As you venture into the world of freelancing you will want to understand some of the basic legal principles around being self-employed. Considering the legal aspects of freelancing does not mean you need to engage legal counsel.
Some basic research and preparation can help you evaluate the legal exposure of starting a freelancing business and limit your liability.
Three legal areas to consider before jumping into freelancing include:
- Personal liability
- Tax exposure
Eliminate Personal Liability
As a freelancer, you are the brand, the product, and the business. Although your freelancing business is completely reliant on your personal talents, your personal liability should not be risked by your freelancing services.
Organize a Formal Business Entity
To separate personal liability from your freelancing business liability, you need to formally organize as a business entity. In a recent article, we explored how small businesses can separate personal liability and business liability through a business.
The same principles apply to a freelancing business, and we specifically identified the LLC as a good business entity for freelancers.
If you don’t formally organize your freelancing business, you most likely are operating as a sole proprietor.
As a sole proprietor, you are personally responsible for any business liabilities created by your freelance work.
Personal liability means that your personally-owned assets (e.g. house, car, etc.) are at risk if your freelancing business faces legal consequences.
Formally organizing a business entity is quick and cheap. Before jumping into freelance work full time, review the business entities available in your state, and formally organize to limit your personal liability.
Respect the Business Organizational Form
The “corporate veil” is the legal term for the mechanism that allows business owners to separate business liabilities from their personal liabilities.
The corporate veil applies to many business entities including corporations and LLCs. To keep the protection of the corporate veil, you must respect the organizational form. In other words, you must keep your business assets and your personal assets separate.
There is no bright line rule for respecting the organizational form. However, there are some general guidelines:
- Keep separate business and personal banking accounts
- Keep books and records for the freelancing business
- Document all transfers of money between your freelancing business and third parties
- Review and comply with state and federal business regulations
- Commingle business funds and personal funds
- Fund personal expenses with business accounts
- Fund business activities with personal accounts
- Ignore IRS guidelines for business use of household property
If you ignore the organizational form, a court could disregard your freelance business organizational form (i.e. “pierce the corporate veil”) and find you personally liable for your freelancing business activities.
Know your Tax Exposure
The tax impact is one of the biggest shocks to those who jump from employee to full time freelancer.
Most employees don’t pay much attention to the taxes employers pay on behalf of the business and employees. Take a glance at this non-exhaustive list of business taxes:
- Federal income tax withholding
- State income tax withholding
- Social Security
- Additional Medicare
- Federal Unemployment (FUTA)
- Workers Compensation
You can leave the employee title with your former employer, but the government will still come for its share of your freelance earnings.
LLC, Corporation, or Sole Proprietorship
In a recent article, we discussed how the recent tax reform affects small businesses.
Whether the small business in question is a small coffee shop, or your freelancing business, the first consideration in tax analysis is the organizational form.
Corporations are generally subject to double taxation; meaning, corporations pay income tax on their earnings and corporate employees pay income tax on their wages.
Sole proprietorships are considered an extension of their owners, and sole proprietors report earnings on their personal W-2s.
The LLC is a hybrid organizational form that allows business owners to choose corporate tax treatment (double taxation) or partnership tax treatment (pass through taxation). S-corporations also utilize the pass through taxation method.
As a freelancer, you will most likely fall into one the above mentioned organizational forms and its associated tax treatment.
However, double taxation or pass through taxation only addresses income tax. When analyzing the tax implications of your freelance business, make sure to review other common taxes that might apply such as the self employment tax and state level taxes.
Get Comfortable with Contracts
In considering a move to freelancing, contracts probably aren’t top of mind. But, familiarizing yourself with contractual provisions before making the move to freelance work can help prevent conflicts further down your career.
Contracts between your freelancing business and your freelance clients should provide certainty around payment, ownership, responsibilities, and restrictions.
Prompt payment from your clients is a key element to a sustainable freelance business. The best way to ensure prompt payment is through strong payment terms in your client contracts.
