LLC or Sole Trader: What’s the Best Option for Freelancers?
For freelancers, the most common form of business entity to adopt is a sole trader. This is hardly surprising, considering its relative simplicity and the ease with which it can be set up. But considering that a freelancer can also legally operate as a one-person LLC (Limited Liability Company), could this be a better option?
The LLC was a Bright Idea
If asked what’s humanity’s greatest invention, most people might be inclined to mention the lightbulb or the steam engine or even the internet. Niall Ferguson, British historian and a Harvard professor of economic history, suggests that more abstract ideas — such as the concepts of debt and insurance — rather than any physical invention, have been the most powerful tools for unlocking human potential.
Another such idea is the Limited-Liability Company. The invention of the company allowed multiple individuals to pool resources and engage in business activities under one organisational roof. However, what fundamentally distinguishes the LLC is that, by having its own separate legal identity from its owners (shareholders) and its managers (directors), it puts at risk only that capital which has been directly invested. This great reduction in risk has long stimulated an immense amount of wealth creation.
When to choose to be an LLC or a Sole Trader?
As previously mentioned, one of the most powerful things about the LLC is how it separates your personal capital from what you’ve directly invested in your business, putting only the latter at risk. As a freelancer with sole-trader status, any risks to your freelancing business are also risks to you personally; personal assets, such as a house or car, may be re-possessed in order to repay a business loan.
How beneficial such separation might be depends on a few features of your freelancing work. Firstly, does it require lots of investment and therefore large loans on which you may default? If so, operating as an LLC might be the best option. There’s a reason that use of the LLC as a business entity came to prominence in the 19th century, alongside the arrival of capital-hungry technologies such as railroads.
Another consideration to make: how much risk does the work itself involve? For example, if you’re freelancing in cybersecurity for a bank, you’re potentially liable for an awful lot more than if you’re a freelancing copywriter for a magazine. There are certain cases, such as fraud, where the director of an LLC can still be held personally liable for the company’s wrongdoing. However, under UK law, this “piercing of the corporate veil” is exceptionally difficult and rare.
Life’s two certainties: death and taxes
A major difference between being a sole trader and an LLC is how your tax bill is structured. As a sole trader, there are two principle taxes on your earnings after your business expenses have been deducted: income tax and national insurance contributions (NIC).
As an LLC, things are a little more complicated. All company profits are taxed at the flat corporate tax rate (19% in the UK). However, you will also be taxed again to actually extract personal income from the company. Income tax is paid on anything extracted as salary (although no corporation tax) and a different set of tax rates is paid on anything extracted as dividends.
Most freelancers operating as an LLC will use a combination of salary and dividends to extract their earnings, usually placing the level of salary at £8424 (the maximum you can take home without paying any income tax or NIC). Of course, any profits that you leave in the LLC and reinvest in your business will only be subjected to corporation tax.
The consequence of all these varying levels of interwoven tax is that it very much depends how much you are earning as to which setup is most beneficial.
To help give you a rough idea, check out our basic tax calculator. To use it, make a copy and fill in the different fields. If you have any question you can email me (email@example.com)
As an LLC, you can also access a variety of beneficial tax breaks that should be taken into consideration. As a sole trader, you can partially claim against items such as mobile phones and computers, but as an LLC you can deduct their entire cost from your profits so that you pay no tax on them at all. As an LLC, other tax-free benefits include expenses as diverse as public transport, medical charges and school fees. You can even legally let out space in your own home to your LLC and offset your mortgage interest and council tax!
The complicated nature of all these competing factors can make it difficult to decide which setup is best for your own personal situation. When researching this piece, I actually reached out to a qualified corporate tax lawyer. His (perhaps unhelpful) advice – “get an accountant”.
Public Perception of an LLC
Public perception is clear — an LLC is considered a more substantial entity than a sole trader. This may not seem like a major reason to opt for becoming an LLC, but it can actually result in a greater chance of landing larger projects and being able to charge higher rates. In some cases, a client will only do business with a freelancer who is classed as an LLC.
No one likes Bureaucracy
Unlike most points mentioned so far, this one is a major drawback if you operate as an LLC: it requires a lot more paperwork. As well as being more complicated to set up, as an LLC you must comply with more regulation – dealing with the Companies house on top of the Inland Revenue and the VAT office – and be more transparent with your accounts, making them visible to the general public.
Of course, the specifics of the paperwork and regulation will all depend on the exact type of freelancing work that you do. What’s for certain is that it will require more effort, organisation and transparency, as well as resulting in both higher accountancy fees and higher penalties for failing to comply.
Changing your mind
A key point to mention is that it’s perfectly fine to change your mind; starting out as a sole trader does not mean that you can’t switch to becoming an LLC at a later date. The answer may be to wait until your freelancing activities are more profitable and receiving the attention of larger clients before switching. Of course, that’s unless you’re planning on taking out a large business loan and want to make sure creditors don’t come for the shirt on your back. It’s exactly this scenario that spawned the creation of the concept of limited liability in the first place, a critical innovation for the success of global capitalism.
– Creating an LLC separates you personally from the risks you take as a freelancer.
– If your income is within a certain range, it is possible to pay less tax as an LLC (see our tax calculator).
– Larger clients often insist on freelancers working as an LLC
– Being a sole trader has the advantages of simplicity, less regulation and less paperwork