Due to the state of the economy and fluctuating inflation prices, where one job is barely enough to make ends meet, a lot of people have decided to find an additional source of income, colloquially known as a “side hustle.”

Normally, this would mean picking up night shifts at different locations. But with the recent cooling of the job market, more people are starting to take the entrepreneurial route.

Before committing to a side job, it’s essential to have a thorough understanding of the specific details, definitions, and requirements involved. Failure to fully grasp these parameters can inadvertently breach IRS guidelines, and undermine the pursuit of additional financial security.

As more people enter the contractor and gig economy, understanding the various business structures available to self-employed individuals—such as sole proprietorships, LLCs, and S-corps—is essential for informed decision-making around financial management, liability, and tax obligations.

Sole Proprietorships

The sole proprietorship is the simplest business model, treating the owner and the business as a unified legal entity.

Contractors often start as sole proprietors because it’s easy to set up and manage with minimal legal formalities. It’s a popular option among freelancers, gig workers, and new contractors.

The drawbacks of a sole proprietorship include high self-employment taxes and the risk of unlimited personal liability.

This business structure places full responsibility for all business debts and legal liabilities on the individual owner. For instance, if a contractor faces a lawsuit, their personal assets—including savings and home—could be at risk.

Uber drivers and online shop owners may benefit from operating as sole proprietors, a structure that is often ideal for contractors who are just starting or have limited revenue.

Sole proprietorships are simple, inexpensive, and do not require a formal business registration. They report their income and expenses on Schedule C, attached to Form 1040.

Limited Liability Company (LLC)

An LLC is a versatile business structure that blends features of both corporations and sole proprietorships. Unique to the U.S., it provides liability protection for the owner while maintaining a more straightforward management framework.

In contrast to sole proprietorships, LLCs establish a legal distinction between personal and business assets, protecting personal property from business-related debts and legal claims.

The downsides of an LLC include its relatively high setup costs, as it requires state registration. The cost of setting up and LLC ranges from $40–$1,000, depending on the state and nature of the business, but the national average is $129 to set up, and about $100 per year thereafter.

Another drawback of LLCs is the need for a formal business structure, which includes creating an operating agreement, submitting annual reports, and adhering to state-specific regulations for continued compliance.

An LLC can be run as a single-member entity or have multiple members. The IRS treats single-member LLCs as “disregarded entities” by default, meaning profits and losses are reported on Schedule C (like a sole proprietorship).

By default, multi-member LLCs are taxed as partnerships, requiring the filing of Form 1065 (Schedule K-1) to report each member’s share of income, deductions, and credits. LLCs have the option to elect S-corporation tax status, which can offer potential savings on self-employment taxes by allowing the owners to pay themselves a salary and avoid self-employment taxes on a portion of the business income.

An LLC offers liability protection, making it an appealing choice for contractors working with clients in higher-risk situations, such as consultants or advisors, or those seeking the flexibility to adjust their tax status as the business grows.

S-Corporations

An S-corp is a tax classification that businesses, including corporations and LLCs, can elect if they meet certain eligibility criteria established by the IRS.

A corporation is eligible to become an S Corp if:

  • It has no more than 100 shareholders
  • Has shareholders who are all individuals
  • Has no nonresident shareholders
  • Only one class of stock

If the criteria is met and the S-corp is approved, S-corporation status offers several tax benefits.

S-corps allow:

  • Owners to pay themselves a reasonable salary from business income
  • Any additional earnings to be taken as distributions
  • Exemptions from self-employment taxes levied on sole proprietors and LLCs

Self employment taxes add an additional 7.65% in taxes compared to W-2 employees, whose employers cover half of the 15.3% total income tax witheld for Social Security and Medicare.

Moreover, S-corporations do not pay federal income taxes. Instead, the business’s income or losses are divided and passed through to its shareholders. 

In turn, an S-corp’s shareholders then report the business’s net income or losses on their individual income tax returns. Thus, the owners of an S-corporation are taxed on their proportional share of the S-corporation’s profits.

S-corps file Form 1120S and issue each shareholder a Schedule K-1 for their share of the business’s income. An S-corporations individual shareholders receive a Schedule K-1 (Form 1120S) to report their share of the business’s income, deductions, and credits. Shareholders then use the information on Schedule K-1 to complete their personal tax returns (Form 1040).

The downsides of the S-corp format include significant tax filing complexities and strict adherence to IRS guidelines on “reasonable salary.”

Contractors must also have stable earnings, as this business structure requires consistent payroll. Additionally, states such as New York, Delaware, and California impose specific regulations and taxes on S-corps.

S-corps are recommended for contractors with consistent, higher income who want to minimize self-employment taxes. S-corps are most advantageous when the tax savings from splitting salary and distributions outweigh the additional administrative work and related filing fees.

Choosing the Right Business Structure

The choice of business structure is a significant decision for contractors and self-employed individuals seeking additional income. Sole proprietorships offer simplicity and low-cost entry but expose personal assets to business liabilities. LLCs provide liability protection and flexible tax options but come with state filing requirements and higher setup costs.

S-corporations can offer tax advantages for high-earning contractors but require strict IRS compliance and additional administrative work. Each structure has its pros and cons, and selecting the right fit depends on the level of liability protection needed, the desired tax benefits, and the contractor’s financial stability.

Given these varying considerations, consulting a professional—such as an accountant or business attorney—can provide valuable insights to ensure the chosen structure aligns with financial goals, risk tolerance, and compliance obligations.

Samuel Adeyemi has authored numerous reports and articles on finance and investment, drawing from over seven years of experience in the field. Outside of his professional writing, he enjoys reading nonfiction essays, continually expanding his knowledge base.