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BWA Independent Contractors’ Experiences with Business Entities and Insurance | |
By: Al Kemp
with contributions from Sue Anderson, Debra Biasca,
Linda Gallagher, Gail
Reitenbach, and Bart Windrum
March 2002
Important disclaimer! In this article, the authors describe their experiences doing business as sole proprietorships, Limited Liability Companies, and corporations. The authors are not giving legal or accounting advice, and they are not qualified to do so. Going into business for yourself is a big step that involves many important business decisions. You should consult with professionals. An attorney and an accountant can help you avoid making serious and costly mistakes. In particular, the subject of business entities shielding individuals from liability involves complex legal issues that are far beyond the scope of this article, which contains very general introductory information.
Some of the information about business entities has been adapted from the GigaLaw.com web site at http://www.gigalaw.com. See the Business Law article on Entity Formation.
Many independent contractors start out as sole proprietors because a sole proprietorship is the simplest way for an individual to do business.
Liability: The individual assumes all liability for the debts of the business.
Trade names: A sole proprietor can do business under a trade name in Colorado by registering the name with the Colorado Department of Revenue. For example, Jane Lopez can do business as (dba) Top-Notch Technical Communications. The cost of a trade name is nominal.
Checking account: Sole proprietors do not have to open a separate checking account if they do business under their own name. However, a separate account is very helpful for accounting and tax purposes. If you are audited, you must be able to distinguish between personal and business transactions. Sole proprietors doing business under a trade name should open a checking account under the trade name. A financial institution may not accept deposits written to a trade name into a personal account.
Taxes: A sole proprietor is taxed as an individual. Business profits or losses are reported on Schedule C of an owner's IRS Form 1040. Sole proprietors are required to make quarterly payments of estimated tax to the IRS and the Colorado Department of Revenue, and they must pay a F.I.C.A. self-employment tax of 7.65 percent. (Employers pay this tax for their employees.)
Taxpayer Identification Number: If a sole proprietorship does not have any employees, it can use the owner's Social Security Number. A sole proprietorship with employees must obtain an Employer Identification Number.
A note about contracts with large corporations: A large corporation may be reluctant to do business with a sole proprietorship. A sole proprietor should be ready to show proof of business liability insurance and workers’ compensation insurance. An errors and omissions policy may be required. A trade name and Employer Identification Number may also help convince the corporation that the sole proprietor has a viable business and is not just an individual looking for work.
A limited liability company (LLC) is easier to form than a corporation, but it provides some of the same benefits. In Colorado, individuals as well as partners can form an LLC.
Liability: As the name implies, an LLC limits the liability of the individual or partners who formed it. Please note that the subject of business entities shielding individuals from liability involves complex legal issues that are far beyond the scope of this article.
Tax: A limited liability company can choose to be taxed like a sole proprietorship (if formed by a single person), a partnership (if formed by partners), or a corporation.
Taxpayer Identification Number: An LLC formed by a single person (with no employees) does not need an Employer Identification Number (EIN). All other LLCs must obtain an EIN.
For more information about LLCs, go to the GigaLaw.com web site at http://www.gigalaw.com. Read the Business Law article on Entity Formation.
For an in-depth reference, see Nolo’s Quick LLC: All You Need to Know About LLCs by Anthony Mancuso, Nolo Press.
A corporation is more complicated than a sole proprietorship. The corporation must have directors, it must issue stock to stockholders, and it must hold meetings of directors and stockholders at least annually.
For IRS tax purposes, certain types of small corporations can be “subchapter S” corporations. An “S corp” can pass all its income and losses directly to the shareholders.
Sue Anderson and her husband have a subchapter S corporation. Sue explains the basic operation: “My husband and I are the sole owners and employees. All income goes into the corporation, and I pay wages and taxes and corporate bills out of the corporate account. We rent office space in our home to the corporation. We reimburse ourselves mileage for car usage driving to client sites. We pay ourselves ‘dividends’ when income exceeds expenses.”
Liability: A corporation protects the owners from personal responsibility for the liabilities of its employees. Please note that the subject of business entities shielding individuals from liability involves complex legal issues that are far beyond the scope of this article. For example, if an individual incorporates solely to avoid personal responsibility for the liabilities of the corporation, the courts may hold that individual personally responsible for the corporation's liabilities.
Wages: Sue Anderson pays her husband and herself reasonable wages because they both work for the corporation. She pays F.I.C.A. taxes on the wages. Sue notes: “If you do not pay wages and avoid paying F.I.C.A. but have actual labor income, you expose yourself to considerable fuss if ever audited by the IRS.”
Dividends: Sue and her husband take money out of their corporation fairly regularly, depending on calculated profit. Sue explains that “this income is taxable but not subject to wage withholding.”
