Editor’s note: This is a guest post by Meredith Karter, founder of BusinessEntity®
Amid rapid changes to the US economy, an increasing number of Americans are leaving behind the security of traditional employment and turning to freelance. The number of freelance workers in the United States increased by 3.7 million to 56.7 million in the last 5 years, according to a 2018 survey conducted by Upwork and the Freelancers Union. For workers, there are several issues to consider before making the jump to freelancing.
Traditional office employment not only offers security in terms of a regular paycheck. Companies also provide a safety net against legal liabilities that might be incurred by your work. As a freelancer, all liability sits with you.
In the US, incorporation as an LLC is one of the easiest and most effective ways that freelancers can protect themselves against liability. But what exactly are the risks? What is involved in incorporating? When should freelancers consider incorporating? And aside from mitigating liability risks, what are the other benefits to incorporating? These are the questions that we’ll be addressing here.
Many freelancers start out part-time, taking on jobs that seem relatively low-risk. But as their portfolio grows and they take on higher-paying, higher-pressure jobs from more demanding clients, the risks can escalate.
Below are the five most common risk areas for freelancers in terms of facing legal action. All can result in financially crippling lawsuits.
Breach of Confidentiality
Consider this scenario: A freelancer working in media or public relations is advising two clients in a similar field and accidentally shares a piece of confidential information from one client with another. If the client feels like they have suffered some economic damage as a result of their competitor gaining proprietary knowledge, the freelancer could be sued for breach of confidentiality.
Intellectual Property Infringement
Consider these scenarios:
- A freelancer producing content for a company’s website accidentally posts a copyrighted image.
- Another freelancer comes up with a slogan for a new product, but after it is launched, a competitor claims that it is borrowed from a campaign they ran a few years earlier.
In both cases, the company can be sued for intellectual property infringement. Contractors often pass the liability for these lawsuits on to their freelancers.
Consider this scenario: A freelancer has been employed to produce an important report for a client, but due to an unexpected family crisis, they fail to produce the report on time. This delay costs the client money as they are unable to meet their own deadlines. The client could refuse to pay for the report, or worse, sue the freelancer for damages.
Consider this scenario: A freelance journalist sells a story to a big newspaper that exposes a local politician for charging personal expenses to the taxpayers. The politician refutes the claim and the source of information and sues for defamation, a liability that the newspaper passes on to the freelancer.
Consider this scenario: A freelancer is hosting an online database of clients for a company, and the database is hacked, exposing the personal details of thousands of customers. The company is charged with failing to safeguard client data, and in turn, sues the freelancer over the incident.
Incorporating to Minimize Risks
Being aware of the potential risks associated with your type of work is the first step to avoiding trouble down the road. Take the time to double check that you are not infringing copyright, and strictly avoid discussing anything about one client with another. Also check contracts carefully and be fully aware of when you are being asked to take on liability and indemnify your client.
For part-time freelancers who earn less than 20% of their income from freelance activities, this is probably sufficient. More serious freelancers should consider incorporating.
There are a variety of different ways to incorporate as a freelancer. The simplest way is a sole proprietorship, which basically means that you are your company. You control all assets and profits, and you report your earnings and losses on your personal tax return. While simple, this is a risky structure, as you are responsible for all debts and liabilities incurred by your work. If you are sued, the amount you could be required to pay is unlimited, and your personal assets, home and car are on the table.
A better option is to establish your freelance activities as a Limited Liability Company (LLC).
Limited Liability Companies
An LLC is a distinct legal entity that can be formed at a state level. It is the least complex structure available after sole proprietorships. When you form an LLC, the government no longer treats you as the owner of your business, and therefore you are no longer liable for its expenses, protecting your personal assets.
In order for an LLC to be effective and respected by law, you do need to treat your freelance work as a separate entity and keep your personal and business finances separate. You should set up a separate bank account for your LLC and pay wages and dividends into your own account.
Other Benefits of Incorporating
As well as limiting your personal liability, incorporating offers other benefits in terms of enhancing your credibility and enabling you to gain tax benefits.
When you incorporate as an LLC, you form an official company, with a name and business registration number. This helps you appear more established, making you more attractive to some clients. Furthermore, some companies will only commission work from registered companies.
In terms of tax, as an LLC you can choose whether you pay all of your taxes through your personal tax return, or whether you pay corporate tax and then only pay tax on the salary that you draw from the LLC on your personal return. This can be beneficial when earning more, as you can keep your salary in a lower tax bracket, and benefit from a lower corporate tax rate when available.
Also, as an LLC (or sole proprietorship) you can deduct the cost of acquiring medical, dental and long-term care insurance for yourself, spouse and dependents from the LLC’s taxable income.
Incorporate in 2019
If you will be earning more than 20% of your income from freelance activities in 2019, now is the time to consider incorporating. Establishing an LLC is one of the simplest and most effective ways of incorporating. Forming an LLC will protect your personal assets against any liability that your work may incur and can also provide considerable tax benefits.
Meredith Karter is the founder and proud owner of BusinessEntity. Since 2010, she has helped over 10, 000 Americans realize their dream of entrepreneurship by helping them incorporate. On her website, she provides DIY guides on how to check for business name availability, and business formation across all 50 states.