Lesson 5: Legalese – Napkin Finance

Lesson 5: Legalese

Whether you’re an accountant, a yoga instructor, or an Uber driver, it’s important to think about how your business is legally structured.

Your business structure will affect how you’re taxed and how much you’ll owe the IRS and your state government each year. It can also affect how you document your finances and could even be relevant if you ever, say, were sued by a client.

Common classifications

These are four popular self-employed tax categories:

  • Individual contractor: You provide services for clients but are not an employee, and your income is reported on the 1099-MISC form.
  • Sole proprietor: You are the only owner and employee of your business. Unless you file otherwise, you’ll likely be taxed as a sole proprietor.
  • Limited liability corporation (LLC): By creating a business entity, you separate business and personal finances and have flexibility in how you elect to be taxed.
  • S corporation: A way for very small businesses to incorporate and take advantage of some of the same tax benefits as larger corporations.

Main differences

Each classification comes with different benefits as you’ll see below.

Classification Main benefit
Individual contractor No tax withholding when you get paid; extensive tax deductions 
Sole proprietor Separate business and personal income; many tax deductions allowed
LLC Creates a buffer between business and personal assets, providing some financial protection 
S Corporation Gives businesses with 100 or fewer employees the tax benefits of being a corporation but lets owners be taxed as individuals 

How to set up

You don’t have to file any special paperwork to be treated as an individual contractor or a sole proprietor.

Setting up an LLC or S corporation, by contrast, requires a little more effort and overhead. And you may need to work with a tax professional to make sure everything is above board. But creating a formal business entity has the benefit of separating your business assets from your personal ones. That can provide important financial protection if you ever get sued.

Pros and cons of incorporating

Establishing an LLC or filing as an S corporation can provide some legal and tax benefits. But it’s not the right move for everyone. Here are some points to consider:

Pros Cons
Potential tax benefits Requires time and money to set up
Flexibility in how you pay yourself  Stricter documentation requirements 
Separate business and personal assets May have to file additional reports or obtain licenses from the state each year

Separation of concerns

While it’s always a good idea to keep your business income account separate from your personal finances, it’s especially important when you’ve established an LLC, a sole proprietorship, or an S corporation.

Expect to maintain business checking and savings accounts, and keep detailed records of salary payments, any shareholder dividend payments, and profit and loss statements.

If that seems like a ton of work, don’t panic—you can always hire an accounting service to help you out. But again, that requires money and mental overhead, so you may only want to go this route if you’re committed to building a business.

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