There is no magic to drafting effective payment terms. Clarity is key. Payment terms are clear if the average person can read through the terms and know:
- Where to find the amount due
- When payment is due
- Payment methods available
- How to dispute a payment
- Who to pay
Other elements to consider including in payment terms of freelancing contracts include:
- How the due date is determined (e.g. X days from service delivery date, invoice date, invoice received date, etc.)
- Late pay penalties
- Lump sum or installment payments
- Early pay discounts
Here is an example of poorly drafted, ambiguous payment terms:
Payment terms are net 30.
The payment terms above leave too many unanswered question. 30 days from what? What are the payment methods? Business days or calendar days? This example fails to address the majority of the payment term considerations listed above.
The below example provides more clarity:
Client shall pay Freelancer no later than thirty calendar days after Client’s receipt of Freelancer invoice in USD via credit card, direct deposit, or other payment method agreed to in writing by the parties.
Clients hire freelancers for the client’s benefit. Accordingly, clients will expect to own the product created.
In contracts, expect clients to claim ownership to any deliverable you create in the course of your freelance work, plus an agreement to assign any rights you may have in those deliverables to your client.
Client ownership, and assignment of rights to your clients is common; however, be careful that clients don’t overreach on this point.
If you have specific methods and processes that make you unique from other freelancers, or help streamline your freelance operation, you should own rights to these methods. Your client does not have rights to this portion of your freelance business, nor should you assign such rights to your client.
For example, assume you are a freelance photographer, and the photos you provide clients have a unique appeal. You achieve that appeal through a special process that includes a specific lens, old-school film, and a particular film development process.
In this example, the photos produced become your client’s property. However, the lens, film, and development process remain your freelance business property. The contract should clearly state that the photos are assigned to the client, but the tools and process used to create the photos remain with you, the freelancer.
Language about ownership and assignment of rights can get tricky in freelance contracts. You may want to consult an intellectual attorney before making the move to full time freelance work so you can pinpoint intellectual property concerns specific to your business.
The bulk of your freelance contracts will likely address the division of responsibility between you and your clients.
Again, use plain language and try to eliminate any ambiguity regarding who is responsible for each aspect of your freelance work.
As an example, assume you are a freelance web designer. Your client may draft a contract that lists your responsibilities as:
Freelancer services shall include twenty hours of website design, two revisions, and services shall be complete upon Client’s satisfaction and acceptance of the website design.
This provision leaves too many unanswered questions. Are there any technical or compatibility requirements? Are the two revisions included in the twenty hours, or an extra two hours? If the client rejects a design, does the Freelancer get paid for extra hours? How many designs can the client reject? What is “acceptance”?
Responsibilities extend beyond the freelance services provided. In the web design example above, the website will eventually go live. What happens if the website has a bug that harms the client?
If the division of responsibility between the freelance web designer and client is clear, the bug might not present a difficult issue. But, if the contract does not address the situation, a website bug could cause a major challenge to the client-freelancer relationship.
There is no golden rule when dividing responsibility between a freelancer and a client. The best practice to divide responsibility starts with an open conversation about roles and responsibilities with your client, and then plainly stating each party’s responsibility in the freelancer contract.
Many freelance contracts, especially those drafted by your clients, will include provisions that restrict you in some manner.
Common restrictions include:
Reasonable restrictions are not uncommon, nor should they cause concern in many situations. For instance, it’s perfectly reasonable that your clients expect you to keep their proprietary information confidential. You should expect and require the same of your clients.
In many cases, a non-compete may be reasonable. For instance, if you provide freelance video production services for a software company, the software company might be reasonable in limiting your ability to produce videos for its direct competitors. You will likely be exposed to new products and trade secrets that the company has a legitimate interest in keeping from the competition.
On the other hand, if you freelance in a niche space, non-competition might cause a problem. For example, if you are a biomechanical engineer who specializes in vehicle rollovers, your potential client base is smaller than the video producer. Accordingly, a non-compete might be unreasonable in this circumstance.
When considering restrictions in freelance contracts, consider what is reasonable given the market and circumstances.
Evaluating the legal impact of moving to full time freelance work doesn’t necessarily mean you need to hire a lawyer. With or without the help of legal counsel, you should separate your personal and business liability, understand your tax exposure, and implement basic contractual protections.