How to set up my business as a self-employed contractor

Question

I am a full time employee in New York City who does contract work on the side. Next year, I would like to set up a business for myself for this, with the expectation that I might become a full-time freelancer / contractor. What is the best way to incorporate myself? Sole-proprietorship, LLC? My goal is ease of management of the business / taxation / etc, as I am a web developer, so everything I do is primarily service oriented (no overhead / inventory / employees / etc).

Answer 1

Mods decided to leave it here, so I'll summarize some of my answers on this question given @OnStartups.

You can find them here, here and here.

Your options are :

Sole Proprietor

You and your business are one and the same. You report your income and expenses for taxes on a Schedule C (for each sole proprietorship a separate schedule), and taxed at your personal rates. There's no liability protection or legal separation between you and your business, and you don't need to have any bureaucratic overhead of managing an entity. You can use your own bank account and have checks written to you directly. You can register for DBA if you want a store-front name to be different from your own name.

LLC

Depending on State, can cost a lot or close to nothing. Provides certain liability protection (depending on State, single-member and multi-member LLC's may have different liability protections). You can chose to be taxed as either a sole-proprietor (partnership, for multi-member) or as a corporation. You have to separate your activities, have a separate bank account, and some minimal bureaucracy is required to maintain the entity. Benefits include the limited liability, relatively easy to add partners to the business or sell it as a whole, and provides for separation of your personal and business finances. Drawbacks - bureaucracy, additional fees and taxes (especially in CA), and separation of assets.

Corporation

Corporation is an entirely separate entity from yourself, files its own tax returns, has separate bank accounts and is run by the board of directors (which in some cases may require more than 1 person to be on the board, check your state laws on that). As an officer of the corporation you'll have to pay salary to yourself. S-Corp has the benefit of pass-through taxation, C-Corp doesn't and has double taxation. Benefits - liability protection, can sell shares to investors, legally distinct entity. Disadvantages - have to deal with payroll, additional accounting, significant bureaucracy and additional layer of taxes for C-Corp (double taxation). Selling corporate assets is always a taxable event (although in your case it is probably not of an importance).

Bottom Line

You have to talk to a lawyer in your state about the options re the liability protection and how to form the entities. The formation process is usually simple and straight forward, but the LLC/Partnership operating agreements and Corporation charters/bylaws must be drafted by a lawyer if you're not going to be the sole owner (even if you are - better get a lawyer draft something for you, its just easier to fix and change things when you're the sole owner).

You have to talk to a CPA/EA in your state about the taxes and how the choice of entity affects them.