Q & A Table of Contents
Legal FAQ Table of Contents
Being a Consultant, Freelancer, or Contractor: Pros and Cons
by Attorney Stephen Fishman
Consulting or freelancing as an independent contractor has benefits and drawbacks.
Freelancers and consultants are known as "independent contractors" in legal terms. An independent contractor (IC) is a person who contracts to perform services for others without having the legal status of an employee. Most people who qualify as independent contractors have their own trade, business, or profession -- that is, they are in business for themselves.
Good examples of ICs are professionals or tradespeople with their own practices, such as doctors, graphic artists, accountants, plumbers, and carpenters. Independent contracting is also common in highly specialized or technical fields, such as computer programming, engineering, and accounting. You can find ICs in almost every field, from construction to marketing to nursing. Any person who is in business for himself or herself qualifies as an IC.
Some people seek to become ICs, while others have the status thrust upon them. Whichever group you fall into, working as an IC has both benefits and drawbacks.
Advantages of Working as an Independent Contractor
Independent contractors reap many rewards that regular wage earners may never experience.
You are your own boss.
When you're an IC, you're your own boss, with all of the risks and rewards that entails. You can choose how, when, and where to work, for as much or little time as you want.
ICs are masters of their economic fate. The amount of money they make is directly related to the quantity and quality of their work. This is not necessarily the case for employees. ICs don't have to ask their bosses for a raise -- if they want to earn more, they just have to go out and find more work or raise the amount they charge. And, because most ICs are not dependent upon a single company for their livelihood, the hiring or firing decisions of any one company don't impact ICs like they do employees.
You may earn more than employees.
You can often earn more as an IC than as an employee in someone else's business. For example, an employee in a public relations firm decided to become an IC when she learned that the firm billed her time out to clients at $125 per hour while only paying her $17 per hour. She charges $75 per hour as an IC and makes a far better living than she ever did as an employee.
According to The Wall Street Journal, ICs are usually paid 20% to 40% more per hour than employees performing the same work. Hiring firms can afford to pay ICs more because they don't have to pay Social Security taxes or unemployment compensation taxes, provide workers' compensation coverage, or provide employee benefits like health insurance and sick leave.
Of course, how much you're paid is a matter for negotiation between you and your clients. ICs whose skills are in great demand may receive far more than employees doing similar work.
You may pay lower income taxes.
Being an IC also provides you with many tax benefits that are not available to employees. For example, no federal or state taxes are withheld from your paychecks, as they must be for employees. Instead, ICs have to pay estimated taxes directly to the IRS four times a year. This means you can hold on to your hard-earned money longer before you have to turn it over to the IRS. Moreover, it's up to you to decide how much estimated tax to pay (but there are penalties if you underpay). This flexibility gives you more control over the money you earn. For more information on estimated taxes, see Paying Estimated Taxes.
You can also take advantage of many business-related tax deductions that are not available to employees. When you're an IC, you can deduct from your taxable income any necessary expenses related to your business, as long as they are reasonable in amount and ordinarily incurred by businesses of your type. This may include, for example, office expenses (including costs associated with a home office), travel expenses, entertainment and meal expenses, cable TV and magazine expenses, equipment and insurance costs, and much more.
ICs can also establish tax-advantaged retirement plans such as SEP-IRAs and Keogh Plans. This enables you to shelter a substantial amount of your income until you retire.
Because of these tax benefits, ICs often pay less tax than employees who earn similar incomes.
Disadvantages of Working as an Independent Contractor
Despite the advantages, being an IC is not always a bed of roses. Here are some of the major drawbacks.
No job security.
When you're an employee, you must be paid as long as you have your job, even if your employer's business is slow. This is not the case when you're an IC. If you don't have business, you don't make any money. As one IC says, "If I fail, I don't eat. I don't have the comfort of punching a time clock and knowing the check will be there on payday."
No employer-provided benefits.
Many employers provide their employees with health insurance, paid vacations, and paid sick leave. More generous employers may also provide retirement benefits, bonuses, and even employee profit sharing.
When you're an IC, you get no such benefits. You must pay for your own health insurance, often at higher rates than employers have to pay. Time lost due to vacations and illness comes directly out of your bottom line. And you must fund your own retirement. If you don't earn enough money as an IC to purchase these items yourself, you will have to do without.
No unemployment insurance benefits.
ICs also don't have the safety net provided by unemployment insurance. Hiring firms do not pay unemployment compensation taxes for ICs, and ICs can't collect unemployment when their work for a client ends.
No employer-provided workers' compensation.
Hiring firms do not provide workers' compensation coverage for ICs. If a work-related injury is an IC's fault, he or she has no recourse against the hiring firm.
Few or no labor law protections.
