If you’re a freelancer, you’re likely operating as a 1099 independent contractor. Unfortunately, that also means you’re paying the most taxes possible, have no legal protection, and are perceived as an individual, not a business.
In 2015, I took my freelancing career full-time. Each year was better than the last, but the more money I was making, the more I was paying in taxes.
During that time, I had to deal with a few client situations that left me uncomfortably exposed from a legal perspective.
Then, when I started turning down paid work for lack of availability, I found it difficult to grow my business by hiring subcontractors because clients were hiring me personally for my skills and experience. The way clients perceived my business was hindering my future growth.
That’s why after nearly 10 years of being a 1099 contractor, I decided to form an S-Corp called Matthew’s Design Co. for four main reasons:
Most freelancers aren’t familiar with S-Corps, so I’ll do my best to outline how each of these four business elements work as a 1099 contractor in contrast to an S-Corp in an effort to shed some light on this unfamiliar and complicated topic.
1099 contractors pay the highest taxes possible. You’ll have to pay federal income tax to the IRS as well as state taxes. In most states, this typically works out to about 30% of your total gross income.
However, freelancers are also hit with a 15.3% self-employment tax, which includes 12.4% Social Security and 2.9% Medicare. When you’re a W-2 employee, your company subsidizes this cost for you, but when you’re self-employed, that tax burden falls on you.
That brings the total taxes you owe as a 1099 contract to roughly 45% of your gross income. So if you earn $100,000, you’re only taking home about $60,000 after taking the standard $12,000 deduction for single taxpayers.
If you’re running a freelance business correctly, you give each client (who’s paying you more than $600) a W-9 form with your social security number (SSN) at the start of a project.
Then, at the end of the year, that client sends you a 1099-MISC form, which is simply a receipt acknowledging that their business is reporting the money they spent on your work to the IRS.
An S-Corp can offer a massive tax savings on your freelance income if you’re an above-average income earner for your geographic location.
The purpose of an S-Corp is to pay yourself what is considered a “reasonable salary” by the IRS (proportional to your total income) and to take the rest as distributions which are NOT subject to the 15.3% self-employment tax.
How It Works
An S-Corporation is a completely separate business entity of which you are an employee and, in most cases, the president. Therefore, any income you earn gets passed to you through the business entity. This is known as “pass-through” income.
Instead of a client hiring you personally, they hire your business. It’s as simple as providing a W-9 form with your businesses information on it rather than your personal information and sending an invoice with the business name on it.
All your income will now be deposited into a business checking account and, using a Payroll company such as Gusto, you’ll pay yourself whatever is considered a “reasonable salary” for your profession.
That income is subject to all the normal taxes and withholdings as if you were working for any other company. In short, you’re a W-2 employee of your own company and you choose how much to pay yourself!
There’s also a huge 20% tax benefit for S-Corps under the new Tax Cuts and Jobs Act of 2017 offering even more savings.
Important: Having a payroll company and business checking account is mandatory for all S-Corps.
However, most payroll software is clunky, confusing, and hard to manage. But Gusto is truly amazing and makes payroll fun, easy to understand, and easy to manage. Some of my favorite features include:
Payroll on Autopilot
Give yourself bonuses and run one-off payrolls
Easily pay domestic and foreign contractors
Automatic end-of-year tax filing
Easily access pay stubs and other important records
Beautiful and intuitive interface
Clear email notifications and reminders
Helpful and responsive support team
It’s so easy that sometimes I forget that I even have a payroll company. I’d highly recommend using them over Paychex or QuickBooks!
S-Corp Tax Example
For example, if you’re making $150,000 as a freelancer living in New York state, a “reasonable salary” might be $60,000. So, you’d put yourself on payroll for $60,000 and take $90,000 as distributions which are NOT subject to 15.3% self-employment taxes. That’s an instant $13,770 you’re not paying in taxes before any deductions or other tax benefits are factored in.
However, if you only make $40,000 as a freelancer, you probably don’t make enough to pay yourself a “reasonable salary” and therefore can’t take distributions. In this case, an S-Corp may not be the right decision for you.
