A New Freelancer Checklist: Structure, Taxes & Insurance Basics

Have you recently become an independent operator? Here’s a quick guide to setting yourself up right.

“The Great Resignation” accelerated by the pandemic is in full effect, with a record 4.4 million Americans quitting their jobs in the latest September numbers. Part of this trend is driven by newly remote professionals who have decided to escape the control of working for an employer, opting for the freedom of freelance and contract work.

If this describes your situation, you are now essentially a business owner, even if your only employee is you.

Here’s a quick guide to some essential steps in setting up a business, including structure, tax obligations, and insurance options:

Step one: Choose the proper business structure

You’ll need to pay taxes on your income, of course. And you are now a business, even if you don’t officially create one. By default, you’ll be considered a sole proprietor without formally registering a business under a separate name with your state’s government. In this case, you’ll need to become well-versed with issuing the IRS’s W-9 tax forms to your clients and using the 1099-MISC form to file your taxes.

But there are several reasons to create a separate business entity, which requires filling out an application with your state’s Department of State and paying fees between $50 and $500 (the average is $145). Here are some of the pros and cons of common structures:

• Sole proprietorship: This is the most common freelancer option and easy to set up, with low fees and a structure that is easy to exit. Again, you don’t have to register with your state, though “there may be local registration, business license, or permit laws you need to comply with to make your business legitimate.” But there is one drawback of being a sole proprietor: you and the business are one entity with no separate personal and business assets. The separation offered by other structures provides a firewall against potential legal and financial liability.

• Sole-member LLC: Registering your business as a limited liability company (LLC) involves fees and filing requirements, and you’ll be issued an Employee Identification Number (EIN) to use on your taxes in addition to your Social Security Number. But an LLC separates the individual and the business entity while maintaining most of the control and flexibility of a sole proprietorship. Profits and losses can be passed through to owners without the business being taxed, and the individual’s assets are generally shielded against financial and legal claims against the business.

• Corporation (S or C): The main benefit of a corporate structure is that the individual is entirely separate from the corporation, and the business is taxed separately (and can sue or be sued as an entity). However, an S Corp (vs. a C Corp) still allows the individual to “pass through” income to their personal return, similar to an LLC. Incorporating—in either version—is usually a more viable option if an owner plans to expand or will hit a certain income threshold, which can bring unique tax strategies.

Many freelancers do just fine as unregistered sole proprietors, but there are specific tax, operational, and other financial advantages to registering a structure. Many of these benefits depend on your income, industry, eventual business size, and other factors. If you’re unsure which is best in your situation, seek professional advice from a CPA, attorney, or business advisor.

Step two: Understand self-employment tax and quarterly payments

People who become an independent contractor for the first time are used to filling out a W-4, choosing the number of allowances, and letting the employer automatically deduct taxes—income and FICA—from their paycheck. But as a newly minted business owner/freelancer, you are responsible for assessing what your taxes will be throughout the year and paying quarterly estimated taxes on April 15, June 15, September 15, and January 15.

One item that surprises many new freelancers is the fact they must pay a “self-employment tax.” In 2021, this tax was 15.3% on the first $142,800 worth of net income. Half of this amount, which is a combination of Social Security and Medicare taxes, was paid by your former employer, and the rest was automatically withdrawn from your paycheck. On the plus side, you can deduct half of the self-employment tax you pay from the number that determines your income tax liability. But essentially, making the same income as a freelancer as you did with an employer comes with a slightly bigger tax burden.

Note that the estimated quarterly taxes you must pay will be calculated based on your tax return for the previous year. Still, you can also monitor your income quarterly and pay an appropriate amount. To avoid a penalty come April, the IRS requires taxpayers to meet one of these two conditions:

“Throughout the year, [pay] the smaller of these two amounts:

• at least 90 percent […] of the tax for the current year
• 100 percent of the tax shown on their tax return for the prior year – this can increase to 110 percent based on adjusted gross income”

The penalty for failing to pay estimated taxes is an interest charge, set “each quarter at the federal short-term rate plus three percentage points. The interest rate for underpayments by individual taxpayers for the fourth quarter of 2021 is 3%.” Again, it may be a good idea to consult with a CPA who helps determine your quarterly payments and ensures you are taking every deduction legally possible. There are unique deductions for self-employed business owners and, generally speaking, more things can classify as legitimate business expenses. And these items can significantly reduce your tax burden.

