If you are considering becoming location independent, it is likely you will also be making a career shift. Most digital nomads are in business for themselves. They are either service-based freelancers, contractors working for a single company, or entrepreneurs. All of these types of work usually require the formal creation and licensing of a business.
Once you decide to start your own gig, you’ll have to determine what type of business structure is best. Your business type determines how you handle taxes and who is in charge of business decisions.
I list the specific types of businesses at the end of this article, but first there are a few key things to understand. My apologies to our international readers, this article is only helpful for US-based companies.
In the US, businesses are registered with the state, some taxes are paid to the state, and most business issues are dealt with by your state. Laws do vary between states, but not by much. You will be able to find the most accurate information by searching for “Business Licensing (your state).” The information below is for my home state of Washington.
The federal government will still need to know a few things about your business, namely how much and what kind of taxes are you paying. This includes taxes on business profit, dividends/distributions, and employee taxes (or self-employment taxes) like medicare and social security. Your business type will drastically effect how you pay taxes. In fact, most people change their business type specifically for the purpose of saving money on taxes.
The type of business you register with the state is does not always need to be the same type you claim with the federal government. For example, my business is registered as an LLC with the state, but the federal government doesn’t recognize LLCs, so I elect to be taxed as an S-corporation. When our trip to South America starts, I will continue to be an LLC with Washington State, but I will elect to be taxed at the federal level as a partnership.
Another reason to consider a different business structure is for liability protection. In the US, where everyone sues everyone, it isn’t such a bad idea. Consider what your risks are, and what you have to protect.
Do you regularly do activities that could cause someone to sue you? I didn’t for a long time. Then I started working huge corporate events as a graphics operator. I was in charge of making sure that when Steve Ballmer walked on stage it said, “Steve Ballmer, CEO, Microsoft Corporation.”. NOT “Steve Jobs, CEO Apple Inc.” That could cause a lawsuit. My risk went up, and I decided a little protection was a good idea.
Differentiating yourself from your business doesn’t mean you can’t be sued. It simply means, that if you are sued, they can only take your business property. They can’t take your car or your house, only what your company owns and anything in your business bank account.
This is the default business type. One person, one business, everything rolls back to you at an individual level. It is the easiest type of business to form and to maintain. In most states, if you make under a certain amount, you don’t even need to apply for a business license. If you are just starting out, this is your best bet.
As a sole proprietor you have no liability protection, you cannot take on any partners and you will have to pay that whopping 15.3% (recently reduced to 13.3%) employment tax on your net income. Sole proprietors file a Schedule C in addition to their 1040 at the end of each tax year.
In most states a married couple can file as a sole proprietorship without needing to form a partnership to be in business together. My husband and I operated this way for several years before becoming an LLC.
Probably the second easiest type of business type to create. It works similarly to a sole prop, except more than one person has ownership of the business. Generally the partners are not married. Each partners shares profits, losses and management of the business. They are also all responsible for the business's debt.
A partnership (as the federal government recognizes it), is required to file a tax form at the end of each year (Form 1065). This form lists business income, expenses, and how it is to be divided amongst the partners. Each partner is then responsible for claiming that income on their personal tax returns at the end of the year. Like a sole proprietorship, the partnership business itself does not pay any taxes. All profits are passed directly to the owners who are responsible for all taxes due. This is referred to as a pass-through entity.
LLPs are almost the same as general partnerships. However, in a partnership, if one member does something really stupid like gamble all the business profits in a bad weekend in Vegas, and then skips town, the other partners are still liable for all of the debt. With an LLP, each partner is not liable for the negligence of other partners. It is a bit more complicated than I have stated here, but LLPs are most commonly used for professional practices like lawyers and accountants.
There are also several other types of partnerships, including Limited Partnerships and Limited Liability Limited Partnerships (LLLP). These structures only apply if some partners do not participate in the day-to-day activities of running the business. They help to protect partners from taking losses greater than their investments.
