By now we’ve all heard about the Tax Cuts & Jobs Act which was passed and signed into law last year. As a freelance creative running a solo venture, you might be wondering how these new laws might affect you.
Many freelance creative types often struggle to determine whether they should incorporate their efforts as a means of saving on their tax bill, and that consideration is more valid than ever under the new tax laws. Should you form an S Corporation or an LLC? When might that make sense? We break it down here – simply – to provide a bit of education and clarity, but it always makes sense to consult with someone (a CPA, an attorney, or both) who knows the details of your own personal situation as a freelance creative.
When Does It Make Sense to Open a Sole Proprietorship?
A Sole Proprietorship reports income and expenses from their business activities on Schedule C of their individual tax returns. They are the simplest (often default) option to organize a business. There is no legal distinction between the individual and the business, so that means a Sole Proprietorship is easy to form and has no additional tax costs.
A Sole Proprietorship is also eligible for the 20 percent “pass-through deduction” under the new tax law. What does that mean? As a sole proprietor, you get an extra 20 percent deduction (that is, you pay tax on a smaller amount), as long as you earn less than $157,500 (or $315,000 if you are married and file a joint return). This deduction goes away for certain types of service businesses as well, but only once you pass the income threshold.
Think about a Sole Proprietorship if:
- You’d rather not think about anything. (Your default option is as a sole proprietor.)
- You prefer simplicity, and you are not particularly worried about liability protection. (Pro Tip: Think about getting some liability protection in the form of insurance, just in case.)
- Your income isn’t particularly high. (Really, it can be any level, but at higher levels there may be tax advantages to at least thinking about other options.)
Here’s an example of someone who might consider creating a sole proprietorship: Let’s say you are a visual artist with a strong studio practice. You regularly show work in group shows, although you don’t have gallery representation (yet). You sell, on average, 10 pieces per year, and you also receive grants (approximately $1,000) for supplies and professional development. You maintain your own liability insurance for your studio and your work, and you are not particularly concerned about liability protection. You earn $18,000 from your studio practice, and you also teach as an adjunct at the local college and as a community arts instructor at your local community center. Both institutions pay you as an employee (not a contractor), and you earn $12,000 from your teaching work.
Your best bet is probably as a sole proprietor. (An LLC could be an option as well, but since the liability protection isn’t a compelling selling point, it may not be worth the cost to you – even if the cost is really low.) The income you earn as an employee is reported on Form 1040, and your other income and studio expenses are reported on Schedule C. Just make sure to keep any expenses you may incur for teaching separate from your studio expenses. (Your teaching expenses are “unreimbursed employee expenses” and no longer deductible to you; your studio expenses are deductible.)
When Does It Make Sense to be an LLC?
Limited Liability Companies (LLCs) are separate business structures formed at the state level. They are relatively inexpensive to form and maintain (a few hundred dollars, usually), and they come with some inherent liability protection, as long as the owner or owners maintain separation between their business and personal assets. This additional protection may be appealing from a business or legal perspective, although it doesn’t necessarily factor into tax considerations. There are no additional tax costs for LLCs since they are treated as “pass-through” entities as well, meaning income and expenses are reported on the owners’ tax returns. They also get the new 20 percent deduction for pass-through entities, FYI, as long as income is below the relevant thresholds.
If there is only one owner, the single member LLC is treated as a disregarded entity, meaning it (practically) doesn’t exist for tax purposes. Everything is reported on the owner’s Schedule C, just like for a sole proprietorship. For LLCs with multiple owners (members), there will be an extra tax filing, but it usually isn’t too complicated.
Think about forming an LLC if:
- You collaborate frequently with others. (You may want the liability protection.)
- You have a high level of personal assets worth protecting.
- You love separation between your personal life and your business life (at least from a financial perspective).
- You don’t mind paying a few hundred dollars to form and maintain the LLC. (The exact amount depends on the state and the number of owners.)
Let’s try another example. You are a makeup artist who works as a freelancer for a variety of clients. Some are corporate entities (for commercials or productions) and others are individuals (for special events, performances, or evenings out). You earn between $60,000 and $70,000 per year, and you occasionally hire an assistant (also a contractor) for larger events. You are the only owner of the business.