Step three: Protecting yourself

Health Insurance

One of the most pressing concerns for new freelancers is obtaining health insurance without employer plans and subsidization. The main options are:

• Filling out an application and shopping providers through the government’s Health Insurance Marketplace. This site enables applicants to compare plans and see if they qualify for various tax credits and assistance. However, those benefits only kick in at lower income levels (generally speaking, less than $50k for a single filer).

• Obtaining private health insurance directly from providers. Many insurance companies have specific plans for self-employed individuals. You can contact insurers directly or work with an insurance agent who compiles options that meet your needs.

• It’s also possible to get some of the savings of group plans by seeking out professional associations that leverage the size of their membership to achieve more affordable rates. For example, the Freelancers Union offers group health plans.

There are also various short-term health insurance options, such as private short-term policies or continuing an employer’s policy for 18 months through the Continuation of Health Coverage (COBRA) program. But these policies tend to be expensive or limited in coverage and are not viewed as long-term solutions.

Disability and Life Insurance

Disability insurance isn’t necessary, but it’s another policy that self-employed individuals should seriously consider. After all, you no longer have paid medical leave and similar employer benefits. Should your ability to work be compromised for any length of time through illness or injury, you simply won’t have any income. The same obviously holds true in the case of death; individuals should prioritize protecting their family with a life insurance policy if they only had one through their previous employer.

As we covered in our previous blog, private life insurance policies have several advantages over employer-provided options—chief of which are they continue when working situations change, and policyholders may realize significant discounts from long-term relationships with providers.

Freelancers looking for disability insurance should closely scrutinize potential policies, including whether they include “own-occupation” and “partial disability” clauses.

• Own-occupation means you are too disabled to work in your specific occupation. This may cover you for a defined period, but benefits stop if insurers determine you could work in another field.

• Partial disability (aka residual disability) partially covers you when you can still work part-time but not full-time. So, for example, if a medical condition causes fatigue and limits your workweek, the policy will still pay out some benefits.

Contacting an insurance broker and shopping providers directly are options for obtaining these policies, as is searching industry and freelancer associations for discounted group plans.

Business Insurance

Most businesses of a certain size and with physical locations take out numerous policies to protect the organization, but not all coverage types are necessary for individual freelancers. Nevertheless, it’s a good idea to consider which of them may apply to your situation, especially as your client list or organization grows.

• General liability covers claims involving bodily injury, property damage, advertising injury, copyright infringement, and reputational harm. An individual working in the professional services industry out of their home may not see much value in the first two items, but the last three could be relevant. For example, an “advertising injury” stems from a claim your business caused harm “by defaming someone else or another company,” and reputational harm is a similar issue. These policies cover medical, court, and admin costs, among other expenses.

• Errors and Omissions insurance (aka professional liability insurance) may interest self-employed workers with a lengthy client list. If a dissatisfied customer claims injury caused by a service provider making mistakes or being negligent, it covers the legal and other costs required to remedy a dispute.

• Commercial Property and Commercial Auto Insurance: These policies obviously only apply if you have significant physical property used by the business or drive quite a bit for explicit business purposes. Commercial property policies cover any damage to business property caused by various issues stipulated in the policy, from burst pipes to theft and vandalism. And like personal auto insurance, commercial policies cover damage to you, others, property, and vehicles for accidents or other forms of vehicular damage.

• Workers’ Compensation: Most states require business owners to take out a policy once they hire employees, but individual freelancers can also get coverage to provide some protection against unforeseen medical expenses, loss of income, inability to work after an injury, and more. This is usually a better option for contractors in certain higher-risk industries, however, such as construction.

Beyond structure, taxes, and insurance

Once you set your structure, understand essential tax obligations, and get the right insurance, the job is not done. Freelancers and independent contractors must find new business, market themselves, and develop processes to fulfill orders and provide services. Some aspects, such as drawing up quality contracts, may require legal help. But these steps are usually only as complex as your industry, number of clients, and size of your business.

Many freelancers embrace these new tasks, satisfied that every ounce of effort is an investment in themselves and their bottom line—not an employer’s. And if current trends continue, it’s projected that just over half of the US population will be doing freelance work by 2027.

Becoming an independent worker is an exciting journey, and one that is being traveled by many in this growing segment of the workforce.

Karp HR Solutions helps businesses design and implement benefits programs that provide real value to employees and guides jobseekers and freelancers on employment issues. Contact us today for a free consultation.