When you decide to become a consultant, you may focus only on the benefits of working for yourself without giving much thought to the structure for your business. However, it's important to choose the best legal entity to maximize your profits and minimize your risks.
Why Your Business Structure Matters
The legal entity you choose for your consulting business can affect you in these key ways:
- Ease of formation: Starting a business can require a hefty amount of paperwork and other administrative duties, or none at all, depending on the legal entity you choose.
- Taxation: Not all business structures are taxed equally. Being strategic in your choice of a legal entity may allow you to take home more in profits and pay less in taxes.
- Liability: Certain business structures make you personally liable for failures of the business, which may mean you have to pay damages out of your own pocket, or through valuable assets like your house or car. Other entities provide more protection for you—and your personal assets—in the event of a lawsuit.
Common Legal Structures for Consulting Businesses
Most consultants choose from four key types of business structure, each with its own unique set of strengths and weaknesses:
A sole proprietorship is a single-owner, unincorporated business—meaning it's not a legal corporation. Sole proprietors are usually referred to as independent contractors, consultants, or freelancers.
If you're not a fan of filling out forms, you're in luck: Sole proprietorships usually don't require much, if any, paperwork. You generally don't have to register a sole proprietorship with the state. By simply starting your business activity, you are considered to be in business. However, you may have to file what is known as a "Doing Business As" certificate with the state if you choose to run the business under a name that is different from your given name. In addition, you may need to obtain licenses and permits to operate in your chosen city.
Keep in mind that sole proprietorships are "pass-through entities" in the eyes of the law—meaning that the business's assets and liabilities are not separate from your own personal assets and liabilities. The business doesn't file its own taxes—instead, the profits and losses pass through to your personal tax return. The only thing you need to do at tax time is to report your business income and expenses on your individual Form 1040, Schedule C when filing your taxes. However, you would be on the hook for withholding any necessary income taxes, including self-employment taxes to pay for Social Security and Medicare.
However, while choosing a sole proprietorship can make tax time less stressful, it can also put your personal assets at risk. If the work you do could as a consultant leads to a lawsuit, being a sole proprietor might not be the best option. As a financial consultant, for example, you may be asked to offer advice to clients. If a client suffers financial losses because of the advice you gave and argues that you were negligent, your bank account or other assets could be on the line in the event of a lawsuit.
Limited Liability Company
Like sole proprietorships, Limited Liability Companies (LLCs) are unincorporated businesses consisting of one or more members, referred to as owners.
Forming an LLC requires more paperwork. You usually have to file “Articles of Organization” with the Secretary of State (which comes with a fee) and are encouraged to assemble an LLC operating agreement that lays out the expectations of the LLC members.
Similar to a sole proprietorship, profits and losses are reported directly on owners' individual tax returns. You would also need to withhold your own personal income tax and self-employment taxes.
However, LLC owners enjoy more asset protection than sole proprietors do: They are generally shielded from personal liability for business failings that aren't related to illegal activity, willful negligence, or the personal wrongdoing of you or co-owners of the LLC. However, a creditor can choose to come after your personal assets if a court "pierces the corporate veil"—that is, argues that there is no separation between you and the business and that your personal assets are fair game for taking. To avoid such a scenario, you must give the impression that you and the business are distinct entities—for example, by maintaining separate bank accounts for your business and personal assets.
Think twice before forming a one-person LLC under the assumption that your personal assets will be protected. A single-member LLC is treated as a "disregarded entity"—which means that your business assets and liabilities generally won't be treated as separate from your personal assets and liabilities.
C Corporations are usually large incorporated businesses with many employees and shareholders. They're usually presumed to be for-profit entities, so they can have an unlimited number of years with losses. This can be a benefit at tax time but talk with your accountant or tax adviser for detailed advice specific to your situation. Like S Corporations, C Corporations must distribute shares of stock to appoint its owners, who are also shareholders.
You must file articles of incorporation, usually with the Secretary of State, to formally form a C Corporation. The corporation also has to elect a board of directors, which will delegate business activities to individuals in the business known as "officers."
C Corporations are treated as separate from the owners of the corporation. The corporation must pay corporate taxes on all profits, and all income earned by employees is also taxable, leading to a phenomenon known as double taxation.
However, unlike sole proprietorships, the C Corporation shareholders are generally exempt from personal liability for business debts—even if one shareholder has a large stake (or 100% stake) in the business. Should someone file suit against the corporation, they are making a claim against the business, not the corporation owners personally.
An S Corporation is a corporation that avoids the double taxation of C Corporations. Unlike sole proprietorships and LLCs, you must distribute stock shares to appoint owners of an S Corporation. This means that S Corporation owners are shareholders, but these entities can have no more than 100 shareholders.
To form an S Corporation, you have to file articles of incorporation and pay the associated filing fee, usually with your Secretary of State. The corporation also has to appoint a board of directors.
Profits or losses are reported only once on the personal tax returns of the shareholders, and the shareholders are taxed at individual tax rates rather than corporate tax rates. S Corporations can pay shareholders dividends, and dividends aren't subject to self-employment tax, which can result in significant savings. However, if an S Corporation shareholder provides services to a business, the S Corporation must pay that shareholder a reasonable salary, which is taxable.
The separation between the business and the owners also shields the personal assets of the corporation owners against business liabilities in most cases. But as with LLC members and C Corporation owners, S Corporation owners should commit to keeping business and personal assets separate to maintain asset protection.
Weigh the Pros and Cons of the Legal Structures
When deciding between these four business entities, first ask yourself whether you want or need to incorporate as a consultant. Legally, you don’t have to incorporate, and maybe that smaller degree of maintenance would suit your business well. Then, weigh the advantages and disadvantages of each entity and choose the one with the ease of formation, taxation, and legal protection you think you can benefit from most:
- Many consultants prefer to operate an LLC than be a sole proprietor or a corporation owner because these entities combine many of the advantages of the other two entities. If you run a small operation and want to protect your assets, this is likely the best legal structure for your consulting business.
- Sole proprietorships are by far the easiest form of business to set up—but offer the least legal protection.
- An S Corporation structure is likely only an option if your consulting business is relatively large, with several shareholders and multiple employees. Protections are similar to those of an LLC, but shareholders have more responsibilities.
- If working as a consultant, there is little reason to consider a C Corporation as an option. Businesses seeking this structure are usually large firms with many employees and many shareholders. Your consultant business would need to be extensive and complex for you to need to go this route.
While these four options are the main types of business structures that will apply to you, trusts and nonprofit structures are also available, but consultants don't typically use them. Understand that you have an array of options for your business when it comes to picking your structure; picking your business structure comes down to what works best for you.