Language:
By Alison K Plaut
Published on 5 Jul 2023 6 min read
Whether you work as an independent contractor or an entrepreneur, deciding between working as a sole proprietor or forming a limited liability company (LLC) can be crucial to long-term success. Thus, the debate over 1099 vs LLC. While both offer significant freedom, your chosen structure can impact your business and potential growth over time. Below you’ll find the pros and cons of a sole proprietorship and an LLC to help you choose the best business structure for your goals.
What Is an Independent Contractor or 1099 Employee?
An independent contractor or 1099 employee is an individual who works for a company or companies on a contract basis. They are not, as the above heading implies, actually employees of the company at all. Instead, an independent contractor is self-employed. As an independent contractor, you perform services that are not controlled by an employer specifying when it will be done and how it will be done.
The term 1099 employee comes from the fact that contractors receive a 1099-misc form if they earn more than $600 from a single client. You are automatically a sole proprietor if you don’t form another business entity as an independent contractor. But, many independent contracts choose to work through an LLC or some other business structure.
Advantages of a Sole Proprietorship
There are significant advantages to working as a sole proprietor, including:
- Complete control: You don’t have to report your activities to any outside organization or file specific paperwork beyond your individual income tax return.
- Lower head costs: You can run a sole proprietorship out of your home and even deduct the costs of your home office from your income for tax purposes (as long as it’s not used for other purposes). You won’t have employees, lowering total expenses.
- Tax benefits: Taxes are simple as a sole proprietor—you file your individual income tax return and include all income without worry about additional business compliance. You may deduct certain qualified business expenses to reduce your total tax obligation.
Disadvantages of a Sole Proprietorship
There are a few disadvantages to consider as a sole proprietor, namely:
- Unlimited liability: If someone chooses to sue you or your business for any reason, you will be personally liable; this is a significant risk for sole proprietors.
- Limited access to funding: As a sole proprietor, you might not qualify for business loans or other forms of funding to grow your business.
- Limited growth opportunities: As a sole proprietor, you cannot hire employees to expand your business. This limits business growth to your work (although you may hire independent contractors).
What Is a Single-Member LLC?
If the downsides of a sole proprietorship concern you, consider a single-member LLC. A single-member LLC is a legal business entity with only one member (you). LLCs offer significant advantages, from simplified taxation structures to greater legal protection. As the name implies, an LLC protects you from personal liability. When you work through an LLC, your personal assets won’t be at risk if your business faces lawsuits or bankruptcy.
An LLC also gives you a flexible management structure with minimal paperwork and follow-up. An LLC may hire independent contractors or employees. Forming an LLC also offers the option to elect to be an S-Corp for tax advantages, further optimizing growth and earning potential. Learn how to set up an LLC for freelancers.
Advantages of an LLC
An LLC is the preferred business structure for many business owners for good reason. Here are the advantages:
- Limited liability protection for members: An LLC prevents the loss of personal assets in case of lawsuits or disputes. When you maintain separate bank accounts, this also simplifies the separation of personal and business funds.
- Pass-through taxation: With an LLC, you may file income on your individual tax return rather than business taxes. This simplifies paperwork and tax preparation so you can focus on the business.
- Flexible management structure: An LLC doesn’t have the same strict criteria as an S-corporation or C-corporation, so you can easily manage business progress without compliance concerns.
Disadvantages of an LLC
An LLC business entity isn’t without a few drawbacks, a few of which include:
- Higher taxes compared to a sole proprietorship: While your tax obligation should be similar for both an LLC and a sole proprietorship, you may have additional filing and tax preparation expenses if you elect to file taxes separately for the LLC. There are also nominal LLC formation and maintenance fees.
- Limited ability to raise capital: An LLC doesn’t have the option to raise capital by offering shares, as a corporation does. While an LLC may be able to qualify for a business loan, it’s limited to securing other funding options.
