Decisions about how to structure your business are really decisions about how you will manage your risk. In this context, “risk” is an open-ended concept that goes well beyond the kinds of doomsday scenarios that we typically think of when we think of business risk: calamitous litigation or ruinous bankruptcy. Risk also touches on small things—mistakes in a deliverable, a missed deadline, missed tax deductions—and everything in between. When you make good management choices about your business, you are managing your risk. In this effort, forming a legal entity can be one approach among many.
To understand the benefits of forming a legal entity for your freelancing business, you first have to examine the consequences of running a business without one. The truth is that not every freelancer needs or wants to take on the added complexity of forming a legal entity for their business. Many small businesses operate without them.
Sole Proprietorships
A business operated by one person without a separate legal entity is called a sole proprietorship. A sole proprietorship is the simplest legal form a business can take. It requires no special legal documentation to come into existence. Rather, it arises as soon as its owner takes steps to operate as a business. There is no legal distinction between the owner of a sole proprietorship and the sole proprietorship itself. Lots of people are sole proprietors without realizing it: a teenaged babysitter or the dog walker you find on Craigslist are (usually) sole proprietors. Many freelancers are sole proprietors, too.
Figure 1.1 Sole proprietorship structure diagram
Figure 1.1 illustrates the interrelationship of the business owner and the sole proprietorship. Here the freelancer is doing business using a fictitious business name, ABC Freelancing. Note that the business is inside the freelancer’s bubble: it has no separate existence apart from the freelancer. All of the business’s relationships fall within the freelancer’s bubble to show that the freelancer is personally responsible for all of it.
Operating as a sole proprietorship has several advantages over other types of business organization. Because it doesn’t require any special paperwork to come into existence, it costs nothing to form. It imposes no special administrative burdens, which can take time and potentially require professional help. Although a sole proprietorship can adopt a unique name, for marketing purposes or otherwise, it can also operate using just the owner’s name. This shaves a bit of cost for business licensing and avoids trademark pitfalls.
Kara the Academic Editor
Kara is an adjunct biology professor with a doctorate from a top university. Because she doesn’t earn quite enough from her day job to cover her expenses, she sometimes moonlights as a freelance editor, working with academic writers in her field to improve their articles before they get submitted to graduate committees or journals for evaluation. She gets most of her work on freelancing websites, though she’ll sometimes find projects through referrals.
Kara has some savings and an old car, but doesn’t otherwise have much in the way of personal assets. She’s never given much thought to forming a legal entity for her freelance work. For one thing, she suspects that the costs of forming an entity would consume a lot of her freelancing income. The freelancing sites she gets work through provide all the framework she needs. Legal risk has never entered her mind; as far as Kara is concerned, academics don’t sue each other. Kara might conclude that she’s better off operating as a sole proprietor for now.
Although they have no formal requirements to get started, sole proprietorships still need to follow certain rules and principles that apply to every business organization. Operating any business requires a business license from the county where the business is located. As part of the business licensing process, sole proprietorships that operate under a name other than the owner’s also need to file a fictitious business name statement, which lets the public know who is behind the name. Local naming rules vary, but at minimum the name needs to be something unique; someone else can’t have the name already registered with the county clerk’s office.
Owners of sole proprietorships report their income and losses from the business on their personal income tax returns, by attaching IRS Schedule C, Profit or Loss from Business, to their federal returns. All the tax calculations, including deductible amounts, are done according to personal income tax rules. Unlike other business forms, a sole proprietorship can’t opt to be treated as a separate taxpayer from its owner. For many freelancers, especially those who aren’t sure about how much revenue they’ll have, the sole proprietorship being included in personal tax returns may have little downside, and can be easier to document. But there is no way to take advantage of the special treatment that tax-regarded entities receive. Chapter 7 goes into more details about some of these advantages.
One potential disadvantage to operating as a sole proprietorship is their perceived value. Many people have a bias in favor of a company that’s organized as an limited liability company (LLC) or corporation, seeing them as somehow more trustworthy or professional than a sole proprietorship. Although this sort of bias favors style over substance, it can be meaningful in some circles. You should think about how much this matters to you and your clients.
Outside of specific tax situations, the main downside of a sole proprietorship is that its owner bears personal liability for the debts and obligations of the business. Every contract the business signs, every debt it owes, and every legal liability it assumes is inseparably the owner’s personal obligation. This can have serious financial consequences, especially if the business goes badly and can’t pay its debts, or it gets into legal trouble. In litigation, the sole proprietor not only pays the costs of litigation out of pocket, if the case goes the wrong way the owner will also need to pay out whatever is owed to the other side of the dispute. A limited liability entity that can’t pay its debts can be put into separate bankruptcy, potentially shielding the owner from serious financial harm. But a sole proprietor who can’t pay the debts of their business can only turn to personal bankruptcy for relief, which can have disastrous consequences for the owner’s private financial wellbeing. A business owner who also owns substantial personal property, like a home, car, investment portfolio, or even a valuable baseball card collection stands to lose a lot if the business involves risk.