A wide array of federal and state laws protect employees from unfair exploitation and discrimination by employers. Very few of these laws apply to ICs.
Risk of not being paid.
Some ICs have great difficulty getting their clients to pay on time or at all. When you're an IC, you bear the risk of loss from deadbeat clients. For information that will help you collect what you're owed, see Getting Clients to Pay Up.
Liability for business debts.
Finally, most ICs are personally liable for the debts of their businesses. An IC whose business fails could lose most of what he or she owns.
To learn more about the ins and outs of working for yourself, get Working for Yourself: Law & Taxes for Independent Contractors, Freelancers & Consultants, by attorney Stephen Fishman (Nolo).
Choosing the Best Ownership Structure for Your Business
The right structure -- corporation, LLC, partnership, or sole proprietorship -- depends on who will own your business and what its activities will be.
When you start a business, you must decide whether it will be a sole proprietorship, partnership, corporation, or limited liability company (LLC).
Which of these forms is right for your business depends on the type of business you run, how many owners it has, and its financial situation. No one choice suits every business: Business owners have to pick the structure that best meets their needs. This article introduces several of the most important factors to consider, including:
- the potential risks and liabilities of your business
- the formalities and expenses involved in establishing and maintaining the various business structures
- your income tax situation, and
- your investment needs.
Risks and Liabilities
In large part, the best ownership structure for your business depends on the type of services or products it will provide. If your business will engage in risky activities -- for example, trading stocks or repairing roofs -- you'll almost surely want to form a business entity that provides personal liability protection ("limited liability"), which shields your personal assets from business debts and claims. A corporation or a limited liability company (LLC) is probably the best choice for you.
Formalities and Expenses
Sole proprietorships and partnerships are easy to set up -- you don't have to file any special forms or pay any fees to start your business. Plus, you don't have to follow any special operating rules.
LLCs and corporations, on the other hand, are almost always more expensive to create and more difficult to maintain. To form an LLC or corporation, you must file a document with the state and pay a fee, which ranges from about $40 to $800, depending on the state where you form your business. In addition, owners of corporations and LLCs must elect officers (usually, a president, vice president, and secretary) to run the company. They also have to keep records of important business decisions and follow other formalities.
If you're starting your business on a shoestring, it might make the sense to form the simplest type of business -- a sole proprietorship (for one-owner businesses) or a partnership (for businesses with more than one owner). Unless yours will be a particularly risky business, the limited personal liability provided by an LLC or a corporation may not be worth the cost and paperwork required to create and run one.
Income Taxes
Owners of sole proprietorships, partnerships, and LLCs all pay taxes on business profits in the same way. These three business types are "pass-through" tax entities, which means that all of the profits and losses pass through the business to the owners, who report their share of the profits (or deduct their share of the losses) on their personal income tax returns. Therefore, sole proprietors, partners, and LLC owners can count on about the same amount of tax complexity, paperwork, and costs.
Owners of these unincorporated businesses must pay income taxes on all net profits of the business, regardless of how much they actually take out of the business each year. Even if all of the profits are kept in the business checking account to meet upcoming business expenses, the owners must report their share of these profits as income on their tax returns.
In contrast, the owners of a corporation do not report their shares of corporate profits on their personal tax returns. The owners pay taxes only on profits they actually receive in the form of salaries, bonuses, and dividends.
The corporation itself pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called "retained earnings"). Corporations also have to pay profits on dividends paid out to shareholders, but this rarely affects small corporations, which seldom pay dividends.
This separate level of taxation adds a layer of complexity to filing and paying taxes, but it can be a benefit to some businesses. Owners of a corporation don't have to pay personal income taxes on profits they don't receive. And, because corporations enjoy a lower tax rate than most individuals for the first $50,000 to $75,000 of corporate income, a corporation and its owners may actual have a lower combined tax bill than the owners of an unincorporated business that earns the same amount of profit.
Investment Needs
Unlike other business forms, the corporate structure allows a business to sell ownership shares in the company through its stock offerings. This makes it easier to attract investment capital and to hire and retain key employees by issuing employee stock options.
But for businesses that don't need to issue stock options and will never "go public," forming a corporation probably isn't worth the added expense. If it's limited liability that you want, an LLC provides the same protection as a corporation, but the simplicity and flexibility of LLCs offer a clear advantage over corporations. For more help on choosing between a corporation and an LLC, read the article Corporations vs. LLCs.
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After learning the basics of each business structure and considering the factors discussed above, you may still find that you need help deciding which structure is best for your business. A good small business or tax lawyer can help you choose the right one, given your tax picture and the possible risks of your particular situation.Changing Your Mind
Your initial choice of a business structure isn't set in stone. You can start out as sole proprietorship or partnership and later, if your business grows or the risk of personal liability increases, you can convert your business to an LLC or a corporation.
