Do you know the difference between being a small business owner versus being an independent contractor?
It’s easy to mix these two terms up. In addition, matters only get even more complicated if you’re trying to figure out if you can be an independent contractor and a sole proprietor. Fortunately, the Internal Revenue Service (IRS) is here to help determine which term applies to you and your role as a small business owner.
Who is an Independent Contractor?
An independent contractor is self-employed, according to the IRS.
Some professions that may be eligible for independent contractor status include veterinarians, lawyers, and accountants. Other professions in an independent trade or business that offer services to the general public are independent contractors. Individuals in creative or technical roles, like graphic designers and SEO professionals, are also independent contractors.
As a self-employed worker, an independent contractor provides services to someone else or to another company. A contractor may complete a one-off project or provide seasonal assistance due to their skill sets. Businesses may establish a rapport with a trustworthy independent contractor and recruit them for additional projects. A business pays contractors for the work they complete. This may be on an hourly basis or for the total assignment.
Benefits and Drawbacks of Working as an Independent Contractor
Working as an independent contractor offers flexibility in choosing projects and setting your own schedule. However, there are drawbacks, such as a lack of employee benefits like health insurance and retirement plans. Independent contractors are also responsible for managing their own taxes, which can involve more paperwork and financial planning.
Example of an Independent Contractor
An independent contractor could be a freelance graphic designer hired to create a company’s logo. The designer is not an employee of the company but is hired to complete a specific project. The company doesn’t control how the work is completed, only the final result of the logo design.
Independent Contractors and Employees: What’s the Difference?
It is easy to blur the lines between whether a worker is classified as a contract worker or an employee of the business. Understanding the distinction between a contract worker vs employee is crucial to avoid misclassifying workers.
According to the IRS, the general rule for an independent contractor is: “if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
What does this mean? If an employer controls how services are performed within their company, an individual would not be considered an independent contractor. It is the legal right of the employer to control the details of what will be done and how it will be done.
Similarly, the IRS states that if an employer-employee relationship exists, the worker would not be classified as an independent contractor.
Common Law Rules
In the event you are uncertain about whether an individual is an employee or independent contractor, the IRS outlines three common law rules. These rules allow employers to better define the nature of the working relationship.
- Behavioral. The company controls, or has the right to control, what the worker does and how the worker does their job.
- Financial. Business aspects of the worker’s job are controlled by the payer. For example, this may include details such as when and how the worker is paid and who provides the contractor with the necessary tools or equipment to do their job.
- Type of Relationship. This factor notes if the worker has a written contract with the employer or if they receive any type of benefits. It also examines if the work performed by the worker is a key aspect of the business.
These factors help determine a worker’s classification, allowing the worker to determine if they are an employee or independent contractor. However, if an employer is still uncertain of a worker’s status they may fill out and file Form SS-8. This form allows the IRS to determine the worker status for the purposes of federal employment taxes and withholding income tax. (Workers that believe they may be misclassified can also complete and file this form.)
Independent Contractor Taxes
Another difference between classifying as an independent contractor versus an employee is found in reviewing tax forms.
For example, an employee receives Form W-2, Wage and Tax Statement from their employer. This withholds income tax and FICA (Social Security and Medicare) tax.
An independent contractor receives Form 1099-MISC. This shows the total income received from companies the contractor worked for. However, it does not deduct payroll taxes. This is because the independent contractor is not an employee. They are not on the company payroll. The earnings of an independent contractor are subject to self-employment tax, which the contractor is responsible for paying on their own.
What is a 1099 Contractor?
A 1099 contractor is an independent worker who provides services to a business under contract rather than as an employee. Named after the IRS form 1099, this type of contractor is responsible for handling their own taxes, and the business does not withhold taxes from their payment.
What are the Benefits of Working Under a 1099 Contract?
Working under a 1099 contract allows for greater flexibility and independence. Contractors can choose their clients, set their own rates, and determine their working hours. Additionally, they have the opportunity to work on a variety of projects, which can lead to more diverse income streams. However, they must also manage their own taxes and benefits.
Who is a Sole Proprietor?
A sole proprietor is a business owner. They own an unincorporated business. Sole proprietorships are default entity formations. The company will remain unincorporated unless the owner decides to take the steps necessary to incorporate the business.
Sole proprietors run a one-person business. This means they operate a business on their own. A sole proprietor entity is a solid starter for entrepreneurs that do not wish to file a lot of paperwork or deal with extra expenses. It is affordable and easy to manage.
Running a sole proprietorship also means the owner of the business gets to act as its boss. They have full control over the company. A sole proprietor is responsible for everything that impacts the business. Essentially, sole proprietors work for themselves, like independent contractors, and enjoy a certain amount of flexibility in running their own business.
However, maintaining full responsibility over a business means understanding that there will be good and bad moments to navigate. Because a sole proprietorship is unincorporated, it lacks the safety net that incorporated entities have in limited liability protection. Over time, a sole proprietor may decide to form a limited liability company or incorporate as another entity formation. Doing so will allow the sole proprietor to receive limited liability protection. This creates a separation between the owner’s personal assets and those belonging to the business. This ensures personal items like houses and cars are not impacted by liability issues.
Sole Proprietors and Taxes
What about taxes? Like independent contractors, sole proprietors are also responsible for paying self-employment taxes.
However, a sole proprietor needs to report all income on personal income tax returns. This means they need to pay the full amount for tax on business profits and self-employment taxes. The amount of tax responsibility can often be upwards to hundreds, if not thousands, of dollars and may present a financial strain on sole proprietors.
In the event the sole proprietor feels they are under too much tax responsibility, they may choose to incorporate as a limited liability company (LLC) As LLC may pick an entity they would like to have the LLC taxed as, like an S Corporation, to “pass-through” income and losses on personal tax returns. Sole proprietors filing taxes must file using Form 1040 and using Schedule C to report income or loss from the business.
Is a Small Business an Independent Contractor?
Independent contractors and sole proprietors work for themselves. A business may hire and work with an independent contractor, but they would not be an employee unless specified otherwise. An independent contractor may, in time, decide they have expanded their services and offerings enough to operate as a sole proprietor. Then, they may begin to run a one-person business.
However, making this shift varies for every independent contractor. Before deciding to pivot to an unincorporated (or incorporated!) entity formation, consult a legal professional. Ask questions about how the change in tax structure may impact you, learn about the best entity formation for your services and offerings, and get advice as to whether this shift into running a small business is right for you.
Wrapping Up
Understanding the differences between being an independent contractor, a sole proprietor, and running a small business is crucial for ensuring compliance and making informed decisions. Both independent contractors and sole proprietors enjoy the flexibility of working for themselves, but each comes with its own tax responsibilities and legal considerations. Whether you choose to remain an independent contractor or evolve into a sole proprietor or an LLC, it’s important to carefully consider your options, consult with a legal or tax professional, and determine the best path forward for your business success.
Frequently Asked Questions
What are the tax implications for independent contractors?
Independent contractors are responsible for paying their own taxes, including self-employment tax, which covers Social Security and Medicare contributions. Unlike employees, taxes are not withheld from their earnings, so contractors need to estimate and pay quarterly taxes to avoid penalties.
What are the common mistakes small businesses make when working with independent contractors?
A common mistake small businesses make is misclassifying workers as independent contractors when they should be employees, which can lead to penalties. Another error is not having a clear contract outlining the scope of work and payment terms, leading to potential disputes.