Limited Liability
Well over a century ago, governments began encouraging people to take more business risk by devising legal entities that offer their owners limited liability. A business entity with limited liability, including corporations and LLCs, has a distinct existence apart from its owners and bears its own obligations. The business entity’s owner is ordinarily off the hook for the vast majority of the company’s debts. The company’s creditors—lenders, service providers, and even people who have won lawsuits against the company—can’t come after the owner’s personal assets to recover what they are owed. We’ll go into the limits of limited liability in Chapter 5.
As you begin thinking about whether to operate as a sole proprietorship or to form a limited liability entity, take stock of the risks you will face as your business grows and changes. For many freelancers, the benefits of operating as a sole proprietorship outweigh the risks, but be sure to think carefully about your situation before you reach that conclusion. To help evaluate your risk, here are a few questions to ask yourself:
•Who are your clients?
Know who your clients are. It’s always a good idea to put a new client’s name through a Google search to see what comes up. An obvious area for caution is if a client has a reputation of treating its contractors badly. Lots of news about litigation can be another data point worth considering.
Also think about your average client, both now and into the future. Is it an individual or a big business? A large organization with deep pockets might be more likely to take aggressive action than an individual, though the opposite can also be true (a large organization might decide it’s not worth the trouble, while the stakes might be comparatively high for an individual). Freelancers who work with especially litigious clients, like lawyers, should be especially careful.
•What stakes are involved in your field of work?
Consider the industry you’re in and the kind of work you’ll be doing. A freelancer who often drives a car for work, or does work that is inherently dangerous (either physically or legally), might face more risk than one who does not. Does your work touch upon your clients’ valuable assets? A website designer who works on an e-commerce site with $100 million in annual sales has more risk than someone who designs personal blog sites with no commercial activity. Likewise for a copyeditor who works on unpublished novels by famous authors. Also think about the kind of stakes your clients face. If their stakes are high, yours are probably high also. If you work on materials related to big corporate transactions, like initial public offerings, do your deadlines factor into the deal’s success? If you make a mistake, could it cost someone their job, hurt a client’s profits, or damage reputations?
•What obligations do you expect to take on?
Freelance businesses can wind up with a lot of different types of legal obligations that can contribute to risk. Will your business carry substantial debts? Beyond loans, which you probably will have to personally guarantee anyway, think about if you plan to work with subcontractors or take on other forms of financial obligation. Even if your client doesn’t pay its bill you will still owe your subcontractors for their work. Also consider the kinds of contracts you’ll be signing with clients. Some clients may require contracts stuffed with onerous terms that are difficult to comply with.
•What kinds of assets do you have to protect?
Someone who owns a home or other substantial property (investments, other passive sources of income, real estate) makes a better target for money-motivated litigation than someone living paycheck to paycheck. Few people will sue for money if they don’t have a chance of collecting; the lawyers still have to be paid even if the losing side has no means of paying a big judgment.
•How risk-tolerant are you?
Your tolerance for risk isn’t just about the sort of assets you might lose. It also relates to your ability to weather a financial setback. A young person who rents an apartment and doesn’t have much in the way of personal assets is probably less concerned about having to start over than someone who is middle-aged, owns a house, and has children. If you are nearing retirement, you are probably especially wary of exposing your savings to business risk.
•What kind of insurance is available to manage your risk?
Every business, regardless of its form, should carry some amount of liability insurance to avoid being wiped out by one bad mistake. Consider the kinds of activities you will undertake for your business. If you plan to drive a car as part of your freelance work, make sure that your auto insurance covers business uses. If your work takes you out of the home, consider a property and liability (P&L) policy to ensure that you’re protected if you damage another person’s property while you’re on the job. Talking to an insurer about your business can also give you better insight into the kinds of risks faced by people in your line of work. Like the commercials on TV say, insurers have seen just about everything. Best of all, this sort of consultation is free.
•How do you anticipate your business growing and changing?
If you decide to operate as a sole proprietorship, you can always form a separate legal entity later. Perhaps your freelancing work is a haphazard side business with long stints between jobs, and the work you’ve been doing hasn’t justified forming a legal entity. But if you anticipate your business growing, with lots of new clients and projects on the horizon, it might be a good idea to form your legal entity before the risks start piling up. It can be difficult to move a sole proprietorship’s obligations into a new company.