How can I convince a firm to hire me as a contractor, not an employee?
QUESTION:
Even though I work as an independent contractor, some prospective clients insist that I allow them to classify me as their employee before they will hire me for a short-term project. How can I avoid this without losing the client?
ANSWER:
As you've discovered, some companies are reluctant to classify contract workers as independent contractors because they fear trouble with the IRS and other government agencies. To avoid this problem, some companies routinely insist that all contract workers agree to be treated as employees.
If you accept classification as an employee, however, you will lose some of the business tax deductions you could ordinarily take as a self-employed person, such as the home office deduction. And if you're classified as an employee by some businesses and an independent contractor by others, you are more likely to face an IRS audit, with all the headaches and expense that entails.
If you run into a client that is paranoid about classifying you as an independent contractor, explain that you ordinarily do business as an independent contractor and that other clients who have classified you as an independent contractor haven't had any problems. Let the client know the other steps you have taken to make sure that you qualify as an independent contractor, such as working for multiple clients, having your own office, having a fictitious business name and business bank account, marketing your services widely, and possibly getting paid by the project instead of by the hour.
Is it infringement if someone uses my company's name for a different business?
QUESTION:
While doing an Internet search, I found that another site is using my company name. It is a construction company and is using the name for a construction product. I have a software development company. Is there a possible infringement on the name even though we are both using it for completely different purposes? I would like to avoid spending a lot of money on trademark searches if possible.
ANSWER:
As a general rule, trademarks do not infringe one another if the underlying products or services of the two companies do not compete and are not distributed in the same trade channels.
As you describe your situation, you and the construction company are coexisting quite nicely. In other words, consumers of your business are not likely to be confused by the similarly named construction company. On that basis there is no infringement.
A moneysaving tip: You can search federally registered trademarks for free on the Internet at the USPTO website (www.uspto.gov).
Domain Names and Trademarks FAQ
Get answers to your questions about domain names and trademarks, and how the two can conflict.
What's Below:
When does an Internet domain name qualify as a trademark?
How can I find out whether a trademark I want to use as a domain name is already being used?
What happens if there is a conflict between an Internet domain name and an existing trademark?
Can a business trademark a domain name for future use?
When does an Internet domain name qualify as a trademark?
A domain name, such as nolo.com, can qualify as a trademark when it is used in connection with a website that offers services to the public. This includes all sites conducting e-commerce and sites such as Yahoo.com that provide Web-related services.
However, only some types of commercial domain names qualify for trademark protection. For instance, while domain names that use common or descriptive terms, such as healthanswers.com or stampfinders.com, may work very well to bring users to a website, they usually do not qualify for much trademark protection. This means that owners of such domain names generally won't have much luck stopping the use of these words and phrases in other domain names. In other words, by using common terms that are the generic name for the service (for example, "dictionary.com") or by using words that merely describe the service or some aspect of it (for example, "returnbuy.com"), the owner of the name will have less trademark rights against the users of similar domain names than she would if her domain name was distinctive.
How can I find out whether a trademark I want to use as a domain name is already being used?
Because so much business is now being done online, most people will want to be able to use their proposed trademark as a domain name so that their customers can easily locate them on the Web.
The easiest way is to check if a domain name is available is at one of the dozens of online companies that have been approved to register domain names. A listing of these registrars can be accessed at either the InterNIC site or at the ICANN site. ICANN is the organization that oversees the process of approving domain name registrars. Every registrar provides a searching system to determine if a domain name is available. Type in the domain name choice and the registrar will determine if it is available.
If you find that a domain name is already taken, it's possible to locate information about the owner of the domain name. A simple way to check ownership is to use Whois.net. Type in the domain name, and the website provides the contact information supplied by the domain name registrant.
Beware that some registrants, especially those acting in bad faith, may supply false information about domain name ownership and in these cases, there’s not much that can be done to track down the domain name holder.
What happens if there is a conflict between an Internet domain name and an existing trademark?
Even if a company owns a federally registered trademark, someone else may still have the right to the domain name. For example, many different companies have federally registered the trademark Executive for different goods or services. All of these companies may want www.executive.com but the first one to purchase it—in this case, Executive Software—is the one that acquired the domain name and has the rights to it.
Sometimes a person (known as a “cybersquatter”) registers a trademark as a domain name hoping to later profit by reselling the domain name back to the trademark owner. If you believe that someone has taken a domain in bad faith, you can either sue under the provisions of the Anticybersquatting Consumer Protection Act (ACPA), or you can fight the cybersquatter using an international arbitration system created by the Internet Corporation of Assigned Names and Numbers (ICANN). The ACPA defines cybersquatting as registering, trafficking in, or using a domain name with the intent to profit in bad faith from the goodwill of a trademark belonging to someone else. The ICANN arbitration system is considered by trademark experts to be faster and less expensive than suing under the ACPA, and the procedure does not require an attorney. For information on the ICANN policy, visit the ICANN site.
