US: what do I need to know about setting up an LLC for contract work?
September 16, 2022 9:19 AM   Subscribe

What it says on the tin. I may be moving to contract work for a while, and have heard vague references to paying less in taxes if I set up an LLC and have wages go there rather than doing a 1099. Consider me a complete noob -- any and all directions, considerations, pros/cons welcomed.
posted by Silvery Fish to Work & Money (13 answers total) 14 users marked this as a favorite
Best answer: I am not a tax attorney or CPA and this is a complex topic, I can give you the highlights as a self employed individual.

LLc doesn't mean anything for taxes. It is a state-level setup that is used for liability protection if you have employees or creditors (ie you take business loans or buy products to transform or sell). An LLC can be treated as a sole proprietor or s-corp for tax purposes. Most people who are doing individual contract work selling their own labor don't benefit from an LLC. It is more important to have business insurance including errors and omissions.

You have two options tax wise. You can act as a sole proprietor, you get a 1099 from your client and it is all treated as personal income, take expenses, then you pay federal income tax as well as 15%ish Self Employment Tax (ie, medicare and medicaid). This is the easiest way to start - in my state there was no business filing requirements to start operating as My Name Consulting, I didn't even need a DBA. I paid $40 for a city business license and that's it.

The second option is to form an S-Corp. Your corporation receives the 1099, deducts expenses, then you pay yourself a reasonable salary via W-2 and take the rest as an owners distribution. You don't pay SE tax on the owners distribution, that is where the tax savings comes from. But it is a math question as to whether this is worth it - there are costs associated with setting up an S-Corp and doing the annual filings. And you can't just decide that your salary is $0, if you want to take a distribution you must first pay yourself at least the market rate for your services.
posted by muddgirl at 9:50 AM on September 16, 2022 [11 favorites]

Best answer: Beyond what muddgirl indicated, there are a number of tax minimization options available by conducting transactions between yourself and your LLC. For instance, the “Augusta Rule” allows you to rent your house out each year for up to 14 days without paying income tax. Your LLC can rent your house from you (at market rate) for board meetings. The LLC can deduct the cost as a business expense, and you can avoid paying income tax on the money entirely.

You can use your LLC to set up a self-directed 401(k) for you as an employee. This self-directed 401(k) can be set up to allow features that most corporate employers don’t allow (like after-tax 401(k) contribution conversions - the “mega back door Roth”). The LLC can direct up to 20% of corporate profit into the 401(k) - again, allowing both you and the LLC to take a tax deduction.

You can also hire your kids as employees (again, at market rate, and assuming they actually do work). This can enable your kids to contribute to IRAs much earlier in life, funded by you, for future tax reduction. This, strictly speaking, does not require an LLC, though.

You should keep in mind two things about LLCs. First, you need to treat the LLC as actually a distinct entity - that means that the LLC will keep different bank accounts, pay its own bills, file its own tax return, and keep its own accounting. Any intermingling of personal business and LLC business potentially allows “piercing the corporate veil” for taxation and for liability. If that happens, you could end up in a situation that is worse than acting without an LLC - and with significant legal expenses on top! Secondarily, many of the tax deductions allowable from an LLC require you to deduct reasonable / market rate expenses, which requires some judgement from you. Nobody at the IRS is going to believe an 8 year old kid is doing exactly $6,000 of work for you each year (IRA maximum) by working 1 hour per week. Similarly, you don’t want to set yourself up for significant tax penalties caused by trying to save taxation. If you are uncomfortable with either of the notions here, you should make sure you are working with a CPA, and perhaps a lawyer, to fully understand what you are required to do to maintain an LLC.
posted by saeculorum at 10:47 AM on September 16, 2022 [4 favorites]

Given that you're not even sure you want to do contract work, or for how long you might be doing contract work, I'd recommend that you work as a 1099 contractor for a while. After doing that, and figuring out if you'll continue, you can always transition to an LLC later.

Working as a sole proprietor is super easy. Just get an EIN so you don't need to give your your SSN. And pay your estimated taxes quarterly. After you've done that, you can look into setting up a dedicated office for tax purposes, and tracking inventory, etc.
posted by hydra77 at 11:02 AM on September 16, 2022

A sole proprietor can also open an individual 401k and make both employer and employee contributions.