Lane the Photographer
Lane is an accountant by day who sometimes earns extra money as a portrait photographer. For several years he has operated his photography business as a sole proprietorship, essentially using his income from the business to pay for upgrades to his photography equipment, which he’s written off as a business expense on his tax returns.
In search of a niche that might turn his photography into a bigger source of income, Lane discovers a demand among the local extreme mountain biking scene for gnarly portraits of riders bombing down mountainsides. Even though Lane lets the riders decide for themselves how crazy they want to be, he worries about his camera causing a distracted client to crash.
Imagining lawsuits by a rider’s next of kin, Lane takes a few steps to manage his risk: he starts looking into insurance that will protect him and his clients if there’s an accident, he begins thinking about forming a legal entity that will limit his personal liability, and he asks a lawyer to draw up a contract for clients to sign that includes a liability waiver.
Thinking about Litigation Risk
Litigation is something you’ll hopefully never face in your freelancing career. You can go a long way to avoid litigation by doing good work and fulfilling your professional obligations, especially where money is concerned. But even when you do everything right you can still get blindsided by aggressive lawyers, and mistakes do happen. Because litigation can be an especially expensive and damaging event for a small business, it’s a good idea to understand a few things about it.
First of all, if anyone ever threatens to sue you or your company, be sure to talk to a lawyer about your options before offering any response; even acknowledging receipt of a threatening letter can have consequences. Aggressive attorneys will threaten all manner of hellfire to recover what their client thinks it is owed. They might threaten to sue for an outrageous sum of money, or they might assert that they can come after your personal assets even though your business is operating as a limited liability entity and the company owns all of the obligation. The goal of such threats is to scare you into making a mistake.
You may be wracking your brain trying to come up with a situation where your business would be sued. It could be that your line of work really doesn’t expose you to litigation, in which case you’re lucky to be able to discount this element of your risk analysis. But bear in mind that litigation can cast a wide net. You might only contribute a small part of a large project, but if a firestorm of litigation breaks out, someone—either at your client or at the company suing it—might run across your involvement and conclude that you should be dragged into the litigation.
Lawsuits are expensive even if you win. No matter how good your case, hiring a lawyer and paying court fees can quickly drain your business’s coffers. Unethical people will sometimes file lawsuits knowing that they’ll get a favorable settlement because the cost of litigation is too high for their victim to endure. This is where insurance can be helpful. A good insurance policy will cover litigation costs, sometimes with the insurer’s own lawyers taking on the case. In these cases, insurers are protecting themselves from making a big payout, so they don’t necessarily have your best interests at heart. But at least they’re picking up the tab.
A threatening letter doesn’t mean you’ve been sued. To initiate a lawsuit, someone has to take the step of filing paperwork in a court and providing you with service of process. Many businesses don’t know that they’ve been sued until a process server shows up at their door with official paperwork. Among the documents the server delivers will be a copy of the complaint the person or business suing you, called the plaintiff, has filed against your business. The complaint describes the technical particulars of what the plaintiff thinks your business has done wrong, and sets out the plaintiff’s demands. A plaintiff’s demands might include a sum of money, or that the court order your business to take certain steps, such as delivering a final product (whether you produce it, or pay someone else to do it for you) or stopping use of the plaintiff’s intellectual property.
A lawsuit rarely goes all the way to trial, simply because it’s too expensive. Your lawyer may advise you to enter into a settlement agreement to end the lawsuit. To stick, a settlement might require your company to pay part of what the plaintiff has demanded, or take other actions. The good thing about a settlement agreement is that you can stop the bleeding from legal fees, and you can have some say about how much your company has to pay. The downside, of course, is that you might have to pay something to settle, even though you don’t think you’re at fault.
If a lawsuit does go all the way through to trial and your opponent wins, what then? The trial moves into the remedies phase, where the court determines whether to order your company to take certain actions and pay some money to make the plaintiff whole. Once the plaintiff has a court order against your company, it becomes a creditor of your business. If you’re a sole proprietorship, the winning plaintiff can now take harsh steps, like putting a judgment lien on your property (such as your house or car). If your company is a limited liability entity, the plaintiff might be limited to going after just the company’s property. For a freelance business that might not amount to much: the cash in the company’s bank account, maybe some equipment you’ve expensed. In Chapter 5 we’ll look at one theory a plaintiff might use to try to reach past your limited liability entity to get at your personal assets. Fortunately, overcoming a properly managed legal entity’s liability protections isn’t easy.