If you’re wondering, no – you cannot game the system and pay yourself a $10,000 salary, then take $140,000 in distributions to save more money. That would be considered illegal.
Operating as an S-Corp is significantly more expensive than operating as a 1099 contractor or an LLC, but you’re saving WAY more than you’re spending to operate the business.
It costs about $1,500 for a CPA to set up the business entity initially and about $1,200-$1,500 for a CPA to prepare your return at the end of each year.
You’re also looking at $45/mo for a payroll company like Gusto and about $35/mo for a proper payment solution such as QuickBooks.
You’ll also want to use a real business address so your home address isn’t exposed to clients. I use Regus virtual offices, which costs about $45/mo and has a mail forwarding service. Lastly, I purchased professional liability insurance for about $65/mo (more on this below)
That means it will cost about $3,600 each year to keep your S-Corp running.
1099 contractors have zero legal protection in the event of a lawsuit. If a client decides to take legal action against you (even if you’ve done nothing wrong), you’ll be responsible for paying any legal fees to defend yourself.
Anyone can sue you at any time for any reason and you’ll have to pay a lawyer to defend you. That’s also why freelancers don’t take clients to court over missed payments. You’ll probably spend more in legal fees trying to get the money than the actual amount you’re owed.
But the biggest legal issue with operating as a 1099 contractor is that all of your personal assets are up for grabs in the event of a lawsuit. Your car, house, computer equipment, jewelry, and any other valuables could be taken to cover costs if you were to lose a legal battle with a client.
Since your sending a W-9 form to your clients with your address (presumably your home address) and social security number, having a client become hostile toward you can be quite scary. You’re completely exposed to potential danger personally, professionally, and financially.
As a single guy living in an apartment, and freelancing on the side with a full-time job, I wasn’t terribly concerned about getting sued. But once I got married and bought a house, this was no longer an acceptable risk to take.
S-Corp Legal Protection
With an S-Corp or an LLC, only the business can be sued. That’s because the client is doing business with your business entity, not you personally (even though you are still the one executing the work).
So if a client won a lawsuit they filed against your business and the business couldn’t afford it, the business would go bankrupt, you would start a new S-Corp, and you’d be back in business without any risk of your personal assets being taken from you.
Additionally, I chose to purchase one million dollars of professional liability insurance (also known as Errors & Omissions insurance) from Hiscox for about $65/mo. This protects my business from claims of copyright infringement, negligence, defense costs, claims from prior work, and more.
Practically speaking, this means that:
if a website you built causes a clients business to lose money, your client will have a difficult time winning a claim of lost income against you since you’re covered up to the amount you’re insured for.
if a website you design launches and a competitor files a copyright claim, your client will have a difficult time winning a claim of negligence or copyright infringement against you.
Hiscox will cover defense fees as well, so you can rest assured that you are protected from most lawsuits and legal claims.
I highly recommend that you purchase some amount of professional liability insurance regardless of whether you operate as a 1099 contractor or have a formal business entity.
Remember, get insured for the amount your clients could sue you for, not the price of the services you offer!
1099 Client Perception
1099 contractors are often perceived as cheap commodity laborers, not valuable business partners. That’s why many freelance clients tend to be cheap, demanding, and controlling.
This usually results in freelancers feeling like they aren’t in control of the project and need to reduce their pricing, extend the timeline, commit to endless revision cycles, and bow to the clients wishes if they want to collect a paycheck.
Over the years, I’ve been able to break away from that stereotype and attract more respectful clients with larger budgets who understand the value I provide.
However, as a 1099 contractor, I couldn’t find a way to grow grow my business beyond myself without lying to my clients.
I know my clients specifically hire me for my skills and expertise. They wouldn’t be happy to find out I was subcontracting the work to someone else. The obvious solution is to brand myself as a business instead of a freelancer. But that leads to another problem…
I can’t brand myself as a business because most of my clients are specifically looking to work with a freelancer. They don’t want the hassle, complexity, or cost of working with even a small “agency”.
I suspect the mis-perception would result in a dramatic decrease in leads or at minimum change the types of clients contacting me for work.