Taxes: Taxes are more complicated than for a sole proprietorship. Sue points out that with a good software program for managing payroll, checking accounts, and tax reporting, it can be more economical to spend time as a bookkeeper than to pay wage taxes on a sole proprietor's earnings.
Taxpayer Identification Number: A corporation must obtain an Employer Identification Number.
Business use of home office: Sue and her husband rent space in their home to their corporation. Such income is taxable but not subject to wage withholding. “We find that renting space in our home to the corporation is far easier than declaring a home office exemption at tax time.”
Business use of vehicle: Some corporations buy vehicles for their employees and charge the employees for personal use of the vehicles. Other corporations reimburse the employees for business use of personal vehicles. The reimbursements to employees are not taxable.
For more information about corporations, go to the GigaLaw.com web site at http://www.gigalaw.com. Read the Business Law article on Entity Formation.
“Corporation kit” books are available that explain the process of incorporating and provide required forms.
Doing business as an independent contractor involves a number of insurance risks and obligations.
Most independent contractors start out with a homeowners or renters insurance policy and a vehicle insurance policy.
An insurance company may cover some of a sole proprietor's business-related losses (such as theft or damage of “home” computer equipment used “part-time” for the business) under the homeowners or renters policy, but it may refuse to pay for any losses of an established business with significant earnings.
An independent contractor's vehicle insurance policy should cover business use of a personal vehicle.
Some large corporations may require their independent contractors to carry significantly higher liability coverage than individuals usually have. The independent contractor can pay for increased coverage on the vehicle policy or take out an umbrella insurance policy, which increases the liability coverage on the contractor's homeowners and vehicle policies. Note that an umbrella policy does not provide protection for business-related liability or errors and omissions.
This policy protects business property, covers loss of income resulting from damage to insured property, and provides business liability protection from property damage or personal injury arising out of the operation of a business. A typical policy for a home business costs several hundred dollars a year.
Because of recent judicial awards for errors and omissions, some insurance companies are reluctant to issue business liability insurance policies to independent contractors who do not have errors and omissions insurance.
This policy protects a business from professional liability caused by errors or omissions in the preparation of a product or service. For example, an independent contractor could be held responsible for bodily injury or property damage caused by erroneous or missing instructions in a user guide or an operations manual.
An errors and omissions policy can be expensive—up to several thousand dollars a year. It pays to shop around. Businesses may be able to get a competitive rate from their business liability insurance company.
Although the owners of LLCs and corporations may be protected from personal liability for errors and omissions, there are a number of situations in which any business may have significant assets including computer equipment, bank accounts, accounts receivable, and major contracts with income that has not yet been billed.
In addition to adequate insurance coverage, an independent contractor's consulting contract should include limitations on liability. Here is the wording that Linda Gallagher uses in her contract:
“The client is responsible (and TechCom Plus is not responsible) for the accuracy of the content of a completed project. TechCom Plus shall not be liable, under any circumstances, for consequential, special, or incidental damages, even if it has been advised that such damages may occur. TechCom Plus' liability arising out of this Agreement, whether in contract, tort, or otherwise, shall not exceed the total of the amounts which the client has paid to TechCom Plus under this Agreement.”
Keep in mind, however, that state and federal laws may override a business's attempts to limit its contractual liability.
Any business in Colorado with one or more employees is required to carry workers’ compensation insurance. According to the Pinnacol Assurance Independent Contractors/Statutory Employers information sheet: “Sole proprietors, general partners, and corporate officers and LLC members who own more than 10 percent of the business are not required to be covered under the [Workers’ Compensation] Act.”
Here is a frequently asked question on the Pinnacol Assurance Web site:
“Why is my workers' compensation insurance carrier concerned if my business uses independent contractors?
“Workers’ compensation insurance carriers must determine whether an individual is a true independent contractor or an employee, per the Colorado Workers’ Compensation Act (the Act). A business cannot avoid liability merely by referring to its subcontractors or, in some instances, its employees, as independent contractors. The employer has the responsibility to prove that the employment relationship meets the requirements of a true independent contractor, according to the Act.”
If an independent contractor works for a company that is required to carry workers’ compensation insurance, that company must include the independent contractor on their workers’ compensation premium unless the independent contractor can prove independent contractor status according to the Workers’ Compensation Act.
If an independent contractor subcontracts work to another independent contractor, the independent contractor subcontracting the work may be required to carry workers’ compensation insurance unless she or he can prove that the subcontractor has independent contractor status according to the Workers’ Compensation Act.
For more information on workers’ compensation insurance including proof of independent contractor status, see the Pinnacol Assurance web site at
http://www.pinnacol.com.
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