Many businesses have started to manage litigation costs by requiring their contractors to agree to resolve disputes through binding arbitration instead of litigation. Arbitration is intended to be a “light” version of litigation, with fewer technicalities and shorter processes leading to a result that is comparable to that of litigation. Because it’s relatively simple, arbitration can involve lower legal fees and get resolved more quickly. As arbitration has grown in popularity it has also grown in complexity, meaning it’s still an expensive process.
The Worst Case Scenario: Bankruptcy
If you reach a point where your business is deeply underwater, creditors are harassing you with phone calls and threatening letters, and you don’t see a way out, bankruptcy offers a potential safety valve. When an individual or business declares bankruptcy, a court orders the debtor to pay what it can, usually by selling off assets, and then voids the rest of the debts. Bankruptcy itself is expensive and can have consequences for your personal finances for years afterward, so it isn’t something to do lightly. But it’s nice to know that it’s there.
An important distinction to understand when you’re still sorting out how to structure your business is the difference between personal bankruptcy and business bankruptcy. These are just the way they sound. In a personal bankruptcy, the individual debtor seeks relief. In a business bankruptcy, a legal entity is the “person” trying to escape otherwise inescapable debt. A sole proprietor has no option but to seek personal bankruptcy, because there is no distinction between the individual and the sole proprietorship. On the other hand, someone who operates a limited liability entity might be able to put just the company into bankruptcy, leaving personal assets out of the process. Bear in mind, however, that in a bankruptcy process the company’s debts will be exhaustingly analyzed, and any debts that the owner has assumed will stick unless the owner separately declares personal bankruptcy. We’ll look into how assumption of liability works in Chapter 5.
The United States offers debtors several flavors of bankruptcy, referred to by their chapter in the U.S. Bankruptcy Code. The two most likely to apply to a small business are Chapter 7 and Chapter 13 bankruptcies.1 In Chapter 7 bankruptcy, which is available both to individuals and business entities, the court appoints a trustee to sell the debtor’s assets and apportion the resulting value among the company’s creditors. In a Chapter 7 business bankruptcy, all of the legal entity’s assets are sold and the entity itself usually gets dissolved. In a personal Chapter 7, the debtor’s personal assets get sold off. Unlike a Chapter 7 business bankruptcy, the Chapter 7 personal debtor can use exemptions to protect some assets from being liquidated. The exemptions are designed to prevent someone in bankruptcy from ending up penniless or unable to earn a living. The specific exemptions are dependent on state law, but usually include things like a certain amount of cash, a portion of the equity in your home, a certain amount of the value in your car, and otherwise valuable but meaningful items like wedding rings.2 Ordinary things like clothes and household goods are usually exempted as well. Importantly, a Chapter 7 personal bankruptcy might allow the debtor to keep assets related to her business. Individuals with high net worth or very large debts might not be able to use Chapter 7 bankruptcy.
Chapter 13 bankruptcy is only available to individuals. Unlike Chapter 7, Chapter 13 doesn’t force the debtor to sell off nonexempt assets. Instead, the debtor gets to reorganize her debts into a repayment plan, which gets the court’s blessing. Ideally, the individual in Chapter 13 bankruptcy gets to carry on doing business as before, with a portion of future income set aside for the repayment plan.
Another type of bankruptcy you’ve probably heard of is Chapter 11 bankruptcy. Chapter 11 is an elaborate and expensive path usually followed only by large businesses or individuals with exceptionally high debt. In Chapter 11 bankruptcy, the debtor gets to reorganize its debts under a payment plan, but creditors get a say in how the plan works. It’s available to both individuals and businesses, with a streamlined process available for “small business debtors” (entities with less than $2,490,925 in debt).
Needless to say, bankruptcy is a complicated knot, with overlapping layers of federal and state laws, personal and business debts, and a parade of creditors. If you take nothing else away from this brief discussion, remember that a business entity can be put into separate bankruptcy from its owner. Provided that the owner isn’t also on the hook for crushing debts related to the business, a limited liability entity can take a big gob of debt into the ether, leaving the business owner free to start again.
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1 Nolo.com is a good resource for information about Chapter 7 and Chapter 13 bankruptcies. Nolo. 2017. “Bankruptcy.” www.nolo.com/legal-encyclopedia/bankruptcy (accessed August 3, 2017).
2 Kathleen Michon. 2016. “Bankruptcy Exemptions – What Do I Keep When I File for Bankruptcy?” www.thebankruptcysite.org/bankruptcy-exemptions, (accessed August 3, 2017).