To further compound the issue, I have little interest in managing people. I’m not even sure if I want to grow my business more, but I’d like to have the option rather than be forced to turn away good work.
S-Corp Client Perception
With an S-Corp, I get all the legal and tax benefits while having the option to re-brand as a business in the future.
While I can continue to operate the same way I did as a 1099 contractor, there are a few subtle differences that impact a clients perception of me.
First, I get to put my business name in the footer of my website. That’s a subtle, yet effective way to let prospective clients know I’m operating as a legitimate business. Most clients will appreciate what’s behind putting a business name there. It instantly signals professionalism.
When I write a proposal for a client, I use the business name, not my personal name. When I send my Master Services Agreement, I use the business name.
When I send clients a W-9 form, it has my business name, employer identification number (EIN), and the little “S-Corp” box is checked.
When clients get an invoice from me, it’s from “Matthew’s Design Co.”, not “Matt Olpinski”.
All of this contributes to the client understanding that they’re doing business with another business, not a freelancer. That type of perception typically results in the client respecting me much more throughout the process.
That matters a lot because unlike before, if I were to tell a client that I’m going to be working with one of my “team members” on their project, it doesn’t feel so strange. It doesn’t feel deceitful. In fact, they may be happy to know that more than one person is being dedicated to their project!
At every step prior to the work beginning, the client has been slowly building trust with my business, not just me personally.
An S-Corp requires you to have a payroll company so you can pay yourself as a W-2 employee (of your own business). But you can also use that payroll company to hire subcontractors with ease. Cutting checks, setting up direct deposits, recurring payments, and even hiring someone full-time (with benefits) are now incredibly easy.
By forming an S-Corp, I’ve laid the necessary foundation for future growth in any direction I choose.
Is an S-Corporation Right for You?
An S-Corp might be right for you if:
You’re freelancing full-time
You’re an above average earner in your city as a 1099 contractor (generally speaking this is probably $50k and up).
You want to save money in taxes
You want legal protection
You want to be set up for future growth
You want to offer stock options
You can afford about $3,200 a year in operating costs
An S-Corp might NOT be for you if:
You make less than what would be considered a “reasonable salary” in your city as a 1099 contractor
You’re only freelancing part-time
You can’t afford $3,200/year ($260/mo) in operating costs
You need legal protection and want to improve client perception, but can’t afford an S-Corp yet
10 Steps to Create an S-Corp
Buy a virtual office address you can use on all the paperwork for your new S-Corp. Make sure it can receive and forward snail mail. It’s important to do this first because you’ll need an address to use for steps 3-10!
Interview CPA firms to find one you like and trust
Pay them to handle all the necessary paperwork for the S-Corp setup
Select a bank, open a business checking account, and make an initial deposit that can cover your estimated payroll
Update your payment info on all business related accounts to use your new business debit / credit card.
Sign up for a payroll company like Gusto or Paychex and start running payroll
Sign up for QuickBooks. Harvest is great too, but Quickbooks is more powerful.
Sign up for professional liability insurance through Hiscox
Delete any old accounts you no longer need to pay for
Start using your business name and address on all W-9 forms, proposals, and contracts. It’s critical to ensure all new clients are using your business EIN and not your personal SSN so that income can be taxed properly under your new S-Corporation.
Frequently Asked Questions
When I started researching S-Corps and LLC’s, I had a million questions that no one seemed to be answering online. So I’m going to list all the questions I had in hopes the answers will help you!
How much does it cost to operate an S-Corp?
One-Time Business/Legal Setup Fee (from a CPA): $1,500
Gusto Payroll: $45/mo
Hiscox Insurance: $65/mo
Regus Virtual Office Address: $45/mo
Annual Tax Preparation: $600-$800 (excluding personal tax return fee)
Total: $3,200/year ($4,700 for the first year)
Will I still have instant access to all my money, not just the salary I pay myself?
Yes! I was worried that if I paid myself $50k, anything beyond that would be tied up in some weird account somewhere. However, that’s not true. You’ll always have access to all your money at any time.
