If you’re a freelancer in the gig economy, you want to save as much money as possible. You already pay a significant amount of money for self-employment tax. Forming a business entity sounds like an unnecessary expense.
It costs money to form an entity, whether it’s an LLC, an S Corp, or a C Corp. Even a sole proprietorship costs money to use a DBA. When flying solo with no overhead and no employees, it seems like the obvious answer is not to form an entity of any kind, but depending on your industry, you may want to reconsider. The consequences of being sued and having no legal protection can ruin your financial life.
Not all entities are created equal
There is a vast difference between legal entities. Most solopreneurs form an LLC because an LLC is easier and less complicated than an S Corp or C Corp. Corporations are best suited for businesses with multiple owners. The S Corp tax code was enacted by Congress in 1958 to encourage the formation of small and family businesses by eliminating the double taxation of the C Corp.
Forming an S Corp will lower the amount of self-employment tax you owe, but it’s not necessarily the right choice for a freelancer. For instance, an S Corp is limited to 100 shareholders, is required to be a domestic business entity, all shareholders must be U.S. citizens or legal residents of the U.S., and is restricted to one class of stock.
If you’ve got plans to expand your business and grow your company, an S Corp might be the best option for you. This detailed chart published by Upwork will show you the differences at-a-glance.
When you’re a freelancer picking up gigs on Craigslist, you probably don’t need to form a corporation, but you should form an LLC.
One disgruntled client can ruin you financially
Website development is a popular industry for freelancers, and it’s also the most volatile in terms of potential for being sued by unhappy clients. If you’re a freelance web designer operating without the protection of a legal entity, you need to be careful. One dissatisfied or disgruntled client can ruin you financially.
Developers regularly get sued by clients for a number of reasons including not delivering according to the agreement. Some clients don’t understand the inevitability of delays and malfunctions in complex projects and aren’t willing to be flexible. In 2009, an Australian company sued a developer for $15 million for delivering a late product without all required functionality.
Security flaws are another point of contention that cause clients to sue developers. As a website designer, it’s your job to secure the project whether you do it yourself or hire someone else. For example, if you create a WordPress website, it takes effort to secure the installation. If you’re a self-taught developer using one-click installation tools and you don’t understand salts, SSL, and disabling PHP file execution, you won’t be able to properly secure a WordPress site. If a client gets hacked, you can be held responsible for damages.
It’s also your job to inform a client when they’re responsible for performing security updates like updating plugins and the WordPress core. Failing to inform the client of their duties could get you sued if the client is expecting you to do the work.
You can get nailed for common practices that are illegal
Some people think images found on Google are free to use, but that’s not true. Unfortunately, web designers get sued all the time for copyright infringement when they use images they know they shouldn’t.
Sometimes, the copyright holder sues the owner of the website, and the website owner sues the designer who created the website. Courts in the U.S. and the U.K. consistently hold web designers responsible for infringement, since there is an implied duty to carry out the work without copying someone else’s material. This should be a good enough reason to form an LLC immediately, regardless of the cost!
Even if a client asked you to use a copyrighted image, you can still be held legally responsible. Without the protection of a legal entity, your bank account and personal assets will be drained to pay for your mistake.
Prevent financial devastation as a freelancer by forming an LLC
You can’t prevent all lawsuits, but forming an LLC will protect you from financial devastation if you are sued. Your risk management strategy should begin with forming a legal entity, and then you can think about insurance policies and strengthening your contracts.
Anna Johansson is the founder and CEO of Johansson Consulting where she works with businesses to create marketing and PR campaigns.
Related: S Corp vs. LLC