Your best bet is probably to form an LLC, and if you are the only owner, it would be a single-member LLC. There are no tax drawbacks to forming an LLC, and you would still file the same tax form to report income and expenses (Schedule C of Form 1040). However, because you occasionally hire an assistant, you might be interested in the additional liability protection that comes with forming an LLC. (Just make sure to keep your business income and expenses separate from your personal income and expenses.)
When Does It Make Sense to be an S Corporation?
S Corporations are a special type of entity. They have a high level of inherent liability protection, but they have the option to be taxed as pass-through entities if they meet certain requirements, meaning there is no additional tax on the corporate entity. (That’s good.) However, they are relatively expensive to form and maintain. (That’s less good.)
Are you sensing a pattern? S Corporations, LLCs, and Sole Proprietorships are all pass-through entities. That means they all are eligible for the new 20 percent deduction on pass-through entities, assuming income doesn’t exceed the threshold.
So in addition to liability protection, S Corporations may have some extra tax benefits, especially when it comes to employment taxes and payments to owners. Plus, thanks to the Tax Cuts & Jobs Act, S Corporations may be a viable alternative structure for individuals who are employees and who have high levels of miscellaneous itemized deductions – think unreimbursed travel expenses, agent fees, and more – on Schedule A of their tax returns. (This is not particularly common for visual artists and designers, but it’s worth checking your 2017 return to see if you have a big number on Line 27 of Schedule A, particularly if the items listed on Line 27 are unreimbursed employee expenses associated with your W-2 job. If so, and if you are in the income range referenced earlier, keep reading.)
S Corporations enable employees to remain employees—but of the S Corporation instead of their former employer—and in that case, they can still deduct business expenses that will now be disallowed under the new tax law. In other words, if you are the owner of an S corporation, you can pay yourself as an employee of that entity, thus, deducting your salary as a business expense and keeping the deductions for those other business expenses (the ones you used to deduct on Schedule A). Confusing, right?
Think about an S Corporation if:
- Your income is at least $125,000. (At lower levels, the cost of forming and maintaining an S Corporation often don’t justify the tax savings, according to Peter J. Riley of Riley & Associates (www.artstaxinfo.com).)
- You don’t mind additional paperwork and tax filings. (Because there are a lot.)
- You don’t mind paying a few thousand dollars per year for the extra paperwork and tax filings.
- You are an employee with a lot of unreimbursed business expenses. (This may help with the loss of the miscellaneous itemized deductions under the new tax law, but stay tuned. The additional interest in these “loan out” corporations is bound to raise questions from the IRS. Definitely make sure you are consulting with tax and legal experts in your area who know the details of your own situation.)
Let’s try another example. You are a graphic designer with a somewhat unusual work arrangement. You are an employee of a major design firm, so the firm withholds Social Security and Medicare taxes from each paycheck, plus a bit for your federal and state income taxes, but you are responsible for paying for your own business expenses including software subscriptions, supplies, travel, and hardware. Your salary as a W-2 employee is $137,500, and you spend about $40,000 in business expenses.
Your best bet might be an S Corporation. Although this is an unusual scenario, this illustrates the new benefit of forming an S Corporation under the 2017 tax law change. Since individuals are losing miscellaneous itemized deductions on Schedule A, this person would lose a pretty nice tax benefit on those unreimbursed employee expenses (subject to some limitations). If this scenario feels familiar (you are an employee, you pay for your own business expenses, and you earn more than $100,000 or so), it’s worth at least asking some questions of your tax or legal advisor. You might have an S Corporation option to explore.
S Corp, Sole Proprietorship, or LLC?
The bottom line? What you are doing is probably fine. If you have unreimbursed employee expenses, do the math to see if an S Corporation is a cost-effective option for you. If you want some inherent liability protection, think about forming an LLC (or an S Corporation at higher levels of income). Keep up with your own best practices when it comes to record-keeping and separating business and personal expenses, and keep making and doing great creative work.