You’ll simply open a business checking account and all your income will be deposited there. This is where your payroll will be debited from. When you need more money than what you’re getting through payroll, you have two options:
Run a special one-time payroll (subject to all taxes)
Simply transfer money from the business checking to your personal checking, which will be classified as a “shareholder distribution” transaction in QuickBooks, not subject to the 15.3% self-employment tax.
It helps if you have your business checking and personal checking through the same bank so the money transfers instantly.
How much money do I need to keep in my new business checking account?
Enough to cover your own payroll. You can decide to pay yourself weekly, bi-weekly, monthly, bi-monthly, etc. The idea is for you to always have enough money in that account to cover your payroll and all of your monthly expenses.
Will I still need to save money for taxes when I take a shareholder distribution?
Yes! This money is still taxed at your normal tax bracket rate, but isn’t subject to self-employment taxes. You should put about 15-20% of any shareholder distributions you take in a separate savings account so you don’t owe money during tax season.
What if I don’t have enough money to cover payroll?
No problem! You’re essentially you’re own employer, so you can simply pause your payroll until there are more funds in your account. However, you can avoid this by choosing a salary that you’ll most likely be able to afford each week or month.
Do I still have to pay estimated taxes each quarter?
Nope! Say goodbye to estimated taxes. Your payroll company will handle all that for you by withholding money from your paycheck, just like a normal employer would.
Do I still have to track my expenses for tax deductions?
No! If you’re using the business debit or credit card for every business transaction in conjunction with a system like QuickBooks, this should be completely automated.
Yes, this is mandatory. However, you’ll get a shiny new debit card with your business’s name on it!
Use this for all business-related purchases and be sure to make this the card you use for online services such as Gusto, QuickBooks, Hiscox, etc so the money is taken directly from your business account, not your personal account. This will be a business write-off at the end of the year!
What should I name my business?
You can name your business anything you want, but the legal name will have to end with Inc., Incorporated, Corp., Corporation or LTD.
Do yourself a favor and think LONG and HARD about what your business name will be prior to starting the formation process. I chose “Olpinski Design LTD” hastily in my accountant’s office, but wasn’t thrilled with it.
As it turns out, it was a huge (and expensive) pain to change it to “Matthew’s Design Co.” later on, so choose wisely! This will be on all your official paperwork!
You can also have an assumed name, which is essentially an alias that you can use on contracts and proposals as if it were the legal name.
Can I use my personal address as my business address?
You can, but I wouldn’t recommend it. You don’t want to expose your personal address to clients and you may want to use something more permanent, especially if you’re renting an apartment.
To accomplish this, I purchased a virtual office address through Regus Virtual Offices. All my mail is sent there, then forwarded to my home address. As a bonus, it’s a real physical space I can use to hold client meetings. It’s a professional and permanent solution.
Do I need a CPA or can I use TurboTax?
I’d highly recommend using a CPA. S-Corps are complex and should be handled by a tax expert. If you use QuickBooks, you can easily give your accountant access to all your transactions to make the tax preparation process simpler for them.
Was it worth it? How much do you really save in taxes?
I saved $7,000 on just 3 months of income at the end of 2018. I’m expecting to save about $20,000 in taxes each year moving forward. That FAR outweighs the operating expenses I incur by having an S-Corp.
Why not form an LLC instead?
Overall, LLC’s are simpler (and cheaper) to setup and much less expensive to operate throughout each year. You’ll still get the same legal protection as an S-Corp, but you won’t see any tax benefits.
If you’re already an LLC, you can elect to be taxed as an S-Corp, which could also have tax advantages.
I hope that helps! If you have a question you’d like answered, email firstname.lastname@example.org or join The Freelance Institute to chat with me and other freelancers from around the world, ask questions, and get the best advice for your freelancing business. I always do my best to respond personally!
Last updated on October 10th, 2022
About Matt Olpinski
Matt runs his own web design and development company Matthew’s Design Co. and teaches thousands of freelancers how to succeed through his personal blog, newsletter, and community for freelancers — The Freelance Institute.