The Best Business Structures for Consultants
When you become a consultant, you may focus only on the benefits of working for yourself without giving much thought to the structure of your business. However, it's important to consider your options to maximize your profits and minimize the taxes you owe. Most consultants choose from four key types of business structure, each with its own unique set of strengths and weaknesses:
A sole proprietor is an unincorporated business. Sole proprietors are usually referred to as independent contractors, consultants, or freelancers. You don't fill out any forms to start this type of business. The only thing you need to do is report your business income and expenses on your individual Form 1040, Schedule C, when filing your taxes. This is by far the easiest form of business to set up—and the easiest to dissolve—but it provides the least protection.
If there is an expectation that the work you do could lead to a lawsuit, being a sole proprietor might not be the best option. As a consultant, for example, you may be asked to offer advice to clients. If a client suffers financial losses from the advice you gave that the client argues is negligent, your personal assets could be at risk.
Limited Liability Company (LLC)
LLCs are unincorporated businesses (taxed as a 1065 business). Owners, legally referred to as members, of an LLC are shielded from personal liability for any failings of the business. The only exception would be if it was proven that an owner or owners were acting illegally. Similar to a sole proprietorship, profits and losses are reported directly on owners' individual tax returns.
Many business professionals believe LLCs present a superior alternative to corporations and sole proprietorships because LLCs combine many of the advantages of both. If you have a small consulting business and want to be sure your personal assets are protected, this likely is the best option.
If an S corporation shareholder provides services to a business, the S corporation must pay that shareholder a reasonable salary. This salary is a separate payment from distributions of profits or losses. S corporations have the same basic advantages and disadvantages of general or closed corporations. S corporations avoid the “double taxation” of C corporations because all income or loss is reported only once on the personal tax returns of the shareholders. However, like standard corporations, and unlike some partnerships, the S corporation shareholders are exempt from personal liability for the business debt.
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 must elect a board of directors and maintain detailed records. S corporations are limited to no more than 75 shareholders.
A C corporation is an incorporated business (taxed as an 1120 business). Corporations usually are presumed to be for-profit entities, and as such, 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. C corporations must pay taxes on all profits, and all income earned by employees also is taxable, leading to what often is referred to as double taxation.
If working as a consultant, there is little reason to consider a C Corporation as an option. Businesses seeking this structure typically are large operations with many employees and many shareholders. Your consultant business would need to be extensive and complex for you to need to go this route.
The Bottom Line
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. Just know that you have an array of options for your business when it comes to picking your structure. Make sure to ask yourself the right kind of questions: “Do I need to incorporate?” and “Why would I want to?”
Legally, you don’t even need to incorporate, and maybe that smaller degree of maintenance would suit your business well. On the other hand, if things like liability, tax savings, and raising capital are at the forefront of your mind, incorporating may suit your business better. Picking your business structure is important and is all about what works best for you.