Employ
Recruit
Key Takeaways
- An independent contractor is a self-employed professional who works on a freelance basis.
- Sole proprietorship or limited liability company (LLC) are the two main business structures available to independent contractors.
- A sole proprietorship is a simple structure with low financial and administrative burdens.
- An LLC is more complex but offers much greater protection for personal assets.
What is an Independent Contractor?
Sometimes known as a 1099 employee, an independent contractor is a self-employed individual, team, or organization that works on a freelance basis to offer specialist services for other businesses and clients. Common examples include consultants, writers, designers, programmers, builders, architects, accountants, lawyers, and health or beauty professionals, but there are few limits on the scope of what an independent contractor can be.
One of the key defining qualities of an independent contractor, as opposed to an in-house hire, is that a client business is usually only able to define the pay, brief, and timeline for delivery of services, but cannot influence how tasks are completed, what hours are worked, or prevent the contractor from working simultaneously with other clients.
When setting up in business, an independent contractor can choose to operate as a sole proprietorship or set up a limited liability company (LLC).
What is a Sole Proprietorship?
By far the simplest form of business structure available to an independent contractor, a sole proprietorship is an entity involving one person who owns all the business assets, collects all the profits generated, and holds full personal liability for any debts or losses accumulated.
In most countries, establishing a sole proprietorship does not require any form of registration. The independent contractor must simply ensure they have the legal right to trade in their chosen territory, that they have any necessary licenses or permits, and that they fulfill all tax, social security, and insurance obligations.
What is an LLC?
As suggested by its name, a limited liability company (LLC) is a business structure that protects its owners by limiting their personal liability for any debts or losses incurred by the company. It prevents any individual from losing more than the total of their investment in the business, meaning personal assets such as homes, cars, or savings will never be at risk due to the shortfalls of the business.
As a more formal and complex business structure, an LLC can only be formed by official registration with the state, which requires filing various documents and, in most cases, paying fees. In many countries, there is also far greater flexibility in how an LLC can be taxed in comparison to the clearer responsibilities of a sole proprietorship.
Can an Independent Contractor Operate as an LLC or Sole Proprietorship?
The short answer is yes, an independent contractor can choose to operate as either a sole proprietorship or an LLC.
Which option is best will depend on a number of factors. These include the need for liability protection, the implications and suitability of various tax options and obligations, and any long-term plans for growth the business might have.
Key Differences Between an Independent Contractor Operating as a Sole Proprietor vs. LLC
When choosing between operating as a sole proprietorship or LLC, there are three key areas of difference that should be considered: liability protection, taxation, and the administrative requirements of the business structure.
Liability
This area of difference is straightforward. The personal assets of individuals in an LLC are protected from the liabilities of the business. This includes debts, losses, fines, and expenses incurred through lawsuits.
In a sole proprietorship, there is no legal separation between personal and business assets in any of these circumstances.
Taxation
Tax reporting and obligations for a sole proprietorship are simple. Any income from the business is reported as part of the owner’s personal returns, a process often referred to as pass-through taxation. Except in specific circumstances, no additional tax is levied on the business.
In the case of an LLC, there is a much wider choice. Owners of an LLC can choose to use a similar pass-through taxation method or instead designate themselves as an S-corp, which passes its profits or losses through to shareholders, or a C-corp, which pays corporate income tax (CIT) directly before sharing remaining profits as dividends.
Administration
No formal registration process and minimal administrative requirements make setting up and running a sole proprietorship far simpler than establishing and maintaining an LLC. The latter is a structured business that is subject to legal registration, annual filings, and a complex regulatory framework.
This makes an LLC more challenging and resource-intensive, but it can gain credibility and status by being an official business in the eyes of both the law and the public.
Benefits of Operating as a Sole Proprietorship
The advantages of an independent contractor operating as a sole proprietorship are found in its simplicity. With no formal registration requirements and a lack of fees or ongoing administration costs, a sole proprietorship is the easiest form of business structure to manage. It also offers the simplest taxation process with owners needing only to file income and expenses on a personal tax return Schedule C.
Benefits of Forming an LLC as an Independent Contractor
The advantages of forming an LLC for an independent contractor come in three main forms. The first, and often most important, is the protection of personal assets by limiting individual liability to the amount they have invested in the business.
The second is the flexibility to choose a taxation method that best suits the needs and circumstances of both the company and the individuals involved.
Finally, a fringe benefit that is not to be underestimated is professional image. Clients may view a company that is officially registered and completing the complex administration required for an LLC to be more official, trustworthy, or legitimate.