LLCs are a relatively new business type. Online information can be very misleading and often times just plain wrong. There is one thing you must understand. The federal government does not recognize an LLC as a business structure. Got that? You can register as one with the state, but the Fed requires you to pick another business type to figure out how to pay taxes. This is the best part about LLCs. They are flexible!
If you decided to become an LLC, you can chose to pay federal taxes as (almost) any other type of business. As I mentioned earlier, my LLC originally elected to be an s-corp, but soon we will change to be a partnership. Partnerships are simpler and require less paperwork on our part.
LLCs offer great liability protection. Owners are referred to as members, and there are no restrictions to the number of members you can have, as long as you have at least one. In addition, LLCs can be owned by corporations, partnerships or other LLCs.
You will have to do a little more paperwork to setup an LLC. Usually an operating agreement must be filed, and several other forms must be filed with the Secretary of State. LLCs in Washington State also have to renew every year and pay a $60 fee. Additionally, you will have to file with Fed to elect your tax classification. Thankfully, you only need to do that once.
Ahhh, the s-corp. The glory of self-employment tax free distributions without having to pay double tax on all business profits. We love s-corps.
Ok, what was that about? Let me explain...
An S-corp is NOT a state business type. It is only recognized by the federal government. If you are an LLC or a corporation with your state, you can chose to be taxed as an s-corp. Some restrictions apply though. You can’t have more than 100 owners/partners/members/shareholders and none can be corporations or partnerships. Pretty easy.
Let’s break this down:
First, owners of s-corps are allowed to take distributions (like dividends). If your business makes a ton of profit, you can take a distribution of that profit. Any distributions you take are exempt from that pesky 15.3% self-employment tax. Yay!
However, you must still pay yourself a salary! You can’t simply say that you work for free and everything is business profit. That’s a big ol’ red flag to the IRS. If your business makes good money and you have cash left after paying yourself a reasonable salary, you may legally take a distribution.
Second, s-corps work as a pass-through entity. Unlike regular corporations, the s-corp does not pay tax on profits. The profits are divided amongst the owners via salaries and distributions and taxes are paid on owners individual tax returns.
Becoming an s-corp means that you will likely save money on taxes. But it also means that you will need to do (or hire someone to do) a lot more paperwork. Because s-corp owners are employees of their business, you have to pay yourself a salary. And with that salary you have to deposit employment and unemployment taxes. You have to file paperwork at least every quarter to show what tax you have paid. And at the end of the year you will need to document your distributions and salaries in another half dozen forms to the government.
If you don’t have the desire to sort this out yourself, or to pay a good accountant, than for goodness sake avoid becoming an s-corp. This is the reason our business will be re-classified as a partnership as soon as we start traveling full time.
The great almighty corporation. Recognized both by the state and the fed, corporations are very complex businesses. They have rights, privileges and liabilities beyond those of other business types. They also require piles of paperwork to create and maintain. Not difficult paperwork, mind you, but paperwork none the less.
Corporations are also subject to the dreaded double taxation. All business profit is taxed by the federal government. This profit is then distributed amongst all the shareholders. Each shareholder is then required to claim that income and pay taxes a second time on their personal tax returns. Every profit is taxed twice.
Like s-corps, c-corps require that owners be paid salaries, dividends be documented, and paperwork filed accordingly with the IRS every quarter (in some cases every month). If you are considering becoming a corporation you will need better advice than mine. Seek a qualified accountant.
If you are one person (or a married couple), and don’t make a ton of money, become a sole proprietor. When stating a business you have bigger things to worry about than saving a few tax dollars.
If you there is more than one owner, form a partnership. If your partner is sketchy form an LLP.
If you are worried about liability, consider becoming an LLC with the state and electing to file taxes as a sole proprietor or a partnership.
If, you are raking in the dough, and are looking for a way to save taxes or bring in new partners, create an LLC and elect to file as an s-corp or a c-corp. Just be prepared for extra paperwork.