And having an LLC by itself does not mean that the Augusta rule is applicable. It would have to be an LLC taxes as an S-Corp, c-corp, or partnership. LLC vs Corp status are separate decisions.
posted by muddgirl at 11:03 AM on September 16, 2022 [3 favorites]

For you I think this is essentially a marketing decision. If you want to take on contracts that are more than a single person would be handling, the LLC can help clients to understand that they are hiring a "company" with many undefined resources, rather than a "person" with 24hrs in a day to sell them.

You can do something similar without the LLC by filing for what's called a "fictitious name" or a "dba" ("doing business as"). In this case you'll still need to put your real name on the w9 tax forms you send your clients, but you'll be able to cash checks made out to your dba. This may or may not be less hassle than the LLC.

Others have covered the legal/tax implications well. I'll just concur that this is a great time to find a good CPA who can give you real advice on all of this, and who will probably save you enough money in time and taxes to justify their fees.
posted by hovey at 11:32 AM on September 16, 2022 [2 favorites]

used for liability protection if you have employees or creditors (ie you take business loans or buy products to transform or sell)

Also, if there's any chance that your work could get you sued (anything from failing to complete the work on time to injuring someone), working within an LLC shelters your personal wealth from your business's. There's still ways you can be personally sued that will pierce the viel but it's a lot harder. It is important to be careful to not intermingle personal and business funds in order to maintain this protection.

LLC laws vary by state so look up a guide for your specific quirks.
posted by Candleman at 12:17 PM on September 16, 2022 [2 favorites]

There may be companies that will not want to hire you as a contractor unless you have an LLC set up.

I used to run a software consultancy in Massachusetts. Our attorney advised us to bring on all software engineers as employees (not subcontractors). Because software development was a primary function of our business, we were supposed to have it done by actual employees.

If someone wanted to work for us a contractor, not an employee, they had to show that they were offering their services generally, not just to us. Evidence for that could be a website, business cards, and forming an LLC.
posted by Winnie the Proust at 1:51 PM on September 16, 2022 [1 favorite]

My understanding is that if you personally are doing the work, you are going to get sued personally for malpractice or negligence. The LLC offers protection if an employee of the LLC who is not you does something wrong - then the employer (the LLC) and employee (who is not you in this case) each get sued but you personally do not. Although you have to be very careful to keep the LLC and your personal finances distinct and separate for that to work.

Also, the debts of the LLC are not your personal debts but anyone entering into a contract with you for a large amount money (like a landlord or bank loan) will know that and require you to personally guarantee the contract so you are back on the hook.

In California there is also an annual fee that has to be paid by all LLC, regardless of income. Income itself gets passed through to owner to be taxed as part of your personal income so no saving there.

Since I am adverse to complicated or dubious tax deductions, I have been happy keeping my own professional services business as a sole proprietorship reporting it on a Schedule C. However, I do make sure that I have both professional liability and general liability insurance so that I am still protecting my household assets against the most common money grabbing lawsuits. (Also being careful to avoid being negligent or engaging in malpractice.)
posted by metahawk at 1:51 PM on September 16, 2022 [3 favorites]

One more thing - the LLC has to have a registered agent with a physical address that is public information. If you are working from home, you would probably want to pay to have someone else act as your agent - lots of place do this for about $50 preyer.
posted by metahawk at 2:22 PM on September 16, 2022 [1 favorite]

Definitely consult with a professional on this. When I was doing similar work, I was advised by an attorney and a tax professional that there was no benefit in setting up an LLC - because I was the one doing the work there’d be no liability protection, and my revenue/expenses were low enough that there would be no tax benefit. This was in New York State - YMMV.
posted by okayokayigive at 3:09 PM on September 16, 2022 [1 favorite]

IANAL and it varies by state, perhaps, but I was told by a lawyer when I wanted to form an LLC to be an independent IT contractor/consultant that the LLC wasn't worth it, because anyone suing would sue you personally in addition to any LLC
posted by TimHare at 3:31 PM on September 16, 2022 [1 favorite]

Best answer: Additional to the above, I learned two important things when setting up my own LLC, badly:

1. Don't incorporate an LLC in Massachusetts; the annual fees are quite high. I gather you don't actually need to register in the same state you work in.
2. Don't list your home address as the LLC headquarters; I ended up having to go to the town board to get a variance from its residential-only zoning.
posted by ook at 8:21 AM on September 17, 2022 [2 favorites]

What would be the best kind of lawyer to consult with about this?
posted by panama joe at 5:39 PM on September 19, 2022

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