In the past few weeks I have received a number of questions about how, why and when to incorporate a freelance business. I’m not an accountant or an attorney, but I’ll give an overview of the topic along with some of my own thoughts. After starting out as a sole proprietor (a self-employed freelancer who is not incorporated), I formed an S-Corporation about 4 years ago and have been very happy with it, although I know freelancers who are LLCs, C-Corporations and people who have been sole proprietors for 20+ years and have no desire to change!

It goes without saying that this information is a) not a substitute for advice from an accountant or attorney and b) depends a great deal on your individual situation and your geographic location. For the purposes of this post, we’ll assume that the prospective corporation will consist only of you, and that you are not going to have shareholders, stock, holdings in other corporations, etc.

Why incorporate: Incorporating gives you some liability protection in that it separates your business’ assets from your personal assets (i.e. your house, car, etc.), and any business-related lawsuits target only the business. Incorporating can save you a substantial amount on taxes, because some corporate structures allow you to avoid paying self-employment tax on all of your income. Corporations may also project a more professional image than a sole proprietorship, which can be an asset when marketing to direct clients. In addition, if you decide to expand your freelance business at some point, being incorporated makes it easier to hire employees or subcontractors. A corporation may also allow you to contribute more pre-tax money to a retirement plan.

Disadvantages of incorporating: Incorporating requires additional paperwork, and the filing fees depend on your state. In some cases, corporations are required to file quarterly payroll taxes and there can be big penalties if you don’t file them. A corporation must file its own end of year taxes, so that’s another tax return on top of your personal tax return.

To me, tax savings are the biggest advantage of having an S-Corp. An S-Corp allows you to take part of your income as “wages” and part of your income as “profit,” and the profit is not subject to self-employment tax. In my case, I took about $35,000 of income as profit in 2007, resulting in a savings of over $5,000 in self-employment tax (self-employment tax is an additional 15% on top of your regular federal rate). Although an S-Corp has to file quarterly payroll taxes ( for me, these are federal income tax, state income tax and state unemployment contributions), I paid my accountant to teach my how to do the payroll taxes myself and they now take me under an hour per quarter. The way I look at it, I’m effectively earning $1,250 an hour to do payroll taxes, which is much more of an incentive than I need to remain an S-Corp!

Corporate structures and how to incorporate: Incorporating is not hard; if you can run a successful freelance translation business, you can incorporate it yourself. It’s a good idea to talk to an accountant about the best corporate structure for you. The three main options are S-Corp, C-Corp and LLC. As stated above, I feel that the main advantage of an S-Corp for a freelance translator is tax relief, so it’s worth investigating which structure will give you the most benefit in terms of avoiding self-employment tax. The S-Corp requires that you pay yourself a “reasonable salary” as defined by the IRS, but my impression is that there is not a hard and fast rule about what that amount is; I usually go for about 50% salary and 50% profit.

The first place to look for information on incorporating is your state’s Secretary of State website. There you will find all of the information on the filing fees and requirements for your corporation. You will also need a Federal Employer Identification Number, which you can obtain for free from the IRS. Once you are incorporated, the EIN replaces your social security number as far as your clients are concerned.

Fees for incorporating can vary widely; in Colorado it costs $20 or less to form and renew your corporation, but when I looked at the website of the Massachusetts Secretary of State, the minimum fee to form an LLC appears to be $500. So, it’s worth checking the fees and requirements for your location and balancing that with the potential savings. If you currently earn $25,000 a year from translation and have to pay a $500 filing fee plus the cost of an additional tax return, the ultimate savings may be minimal. However, I’ve heard various accountants say that anyone who is a sole proprietor and earning more than $40,000-$50,000 per year can benefit from incorporating.

It seems like a common question of late is “How is the economy affecting your job?” While translation may not be recession-proof, my sense is that most of us are doing fairly well even in the down economy. The reasons behind this could be a post in themselves: for one, the weak U.S. dollar makes it attractive for overseas companies to purchase goods and services (including translation!) here. So for now at least, it seems that most U.S.-based translators aren’t suffering from a lack of work.

However, unscientific evidence suggests that late payment and non-payment are getting to be more of a problem. For example, in the first 5 1/2 years that I freelanced, my late payment and non-payment problems were very minimal, and dropped to nearly zero after I started requiring individual clients (i.e. not established companies) to pay in advance. In the last six months, this situation has changed dramatically, and I’ve had to deal with three different non-payment situations involving established companies. In all three situations, I had reason to believe that the company was solvent and reliable; i.e. I had worked with them before or a trusted colleague referred me.

Interestingly enough, all three of these non-paying clients dealt with the situation in exactly the same way: by doing nothing. Whether I e-mailed, called, or sent a certified letter, they simply did not respond at all, except to sign the return receipt for the certified letter.

Because of this trend, I’ve revised my terms of service. In addition to requiring individual clients to pay in full in advance, I’m now requiring that if a company is not a member of ATA or a similar association or is not rated on Payment Practices, it must pay 50% in advance for at least the first project. I can still see some problems with this policy, but for now I feel that it protects me against a complete non-payment situation.

Is the economy changing how you do business?