- Legal requirements and paperwork: While paperwork and legal requirements for an LLC are relatively simple, you must still meet requirements, which take some time and costs.
What Are the Differences Between an LLC and an Independent Contractor?
Working as either an independent contractor or through an LLC offers many of the same advantages. You’ll work for yourself, set your own hours, and maintain simple accounting structures where you can report income on your individual tax return. However, some key differences exist like registration requirements and liability protection. Here’s a breakdown of how each can affect your business in the long term.
Registration
An independent contractor doesn’t need to register to start working. Depending on the services you offer, you may need to register with the state or local governing body. This is especially true for highly regulated careers such as doctors or lawyers. For other professions, including plumbers, electricians, computer programmers, artists, designers, or writers, you can usually start working without registering your business. However, it’s always worth double-checking state and local regulations.
On the other hand, an LLC must be registered with the state governing body, usually with the secretary of state. You may also need to register the LLC with the local chamber of commerce. Find support to form and register an LLC here.
Legal Structure
As a sole proprietor, you don’t have a legal entity to work through. There are pros and cons to this (see above). In contrast, an LLC is a legal business entity that can open bank accounts, qualify for business loans, hire employees, and file taxes independently. This legal structure offers great flexibility with legal protection.
Taxes
As an independent contractor or an LLC owner, you can file income from the business on your individual income tax return. As an LLC owner, you can also elect to file taxes separately for the business entity, although this may increase costs and filing preparation time. Learn more about US tax filing requirements for businesses.
Liability
Perhaps, the biggest difference between an independent contractor and an LLC is liability protection. An LLC offers liability protection to its owners in case of lawsuits, bankruptcies, or other legal claims. An LLC, therefore, protects your personal assets. A sole proprietorship doesn’t offer legal protection or protect your assets. In case of lawsuits, you will be personally liable.
Management
Regarding the management of an independent contractor vs an LLC, both have simple management structures. Independent contractor management is somewhat simpler, as an LLC must meet legal requirements. But this factor is negligible, compared to the other concerns discussed here.
Business Operations
The differences between an independent contractor and an LLC for business operations are minimal. If you elect to form a single-member LLC, your business operations will be very similar to that of an independent contractor. However, an LLC may choose to hire employees or secure business loans to help with business operations, potentially leading to faster expansion.
Should an Independent Contractor Form an LLC?
For most independent contractors, forming an LLC requires minimal effort and low costs, while offering significant advantages. The legal protection, the possibility to hire employees to expand the business, and the possibility to secure business loans make forming an LLC a smart business choice.
Final Tips on 1099 vs LLC
Should you remain a sole proprietor or form an LLC? While you can certainly start working as a sole proprietor, an LLC offers significant advantages to protect your assets from liability. Likewise, electing to make the LLC an S-corp can offer additional income tax savings and advantages.
To find out how to save on taxes and invest in your business this year, contact Doola. Its bookkeeping software is designed to serve as the ultimate go-to tool for busy founders like you. Get Doola bookkeeping services here and see how they can help your business grow this year!
FAQs
How can you choose the right business entity for your needs?
Consider the plan for your business, expansion opportunities, the risk for your personal assets, the tax advantages of business structures, and the need for future funding for business growth. For most sole proprietors, an LLC offers significant advantages, but sometimes, an S-corporation or C-corporation will offer greater advantages.
How do you protect your personal assets as an independent contractor?
As an independent contractor, you can protect your assets by forming an LLC and running business activities through that business structure.
Can an independent contractor hire other workers?
An independent contractor cannot hire full-time employees but may hire other independent contractors.
Can you have an LLC and still receive a 1099 form?
Yes, LLCs will receive 1099 forms as long as they have not elected to form an S-corp. Learn more about LLC partnerships and 1099 forms here.
What kind of insurance should an LLC have?
An LLC should have general liability insurance to protect the business. You might also need professional liability insurance, workers’ compensation insurance, or specific coverages to comply with contracts, depending on the business activities of the LLC.
