Webinar question: Should I incorporate?

This is post #2 in my ongoing series of questions from the webinar on “Getting started as a freelance translator” that I presented for the American Translators Association earlier this month.

A participant asks: As a self-employed freelance translator, should I operate as an LLC, an S-corp or a sole proprietorship?
Short answer: If you freelance full-time, I think it’s worth incorporating. As long as you don’t mind the extra paperwork, incorporating has some significant tax and liability advantages.

Longer answer: First, I’m not an accountant or an attorney. Second, I have an S-corp so I’m more informed about S-corps than about LLCs and C-corps. Third, I can’t speak to tax issues in countries other than the U.S. That being said:

• Running your freelance business as a sole proprietor is really simple; just report your freelance income on IRS Schedule C, pay self-employment tax on it and you’re pretty much set. Running a corporation is a little more complicated: you may have to file monthly or quarterly payroll taxes and a separate end-of-year corporate tax return. You will have to pay to register your corporation every year and the IRS may be less lenient with you than with a sole proprietor if you mess up your taxes. If you don’t want to be bothered with any extra paperwork or filing requirements, stick with sole proprietorship.
• The hassle factor of incorporating depends on the state in which you live, since corporations are registered at the state level. Here in Colorado, incorporating is very simple and cheap but you do have to renew your corporate registration every year. Check your state’s Secretary of State website for the requirements where you live.
• The tax advantages of incorporating can be significant. When you work as a sole proprietor, you pay self-employment tax (currently 15.30%) on everything you earn, minus your business expenses. This is in addition to the normal Federal rate that you would pay if you worked for an employer, so it’s a big hit. Some corporate structures allow you to take some of your earnings as “wages” which are subject to self-employment tax and some of your earnings as “profit” which is not subject to self-employment tax. My understanding is that this applies to S-corps and C-corps but not LLCs unless the LLC files taxes as an S-corp. So for example if you gross $70,000 and take $40,000 as wages and $30,000 as profit, you have the potential to save $4,590 in self-employment tax (15.3% x 30,000). Even if you do quarterly payroll taxes (mine take about an hour per quarter) and pay an accountant to file your corporate tax return, this is a big win.
• Liability: I have never heard of a lawsuit against a freelance translator, but the U.S. is the most litigious country in the world so it’s certainly not out of the question. Incorporating separates your business and personal assets; if you’re sued, the plaintiff can only go after your business’ assets and not your house, car or personal bank accounts. If you’re a sole proprietor, your personal assets are theoretically fair game if you are sued for a business issue.
• Incorporating seems to make you less likely to be audited by the IRS. It’s a bit hard to pin down the exact statistics, but articles such as this one by respected tax professional Barbara Weltman suggest that audit rates for S-corps are dramatically lower than those for sole proprietors. Weltman states that the total S-corp audit rate is 0.4% and the audit rate for Schedule C filers earning between $100,000 and $200,000 per year is 3.9%.