The term independent contractor refers to someone who personally owns their business and is the only owner. In fact, the owner and the business are the same legal entity, so any debts incurred by the business are also the responsibility of the owner.
As an independent contractor, you have choices for how to run your business from a tax standpoint. These choices include:
- Sole proprietorship
- LLC
- S corporation
- C corporation
- Partnership
Depending on the goals of the business and how many people will be involved in the business, people choose different business structures. Many people end up choosing sole proprietorship simply because it’s the easiest business type to get set up in most states. However, the other business structures, such as an LLC can provide distinct benefits that being a sole proprietor just doesn’t provide. We’ll go into more detail about those below.
Since an independent contractor doesn’t receive a W-2 form for paying taxes, they will receive a 1099 form, which shows no tax deductions. This is because they are responsible for paying their own self-employment tax like Medicare and Social Security, in addition to personal income tax. A lot of independent contractors even pay taxes on a quarterly basis to keep track of what they owe throughout the year.
Is it better to be 1099 or LLC?
To better answer that question, let’s go over some of the differences. Probably the biggest differences are the setup of each as well as the liability protection.
To set up an LLC, you will need to register it with the state, selecting a name, choosing a registered agent, and forming articles of organization. And of course, with this paperwork comes a filing fee, which varies by state. As a 1099 independent contractor, all you need to do is make sure you have the proper licenses and permits for your business and simply start conducting business.
While there is paperwork involved with setting up the LLC, the LLC structure provides an independent contractor with personal liability protection. It will protect the independent contractor from any debts or claims made against the business so their personal assets are not at stake. With a sole proprietorship, this is not the case. And debts or claims made against the business will also go against the individual owner and their personal assets are in jeopardy.
Should a 1099 employee create an LLC?
There can certainly be advantages for a 1099 employee creating an LLC. We’ve highlighted some of the main reasons that 1099 employees decide to create an LLC below.
Limited Liability Protection
Probably the biggest reason a 1099 employee would want to create an LLC is to have the personal liability protection that the LLC provides. As a sole proprietor, if someone files a claim against you and tries to go after your personal assets, they can. This could be your home, your car, or your money in the bank. Sole proprietors are also at risk for lawsuits resulting from personal injury.
With an LLC, however, the owner is given limited liability, meaning you won’t be personally responsible. So, any debts the business takes on or claims against the business, your home, car, and personal bank accounts won’t come into play.
It’s important to note though that even if you form an LLC as an independent contractor, you will still be personally responsible if you engage in malpractice or negligence. If there is a lawsuit against you and damages are awarded, you will be responsible. In this case, it’s a good idea to make sure you also have liability insurance to protect you.
Tax Flexibility
Another reason independent contractors like to form an LLC is because it allows them to decide how the business will be taxes. While an LLC is taxed as a disregarded entity by default, they can choose another option. When taxed as a disregarded entity, all profits and losses are passed through the business to the owner’s personal tax return. This means that the owner then pays taxes on any profits at his individual tax rate.
If an LLC owner doesn’t want to be taxed as a disregarded entity, then he can elect to be taxed as a C corporation or S Corporation. In order to do this, you just need to file a document with the IRS noting this election. Then, the LLC will be treated as a corporation for tax purposes. That means the LLC will file the corporate tax forms and will be subject to corporate tax rules. However, an independent contractor who is a sole proprietor will not have this option.
S Corporation Election
Let’s talk about what will happen if your elect for your LLC to be taxed as an S Corporation. If you are taxed as an S Corporation, as the owner of the LLC, you technically work for the corporation as an employee. That means that as the owner, your wages are subject to Medicare and Social Security taxes at the amount just like a sole proprietor would pay.
However, not all of the profits the business earns have to be distributed to the owner as employee wages.
Instead, the owner can be paid through S Corporation distributions. That would mean the profits are paid to the owner as a shareholder rather than an employee. This means that the distributions aren’t subject to Social Security and Medicare tax. As the owner of the LLC, you would only need to pay income tax on them at your individual tax rate. This can make a big difference in the amount of Social Security and Medicare taxes.
Of course, the larger the distribution to the shareholder, the less Social Security and Medicare tax you will need to pay. However, the IRS does require that S Corporation shareholder-employees pay themselves a reasonable salary, similar to what other businesses pay employees in the same type of industry. If you don’t then the IRS has the ability to recategorize the distribution as employee wages, which means you will then have to pay Social Security and Medicare tax on the wages.
C Corporation Election
Another option is to elect to have your LLC taxed as a C Corporation. The distinction with a C corporation is that it is actually a separate entity that pays the corporate tax rate on all profits. While C Corporations enjoy lower tax rates, they are subject to double taxation. That’s because the money is taxed first at the corporate rate when a C Corporation distributes profits to the owner, and then again at the owner’s capital gains tax rate. This isn’t usually a good choice for independent contractors unless you are making at least $300,000 in profits.
LLC Pass- Through Deduction
LLC owners that elect any federal tax status other than C Corporation, are able to deduct up to 20% of the net income earned from their business entity, now through 2025. That means if the LLC makes $100,000 in net income, the owner could deduct up to $20,000 from his personal income taxes. That’s a pretty big deal.
We should point out though that there is an annual threshold, and if the taxable income exceeds that, then the deduction will be limited to just 50% of the amount the LLC paid to the employees, or 25% of the amount paid to employees plus 2.5% of the value of depreciable business property.
Credibility
One of the perhaps most overlooked reason to create an LLC as a 1099 independent contractor is to build your credibility for your business. As a sole proprietor, it’s just you as your business. This could give the appearance of your business being very small or not successful. But, with an official LLC, having taken the time to create a formal business structure, that could indicate to people that your business is successful and a legitimate business. It could make some clients take you more seriously as a business owner.
Do you pay more taxes with a 1099?
You have to remember that independent contractors will need to pay personal income tax as well as self-employment tax. This is because you are not someone else’s employee, but are self-employed. S, you will have to pay the Social Security and Medicare taxes, or self-employment taxes, yourself.
For federal taxes, a sole proprietor’s net business income gets taxed on his individual income tax, at the proprietor’s individual tax rates.
Do you pay less taxes with an LLC?
A single member LLC is seen as a disregarded entity for federal tax purposes. That means it’s taxed the same way as a sole proprietorship. Both an LLC and sole proprietor can claim the full array of tax deductions for businesses. And, as an LLC, you’ll only pay Social Security and Medicare taxes on your share of the company’s net income. While federal tax treatment is similar for both, you will want to consult your CPA or tax advisor for state and local taxes.