Courts and arbitrators generally side with trademark owners in these disputes and order the cybersquatter to stop using the trademarked name.
Can a business trademark a domain name for future use?
It is possible to acquire ownership of a trademark by filing an "intent-to-use" (ITU) trademark application with the U.S. Patent and Trademark Office (PTO) before actually starting to use the domain name. The applicant must start using the domain name within the required time limits -- six months to three years after the PTO approves the trademark, depending on whether the applicant seeks and pays for extensions of time. The filing date of this application will be considered the date of first use of the trademark as long as the applicant actually uses the trademark within the required time limits.
Buy-Sell Agreement FAQ
Don't neglect to write a business prenup before putting money into a venture.
What's Below:
When does a business need a buy-sell agreement?
A buy-sell agreement is used for buying and selling businesses, right?
Can a co-owner’s personal bankruptcy affect the business?
What’s the best way to value a company when an owner is being bought out?
What happens if a company needs to, but can't afford to, buy out one of its owners?
Can a buy-sell agreement be used to avoid estate taxes?
When does a business need a buy-sell agreement?
Every co-owned business needs a buy-sell, or buyout, agreement the moment the business is formed or as soon after that as possible. Every day that value is added to the business without a plan for future transition, it increases its financial risk.
A buy-sell agreement is used for buying and selling businesses, right?
No. Despite the name, buy-sell agreements have little to do with buying and selling companies. Instead, they are binding contracts between co-owners that control when owners can sell their interest, who can buy an owner’s interest, and what price will be paid. These agreements come into play when an owner retires, goes bankrupt, becomes disabled, gets divorced, or dies -- in other words, a buy-sell agreement is a sort of prenuptial agreement between business co-owners. Mainly these agreements guide buyouts between the owners themselves; that's why we like to call them buyout agreements.
If a co-owner of a business gets divorced, can the former spouse ask the divorce court for part ownership in the business?
In some states, yes, and the former spouse can succeed in getting it, too. In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), all earnings during marriage and all property acquired with those earnings are considered community property, owned equally by husband and wife. When property is divided during a divorce, each spouse can claim a right to all community property.
Even in non-community property states, a spouse could argue for a partial interest in the business, because marital property laws require property to be divided equitably during divorce.
To avoid this prospect, a good buyout or buy-sell agreement requires the former spouse of a divorced owner to sell any interest received in a divorce settlement back to the company or the other co-owners, according to a valuation method provided in the agreement.
Can a co-owner’s personal bankruptcy affect the business?
In the worst case scenario, a bankruptcy trustee could liquidate the business (sell all of its assets) and take half to pay the bankrupt owner's debts. To prevent a business from getting tied up in bankruptcy court, the owners can sign a buy-sell or buyout agreement that requires a co-owner who faces bankruptcy to notify other co-owners before filing. Under the terms of this agreement, this becomes an automatic offer to sell the bankrupt owner’s interest back to the other owners. The buyout money goes to the bankruptcy trustee and the business can proceed without difficulties.
What’s the best way to value a company when an owner is being bought out?
You can hire a professional appraiser or use a valuation formula to come up with a price using financial statements from one or more years. But the problem is that valuing a business at the time of sale usually results in co-owners seizing on different valuation formulas, which can produce very different results. For that reason, it helps for the owners to agree on a way to value the company in advance in a buy-sell or buyout agreement. This gives owners the chance to discuss and vote on how a reasonable price for the company should be calculated. The fact that a sound method was agreed to beforehand can go a long way to reducing conflict when the time for a buyout comes.
What happens if a company needs to, but can't afford to, buy out one of its owners?
Requiring an immediate 100% lump-sum cash payout can prevent even the most successful company from buying back an owner's interest. That's why having flexible payment terms built into a buy-sell or buyout agreement, signed in advance, can help. For instance, a buyout agreement can provide for a down payment of 1/4 to 1/3 of the buyout price followed by installment payments for three to five years at a reasonable rate of interest.
Can a buy-sell agreement be used to avoid estate taxes?
Buy-sell, or buyout, agreements have been used successfully to lower estate taxes in intergenerational businesses -- businesses where at least one co-owner plans to leave the interest to heirs who will remain active in the business. This can help a family business owner pass the business on to children or other relatives without burdening them with unnecessary estate taxes caused by an aggressive value of the business. The key for estate planning is choosing a conservative price or valuation formula for the business in the buy-sell or buyout agreement. The result can be to legally set the value of the ownership interest at an amount considerably lower than its sales value at the time of death.