a corporation. The SMLLC can own assets and borrow money. It can sue, be sued, and open bank accounts. An SMLLC’s owner operates the business and manages the affairs of the company.
In most cases, the SMLLC owner(s) is not an employee of the business. The SMLLC owner is a self-employed business owner, much like an independent contractor.
Benefits of The Single-Member LLC For Independent Contractor
There is a reason for the increase in the number of single-member LLC independent contractors; the LLC structure provides an independent contractor with several advantages over the sole proprietorship.
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Advantages Of An Independent Contractor LLC
Limited Liability
A sole proprietor is personally liable for the business’ debts. Let’s suppose that as a sole proprietor, you owe money for the purchase of construction materials to a company. In the event of a dispute over the debt, the materials distributor may end up suing you as an individual. Liabilities can include your car, home, and your personal bank account.
Sole proprietors are personally liable for any business-related lawsuits. For instance, if there is a workplace accident in your office, you can be personally sued for the damages as a sole proprietor. Forming an LLC as an independent contractor raises a “corporate veil” around your business, which shields you from personal liability in the event of litigation against you.
An LLC relieves you from the legal liabilities that you may otherwise face as a sole proprietor. Incorporating an independent contractor business as an LLC provides the same limited liability that a corporation enjoys. The term “limited liability” means that the owner of an SMLLC is not personally responsible for paying its debts. If there is any legal liability involving another company or individual, they can sue the LLC but not you personally. The creditors cannot pursue an LLC owner (technically reffered to as a “member”) to settle legal matters.
A judgement against an LLC, can result in the loss of a company’s limited liability status. In some cases, LLC owners must personally guarantee loans to their LLC.
Forming an SMLLC does not relieve you from personal liabilities. If you are an independent contractor who forms an SMLLC, you remain personally responsible for any damages due to your negligence, malpractice, or fraud.
It is crucial for an independent contractor to have liability insurance even if they form an LLC.
Tax flexibility
LLCs offer their owners the flexibility to choose how their business will be taxed. The IRS, by default, treats the LLC as a sole proprietorship in regards to taxes. This means that the taxes from the LLC “flow through” to the member(s). An LLC’s owner is technically called a “member”. An LLC can be a single-member or a multi-member LLC.
The member files an IRS Schedule C form to report the business’ gross profits and expenses. The profits and expenses pass through the business to the owner’s personal tax return.The amount that the owner is taxed on depends on their individual tax bracket.
Although rare, LLC members have the option to have their contracting buisiness be taxed as a regular S corporation. This is done by filing a document called an election with the IRS office. Once the change from LLC to S/C corp has been approved by the IRS, the company is taxed as a regular S-corp. In most cases, it is not worthwhile to elect for s-corp taxation for a small independent contractor business.
Potential Tax Savings For C Corporation Election
Sole proprietors are legally obliged to pay Medicare and Social Security taxes on any profits their business earns. The combined taxes between the two can be as high as 15.3%.
An LLC owner can save on Social Security and Medicare taxes if they choose to be taxed as a C corporation rather than as a sole proprietorship. If an LLC owner chooses that path, they will work as an employee of the SMLLC rather than as the owner. The business owner’s own salary as the employee is liable for the 15.3% tax rate. In this case, the owner is not taxed on the company’s entire profits.
Electing to be taxed as a C corporation makes their SMLLC a separate taxpaying entity that is liable to pay corporate rate taxes on all its profits. Thanks to the Tax Cuts and Jobs Act, C corporations pay a flat tax of 21% on all profits made by the SMLLC. While the C corporation income tax rate of 21% might seem low, they are subjected to double taxation.
When a C corporation distributes its profits to the owner, the income will be taxed again. It is taxed at 21% at the corporate level and again at the owner’s capital gains tax rate. The capital gains tax can range from 0% to 23.8%. In some cases, the combined C corporation income taxes will be lower than the personal tax rate of a sole proprietorship because of the added self-employment tax.
Potential tax savings through S corporation election
An SMLLC owner can save money by electing S corporation taxation.
An SMLLC does not have to distribute the company’s entire profits to the owner as an employee’s wage. Instead, the company can pay the owner some of the profit from the business as S corporation distributions. These profits pass through the S corporation to the owner. In this case, the owner is paid as a shareholder instead of an employee. These distributions are not liable for Social Security and Medicare taxation.
By electing to be taxed as an S-Corporation, the SMLLC’s owner only pays taxes on their individual tax rate which might save them a substantial amount of money. The IRS requires that S corporation shareholder-employees have adequate salaries. These salaries are liable for taxation. Trying to circumvent the taxes by using S corporation distributions for the entire profits can result in the IRS recharacterizing the distribution as employee wages. Following this outcome, you would end up having to pay taxes on the company’s entire profits.
Credibility for your business
As an independent contractor operating as a sole proprietorship, you and your business are the same legal entity. In the business world, a sole proprietorship lacks credibility.
Going through the process of forming an LLC shows that you are a serious business owner who wants to run a reputable company. The inclusion of LLC in your business name communicates trust and professionalism to your clients and suppliers.
Cons of Forming a Single Member LLC
Forming an LLC as an independent contractor has some drawbacks.
LLC Formation Costs
The LLC formation process involves filing articles of organization with the Secretary of State office. You must also draft an operating agreement. You can save on the formation costs by filing everything yourself, but you might save time by hiring an LLC formation service. Conversely, as a sole proprietor, you do not need to spend money on forming and maintaining your business’ legal structure.
In some states, LLCs are liable to pay a minimum annual tax. The single-member LLC tax rate can differ from state to state. For instance, a California LLC has to pay a minimum $800 annual tax. It is the highest single-member LLC tax rate in the country. Other states charge similar taxes. Sole proprietors are exempt from minimum annual taxes.
Is Forming a Single Member LLC Right for You?
Creating limited liability by forming an LLC for your independent contractor business has many advantages. If you feel that the advantages of forming an LLC for your contracting business outweigh the potential disadvantages, you should consider forming an SMLLC (Single Member Limited Liability Company). It is the ideal way to attain limited liability for your work as an independent contractor. If you elect for taxation as a corporation (S-Corp or C-Corp), you could benefit from corporate tax savings.
We hope this article helped give you the information you need to help you decide whether or not you should form an LLC as an independent contractor.
