LLC for Contract Work: When It Actually Pays Off and How to Set One Up

A limited liability company (LLC) for contract work is a viable option when you regularly bill clients, need a business entity to issue invoices, or need liability protection. Generally, the threshold for forming an LLC for contract work is between $30,000 and $50,000 in annual contract revenue. This is not the case for initial work.

Have you recently been asked if you “need an LLC”? Many service-based 1099 contract workers, especially consultants, developers, and designers, have. We get this question all the time. The truthful answer, like many legal questions, is: it depends. It depends on your individual situation and your clients’ requirements.

Forming an LLC for contract work allows you to create a business and protect your personal assets from legal claims. It may also let you elect S corporation taxation. To realize the tax savings from being taxed as an S corporation, your contract work for the year should exceed $60,000, ideally reaching $80,000.

Do You Actually Need an LLC to Do Contract Work?

No. Many contract workers do not form an LLC. You can operate as a business and invoice clients as a sole proprietor. An individual can use their Social Security number or an employer identification number (EIN) to receive payments.

Defining the issue is easy. It occurs when something goes wrong. A sole proprietor has no distinction between personal and business legal entities. If there is a legal claim against a business, the claimant can pursue personal assets. For example, a client may allege that the business service caused them to incur a financial loss and seek legal recourse against the business owner personally.

Some contractors form a limited liability company (LLC) to protect personal assets against business liabilities, at the request of a client’s legal team. Usually, large companies do not make business payments to individuals. An LLC allows a business to obtain a separate tax identification number (EIN) and bank account.

What an LLC Actually Protects You From

An LLC provides liability protection to its members. A member is personally protected against the debts of the LLC. An LLC does not protect the member against liability for his or her own personal debts.

A member of an LLC can be personally liable for the LLC’s debts if the member fails to observe LLC formalities. Members are required to observe certain formalities, such as keeping separate business bank accounts. A member of an LLC can be personally liable for the debts of the LLC if a court “pierces the corporate veil.” A corporate veil is “pierced” if a member uses his or her own personal business bank account to conduct business of the LLC.

Single-Member LLC vs. Sole Proprietorship for Contractors

For federal taxes, a single-member LLC is ignored for taxes (disregarded entity), and members still report taxes personally. The member is liable for self-employment taxes. The LLC provides liability protection from business creditors. For tax reporting, members can elect S corporation status.

State Filing Fees and Timelines

Fees for formations vary and are often surprising. The following fees are for current formation fees.

Delaware increased their formation costs this year. Their charges for formation and annual taxes are as follows: $110 for the Certificate of Formation and $400 in annual taxes (previously $300). The tax is due each year on June 1. As with corporations, Delaware requires LLCs to have members but does not require an annual report.

The filing fee to form an LLC in Wyoming is $100, plus a processing fee. The annual report carries a fee of $60 or $0.0002 per dollar of Wyoming business assets, whichever is greater. Wyoming is a no-frills state for business, with no personal or corporate income tax. Because of this, numerous businesses, particularly those operating out of state, have registered to do business there.

Domestic business filings for LLCs by contractors in the U.S. are $50 in Arkansas and Kentucky and up to $500 in Massachusetts. Generally, contractors should file in their home state rather than in other states where they do business, because they would need to register as a foreign LLC and pay fees to do business in those states.

There is a trade-off when choosing a no-frills state. Processing times for business filings in Nevada and Wyoming are same-day with expedited service. Other states can take 2 weeks. Electronic filings in Delaware and Wyoming take 1 to 3 days.

Getting an EIN as a Contractor

An EIN is required to open a business checking account and to issue clients a W-9 instead of providing your Social Security Number. An EIN can be obtained for free through the IRS EIN Service. The application takes less than an hour to complete.

Due to the requirements of the online EIN tool, foreign-based founders have to use the fax or mail option to submit Form SS-4. Fax applications take roughly four to five business days to receive the confirmation letter (CP 575), and mail applications take four to six weeks.

As we know, foreign-based contract workers want the EIN as soon as possible to start sending invoices. Out of the hundreds of forms we’ve completed for foreign-based contract workers, we’ve found the fax application process to be significantly more expedient than the mail process.

Common Mistakes Contractors Make When Forming an LLC

Thinking they have to incorporate in a state where they have no ties or connections. For example, a contract worker based in Texas has no reason to incorporate in Delaware. In that case, the contract worker is adding an unnecessary layer of complication and increasing costs.

The main reason liability protection fails is the merging of personal and business finances. For the first couple of years of a business, money is fungible. It can be difficult to draw a clear line between business and personal money. However, if you end up in court defending your liability protection, merging personal and business money is a fast track to losing.

People often assume that after setting up an LLC, they no longer have to pay self-employment taxes. This is not the case. An S Corporation election is required to achieve this. The election makes financial sense only once your business is large enough to justify the added complexity of payroll and filings.

People also tend to forget about their LLCs’ annual renewals. If an LLC’s taxes are not paid on time, the state charges penalties, and the LLC is placed in a status of “not in good standing.” Being in this status can also block a business from accepting new clients.

Lastly, if a business operates without a contract for a service, it exposes itself to the risk of a default judgment.

Contract-Specific Considerations

If the majority of your contract work is done through Upwork or other staffing agencies, creating an LLC will likely not change the payment terms for your contract work. Some staffing agencies require contractors to work through a specific entity, regardless of how the staffing agency classifies the worker for tax purposes.

Create a simple ledger to track which contracts and invoices belong to which client. This information may prove useful in the event that your LLC’s operation is called into question. The ledger should be created on the first day work is done for a new client.

If you have an overseas client and are paid in that client’s currency, you must report that income on your U.S. tax return. Where the contract work is performed has no bearing on the classification of the income for U.S. tax purposes.

FAQs

EasyFiling provides LLC formation and first-year registered agent services and also helps non-resident founders without an SSN. We also offer assistance in filing formation documents for an LLC and processing EINs.