This is one of the questions I get asked most frequently by independent management consultants. Unfortunately, it’s also one of the hardest to answer because every person’s situation is different and there are multiple factors to consider. While this article will help you think through the various factors, here is the short answer: 90% of the self-employed consultants I know are set up as either a sole proprietorship or a single-member LLC.
Why is this decision so important? Although it can be a boring subject, your business structure will have significant implications, including:
Taxes. Not only how much or how little you pay but also the ease or complexity of preparing your taxes.
Lawsuits. We live in an extremely litigious society and need to consider asset protection; this is why business insurance is also an important consideration.
Image. Potential clients will perceive you differently if you have “LLC” or “Inc.” as part of your business name. More about this below.
What are your options? There is plenty of information on the web but it can be overwhelming. Here are the most common choices for self-employed professionals:
Sole Proprietorship. This is the easiest to set up and administer. You are the sole owner. Taxes are handled on your personal tax return on Schedule C. The biggest drawback? Your personal assets aren’t protected. In other words, if you get sued, the plaintiff (for example, your client) can go after personal assets such as your house. This sounds bad but there are ways to mitigate it. More details below.
Limited Liability Corporation (LLC). You may be the sole owner or you may have partners. As with a sole proprietorship, taxes are handled on Schedule C of your personal tax return. Your personal assets are protected from creditors or in the event of a lawsuit.
Corporation (C corporation). This is the most complex structure to set up and maintain. It requires detailed record keeping, and you have to file a separate tax return. Also, the corporation will pay taxes on net income, and you will also pay taxes on your personal tax return. This structure is usually overkill for self-employed consultants unless you plan to have shareholders and/or become a bigger consulting firm with partners and/or employees. Still, I see people do it. Maybe they really want to put “Inc.” at the end of their business name to seem ultra-professional. This structure does not give you any more legal protection than an LLC.
S Corporation. This structure is fairly uncommon for independent consultants, though gaining acceptance. An S corporation is a hybrid of an LLC and C corporation. Like a C corporation, it is set up by filing Articles of Incorporation with the government and issuing stock to the owner(s). The owners have the same protection from liability as members or shareholders of an LLC or a C corporation, so your personal assets are protected. It differs from the C corporation in how taxes are paid. Taxes are handled by passing through the income and losses to the shareholder(s)—presumably you, and then these items get factored into personal tax returns. There is no risk of “double taxation” as with a traditional C corp. (Note that although no tax is paid by the S corporation, it still has to file an annual tax return on Form 1120S. This is for informational purposes only and provides the IRS with an overall view of the business' earnings and expenses.) In our field I have only seen this structure once when two people were creating a consulting business together. However, recently I read that this structure may be advantageous from a tax perspective, particularly in states with a high state income tax. (Note: California has the highest tax rate at 13.3% followed by Oregon at 9.9% and Minnesota at 9.85%.)
Factors to consider and questions to ask yourself:
What is your business objective? Do you want to be a solo practitioner doing interesting, profitable work, or do you want to create a boutique consulting firm or larger company? If you’re not sure, start simple as a sole proprietorship; you can change your business structure later.
Where do you do your work? If your clients are never in your office, your risk of a physical injury and lawsuit is practically zero.
How will you fund your business? If you want or need investors, including friends or family, you should not be a sole proprietorship. Don’t assume your friends or family won’t sue you if things go south.
Who are your clients? There are two angles to consider here. Mid to large companies are less likely to suffer enough damages compared to their revenue to bother with a lawsuit. On the other hand, they are likely to require a more formal business structure in order to pay you on a business-to-business basis. In other words, if you are a sole proprietor without a corporate structure you may have to be paid like a temp worker on a W-2 tax basis through a staffing firm. There are significant tax implications to this but that’s a different topic. If you’re curious, watch my 70-second video “Friends Don’t Let Friends W-2.”
What type of consulting do you do? If you make a mistake or give erroneous advice, how expensive will the consequences be for your client? I have never heard of anyone suing an organizational change consultant. On the other hand, a branding consultant may unintentionally trigger a copyright infringement. Here is an unofficial list of business consulting fields that are higher risk:
- Aerospace consulting
- Architecture, engineering or construction management
- Environmental consulting
- Land acquisition
- Mining, oil, gas, or petroleum consulting or advice
- Safety consulting or advice
- Technology, particularly anything involving data or coding
Do you have a lot of assets to protect and are they protected in other ways? This gets tricky. My understanding is that your retirement accounts are indeed protected in the event of a lawsuit, even as a sole proprietor. On the other hand, if your assets are held in a family trust, chances are they are not protected from a lawsuit. Also, be sure to factor in personal and business insurance. In California, it is cheaper to buy $2 million of general liability business insurance than to register as an LLC (about $430 vs $800 a year).
Are you good at paperwork and record-keeping? Each business structure has varying amounts of administration with regard to the initial set-up, annual business filings, and tax filings. A sole proprietorship is the easiest, followed in order by an LLC, S corp, and C corp. The last two require maintaining formal minutes of stockholder meetings, even if you are the only shareholder, as well as salary documentation. As mentioned above, the traditional C corporation also needs to file a separate tax return.
What is your risk tolerance? This is highly personal. If you feel that the type of consulting you do is very unlikely to result in a lawsuit, then keep it simple and set your business up as a sole proprietorship and buy business liability insurance. On the other hand, if the idea of a lawsuit increases your blood pressure, protect your
self with both a corporate structure and business insurance. (A lawyer’s caveat: even if you set up your business as a corporation—LLC, C corp or S corp—a plaintiff can still sue you as an individual and claim that your legal business structure is a sham and should be ignored for liability purposes. This is one of the reasons why meticulous record-keeping is so important.)
How important is your professional image? This takes two forms, your ego and your payment status. I know plenty of consultants making over $200,000 a year as sole proprietors. They want to do interesting work and make a lot of money with as little hassle as possible. I know others who are incorporated as LLCs or C corporations, but I doubt they are any more profitable than the sole proprietors. I suspect that they want to be perceived as a legitimate business (their ego’s point of view) and/or be paid on a corp-to-corp basis (a financial point of view). They are targeting big corporations as clients so they need to have the corporate structure to help avoid being paid like a temp worker through a staffing agency.
In sum, the business structure you choose has to do with your personal assets, the likelihood of a lawsuit, your risk tolerance, and how you want to go to market. It’s a major decision and can have serious tax consequences. This article is intended as a starting point. Since every person’s situation is unique, talk with your legal and tax professionals.