The biggest reason for a client to incorporate or to form an LLC is to protect their personal assets, however, those who work as freelancers also benefit from tax savings and reduced audit risk.

A freelancer who is the sole owner of the business is automatically a sole proprietor, without taking any formal steps to establish their business. As a sole proprietor they report their business income and expenses on Schedule C of their personal income tax return, Form 1040. If they are profitable, they also owe self-employment tax on net earnings. And, since self-employment tax is a combination of the employee and employer shares of Social Security and Medicare taxes — only half is deductible on their personal return.

Limited Liability Companies

This legal status gives your client personal liability protection; any business creditors can only look to the assets of the company to satisfy their claims. Taxwise, an LLC with a single owner is taxed just like a sole proprietorship, with income and expenses of the business reported on Schedule C of a personal tax return. Because your client is the only owner (member) of an LLC, they are viewed under the federal income tax law as a “disregarded” entity. They may also be liable for self-employment tax. A LLC owner (technically called a member) is essentially treated the same as a sole proprietor for purposes of self-employment tax. Payments from the business to the LLC owner, usually called a “draw,” have no impact on liability for self-employment tax.

Incorporation

A corporation is a separate legal entity set up under state law that fully protects the assets of its owner (shareholder) from the claims of creditors. Incorporation automatically makes the business a separate taxpayer. The corporation files Schedule 1120 to report its income and expenses for the year and pays its own tax at its own tax rates. The owner of the corporation only pays tax on payments from the corporation to himself or herself, such as wages, dividends and taxable fringe benefits.

Becoming a corporation does not mean the corporation must be a separate taxpayer. A business owner can immediately elect to have the corporation taxed as an S corporation by filing simple forms with the IRS and with the state, if applicable.

The result: profits, losses and other tax items pass through the corporation to the business owner and are reported on their personal tax return (the corporation does not pay tax). The S corporation files a return, Form 1120S, which acts as an information return, telling the IRS about the business’ income and expenses. Your client, as the owner, reports the net amount on their personal return, as well as any payments, such as salary, made by the corporation. An S election can be made even when your client is the only shareholder of the corporation.

Medical coverage

The cost of medical insurance today can be staggering, especially for freelancers and others who work alone. Some have seen their premiums shoot up 28 percent or 32 percent in a single year! As a result, more than one-third of self-employed people have no health coverage at all.

One of the ways in which freelancers and consultants can afford health coverage is to put the cost on a business-deduction basis. For a C corporation, all medical insurance premiums are a deductible business expense. For any other business, the owner can deduct the full premiums, but only as a personal expense — the premium for the owner is not treated as a business expense.

For example, say a freelancer with an annual net income of $100,000 pays $10,000 for health coverage for herself and a dependent. As a sole proprietor, the $10,000 is deductible as a personal expense; it is an above-the-line deduction, which can be claimed even if other personal expenses are not itemized. But the premiums do not reduce her net earnings from self-employment, the figure on which she pays self-employment tax.

If she had incorporated, the C corporation could have reduced its net income by $10,000. She would receive the $10,000 health coverage as a tax-free benefit and would only pay income tax on the amount of salary paid to her by the corporation.

Typically, in solo corporations, the taxable income is “zeroed out,” meaning an amount is paid to the owner as salary to bring taxable income down to zero so no tax is paid at the corporate level. This is especially so for consultants because, under a special tax rule, any taxable income in their C corporation is subject to a flat 35 percent tax rate.

For a family of four, out-of-pocket medical expenses can run to tens of thousands of dollars annually, to pay such costs that are not covered by insurance, such as orthodontia, mental-health services, and eye glasses. By having a medical reimbursement plan, these costs can be placed on a business-deductible basis. If they are not paid through a medical reimbursement plan, the cost can be deducted personally by the business owner, subject to limitation. The itemized medical deduction is limited to amounts in excess of 7.5 percent of adjusted gross income — someone with adjusted gross income of $100,000 cannot deduct the first $7,500 of un-reimbursed medical expenses. And what is deductible only gives a tax benefit at the owner’s tax bracket (e.g., a $1,000 deduction by someone in the 28% tax bracket yields only a $280 benefit).

Audit risk

Today, even though the risk of being audited by the IRS is relatively low, business owners have cause for concern that they might become a target. One reason for this concern is the $345 billion “tax gap,” which is the spread between what the government thinks it is owed and what it actually collected. The government believes that a sizable share of the tax gap can be traced to self-employed individuals who may omit income or inflate deductions, so audit rates for those filing Schedule C are much higher than for other businesses and may even rise in the future.

For example, for the government’s 2006 fiscal year ending September 30, 2006, the audit rate for sole proprietors reporting gross receipts of under $25,000 was 3.8 percent; for those with gross receipts of $100,000 or more, the rate was 3.9 percent. For C corporations with assets under $10 million, the audit rate was only 0.8 percent.

Next Steps

Visit BizFilings at http://aicpa.bizfilings.com/ to help your freelance clients benefit by forming an LLC or corporation. An AICPA member discount will be automatically applied within the online order form. Or, if you or your clients prefer to place orders by phone, please call a customer service representative at 800-981-7183. Please remember to mention AICPA when ordering to receive the discount.