When to Choose Sole Proprietorship vs. LLC as an Independent Contract
Whether to run an independent contractor business as a sole proprietorship or LLC might depend on your company’s situation, your current status, or your length of operation.
| Sole Proprietorship | LLC (Limited Liability Company) |
|---|---|
| Preferred by smaller businesses | Suitable for individuals with significant personal assets |
| Best for businesses with minimal legal or financial risk | Ideal for industries with higher exposure to legal or financial risk |
| Simple to set up and operate | More formal structure with added administrative complexity |
| Not designed for large-scale growth or hiring | Better for businesses planning to scale operations or grow teams |
| Offers no liability protection for personal assets | Provides liability protection, separating personal and business assets |
| Limited tax flexibility | Allows for more flexible tax treatment options |
Costs Associated with Operating as a Sole Proprietor vs LLC
Every business is about ensuring incomings are higher than outgoings so cost is always an important factor when deciding what structure a company should take.
When comparing a sole proprietorship with an LLC, the difference in cost couldn’t be starker. In terms of setup and administration, there is virtually no cost associated with running a sole proprietorship.
An LLC, on the other hand, requires registration fees, filing fees, and other costs which could amount to hundreds or even thousands of dollars before the company is even officially formed. These businesses are then subject to annual state fees, administrative costs, and may even require legal and accounting support to remain compliant with regulations and keep finances in order.
Legal and Compliance Considerations for LLCs and Sole Proprietorships
Maintaining compliance with regulations and operating in adherence to the law are prime concerns of any business. Failure to do so can result in consequences including fines, reputational damage, and even restrictions being placed on the business.
In general, the legal requirements placed on a sole proprietorship are minimal and usually restricted to ensuring the right licenses and permits are in place. Some sole proprietors may also be required to have insurance or to navigate legal frameworks specific to their area of business.
An LLC is bound by these same rules and, in most cases, must also meet state and national filing requirements. It is common that an LLC is obliged to designate and maintain a registered agent, and there may be some legal stipulations on who this can be. Finally, due to the differences in liability and tax obligations, it is necessary for all LLCs to have their business and personal finances fully recorded, up-to-date, accurate, and kept separate.
How to Transition from a Sole Proprietorship to an LLC
For many businesses, operating as a sole proprietorship is the best path during the early days when the key is to keep things as simple and low-cost as possible. As the business evolves, however, it may become prudent to convert to being an LLC.
Examples of reasons to transition are a growing need to protect personal assets, the desire to take on a business partner or employees, or the benefits of changing the way the business’ tax is calculated and paid. This change can be made at any time and is as simple as forming a new LLC and moving your business over to it.
The basic steps of forming an LLC are:
1
Confirming a Business Name
A sole proprietorship can operate under the personal name of its owner, but an LLC needs its own registered name. This should be unique and not infringe on any existing trademarks so the operator will need to search both state and national records before settling on a name. If the business has growth ambitions, an international search may also be wise.
2
File Articles of Organization
The first piece of vital admin for registering an LLC is filing the articles of organization. This is a document containing basic information about the business including its name, address, purpose, management structure, and details of its registered agent.
3
Create an LLC Operating Agreement
The next step is to make the responsibilities and rights of every person involved in the business clear through an LLC Operating Agreement. This is essentially a contract that specifies voting rights, how profits and losses will be distributed, details of any non compete clauses, and the retirement or exit processes that must be followed when a person leaves the company.
4
Obtain an EIN
Any LLC will also need to make sure it is properly registered for taxation. This means filing the necessary forms to obtain a new employer identification number (EIN) that is separate from any EIN held by the individual(s) involved.
5
Open a Bank Account
In order to keep personal and business finances separate, an LLC should always have its own bank account.
6
Ensure Full Legal Compliance
Depending on the local laws, an LLC may be required to obtain additional licenses and permits or to fulfill other regulatory requirements. Ensuring all that is needed is in place should be done immediately at the start of LLC trading to prevent issues arising later.
7
Consult Professionals
Switching from a sole proprietorship to an LLC is a big step. To best navigate the more complicated legal and tax considerations of becoming an LLC, it is always recommended to consult with legal and/or financial professionals who can give expert advice and assistance to ensure everything is in hand and full regulatory compliance is achieved from the start.
Conclusion
When working as an independent contractor, there are distinct benefits and considerations for both possible business structures.
A sole proprietorship is simpler, has a lower cost, and is easier to manage. An LLC offers greater protection, professionalism, and tax flexibility.
The best option will depend on the position and needs of the business, which may evolve over time and prompt a transition from one to the other.
Author: Charlotte Evans
Charlotte is an Human Resources Information Systems and Martech expect, Charlotte has worked for major brands in the industry including FactorialHR and Tooltester. Originally from Manchester, UK, with a Bachelor's degree from the Manchester Metropolitan University, Charlotte currently lives in Barcelona, Spain.