The art of classifying Independent Contractors requires a thorough understanding of various business organizations and the nuances that each type of set up entails. Although not a requirement of any state or federal agency, the fact that an Independent Contractor operates as a bona-fide business is a factor that the IRS and various state agencies will consider in determining whether a resource is properly classified as an Independent Contractor. In this article we’ll review the different business structures that an Independent Contractor could set up.
By organizing their business in an official capacity, the Independent Contractor legitimizes their business, as well as confirms their own understanding that they are self-employed and not an employee of another entity.
The most common business organizations for Independent Contractors include C-corporation, S-Corporation, Partnership, Limited Partnership (LP), Limited Liability Partnership (LLP), Limited Liability Company (LLC), and Sole Proprietorship. Each type of entity maintains different requirements, as well as different protections under the law, both in a financial and liability sense. Understanding the type of organization an Independent Contractor chooses provides insight into the nature, magnitude, scope, and maturity of the organization as well as the business acumen of the Independent Contractor, all of which are important when making an Independent Contractor classification.
A corporation is an independent legal entity that is owned by shareholders. There are two types of corporations, a C-corp, which is a traditional corporation, and an S-corp which is an elected special tax status. A C-corp is a standard corporation, with multiple classes of stock, and is subject to double taxation, one tax at the corporate level on the corporation income and another tax to the shareholders when profits are distributed. A C-corp does offer its shareholders a shield from liability however, which is sometimes referred to as the “corporate veil.” This “corporate veil” provides a shield from liability for the shareholders for corporate debts. A C-corp is treated as a separate legal person, which is solely responsible for the debts it incurs and the sole beneficiary of the credit it is owed. This type of set up is primarily attractive to larger businesses. If an Independent Contractor is set up as an C-corp, he has taken multiple steps to set up and continue to run his business as a distinct entity, separate from himself. It is unlikely the owner/shareholder of a C-corp would be misclassified as an IC.
Unlike a C-corp which requires Articles of Incorporation and a filing with the Secretary of State, an S-corp is a special type of corporation, created through an IRS tax election. S-corps are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes and report the income and loss on their person tax returns. This allows S-corps to avoid the double taxation of their corporate income, like a c-corp. S-corps are typically preferred by smaller businesses, in fact, one of the requirements to set up an S-corporation is that the business have no more than 100 shareholders. The S-corp is also limited to one class of stock, unlike the C-corp which can have multiple classes of stock. The S-corp is attractive to many small business, and therefore is probably the most common business set up we see among Independent Contractors. An S-corp is easy to set up, but does require some maintenance and the adherence to certain business criteria. Like a C-corp, an S-corp demonstrates that the Independent Contractor has taken the time to set up a special tax status for their corporate income, and separate the business from the business owner.
A Partnership is a single business where two or more people share the ownership. Each partner in the partnership contribute to the business and each share in profits and losses of the business. Forming a partnership typically requires the overt act of registering with the state. It is also evidence that the partners truly wish to be in business with the other partners due to the shared liability of debts and business decisions among the partners. Each partner shares in the profits and losses of the business. Each partner is liable for their own actions, but also for the business debts and decisions. Additionally, the personal assets of all the partners can be used to satisfy the debts of the partnership. By setting up a partnership, a partner is showing is desire to be a partner in a business, and this is indicative of independent status. A Limited Liability Partnership (LLP) and Limited Partnership (LP) are organizations with limit the liability of the partners, but similarly lend to a classification of Independent Contractor status.
A Limited Liability Company (LLC) is perhaps the most popular business organization, as well as the most recently established. An LLC is a hybrid model, which combines the pass through taxation of a partnership and sole proprietorship with the limited liability of a corporation. There are many advantages to operating under an LLC including choice of tax status. LLCs can elect to be taxed as a sole proprietor, partnership, S-corp, or C-corp. LLCs also offer limited liability to their members similar to C-corps. LLCs in most states are treated as entities separate from their members. LLC formation, though, while offering many of the advantages of C-corp set up, entails much less administrative paperwork and record keeping requirements.
A Sole Proprietorship is the simplest business form under which one can operate a business. Unlike the business structures discussed above, the sole proprietorship is not a legal entity, and instead merely refers to a person who owns the business and is personally responsible for the debts. The owner receives all the profits and has unlimited responsibility for losses and debts. No overt action must be taken to operate as a sole proprietor, and there is far less separation between business owner and business. For this reason, while it is perfectly legal to operate as a sole proprietorship, it is also the business structure that is least determinative of independent status when making an Independent Contractor classification.
When Synergy Services is tasked with making an Independent Contractor classification determination, business organization structure is one of many factors evaluated during our analysis of each Independent Contractor classification. Understanding the risk levels that different business structures can introduce – for example, between engaging with a consultant whose business is structured as a Sole Proprietorship rather than a C-corp – allows our compliance specialists to mitigate risk for our clients and make the process as efficient as possible for the individual consultants.