In recent years, discussions are taking place, both in the US and worldwide, about independent contractors and their role in the gig economy. Multinational corporations around the globe are continually finding ways to reduce their worker-related expenses while tax authorities are scrambling to get the rights, benefits, and taxes of contractors in order.
In this article, we hope to give you a clear overview of independent contractors and shed light on their scope of work, rights, and obligations, as well as differences compared to employees.
What is an independent contractor?
An independent contractor is someone who supplies services or products to the general public as a non-employee. As a contractor, you have your own business and are in charge of paying taxes and benefits. Contractors are usually entrepreneurial spirits; they have either gained expertise in a field by working as an employee for a long time or someone wishing to break the confines of being an employee and be their own boss.
Independent contractors’ clients are not responsible for providing any type of employee benefits, but they also can’t control their work process. Independent contractor controls how long and in what way they perform the work, and the client has a say only in the final result. Contractors use their own equipment to do their job and are responsible for filing their income tax returns. The earnings of an independent contractor are subject to self-employment tax as an addition to federal income tax. A synonymous term for an independent contractor is a freelancer.
Before the digital age and the gig economy era, some professions were standard in the contractor book, such as dentists, lawyers, vets, doctors, and others classified as independent contractors by the Internal Revenue Service (IRS). Nowadays, however, the list of professions who can be freelancers or independent contractors has grown substantially to include designers, writers, artists, subcontractors, real estate agents, and many other categories of professionals.
Independent contractor vs. employee
An Independent contractor is not an employee. Sometimes, independent contractors are referred to as contractor employees or 1099 employees, but these terms are not quite correct.
The IRS uses several methods to determine whether a person is a regular employee or has independent contractor status. These methods align with the guidelines of the United States Supreme Court for distinguishing contractors from employees.
Degree of control over the work of independent contractors
Common law rules are in place to differentiate employees from contractors, and they do it based on the degree of control and independence. Control factors come in three categories:
- Behavioral control means the employer or client has the right and possibility to control how the job is done. Keep in mind that this doesn’t have to mean they actually enforce the control over how you work - just that they can. By exercising control over the work process, we mean giving any instructions on using equipment, work location and hours, the order of tasks to perform the job, etc. The more control over the work process a client has, the less likely you are an independent contractor.
- Financial control, which means controlling the business aspects of the worker’s job. If the business activity of the contractor requires significant investment into equipment, and they make that investment to be able to work for clients, it is likely they are independent. The opportunity to make a profit or loss and the availability of the worker on the relevant market also come to play when determining independence.
- Type of relationship, which illustrates the perception both sides have of the relationship. Written contracts don’t mean much to the IRS just because they state someone is an independent worker who pays their own taxes and benefits. The nature of the relationship and how the sides work together determines the relationship. Of course, any payments of employee benefits would indicate employee status, but other factors count as well. If a client is hiring a freelance worker for an indefinite period rather than a specific time frame, this would indicate an employer-employee relationship. The same goes for the type of services provided: if a contractor you hired is providing services crucial for your business, they are more likely to be employees.
Is an independent contractor self-employed?
Yes. According to the US Labor Law, an independent contractor is not an employee and the working relationship between them and their clients consist of providing services on a contract basis. Therefore, an independent contractor is self-employed.
Is an independent contractor a sole proprietor?
An independent contractor can choose to operate in any business entity such as sole proprietorship, Limited Liability Company (LLC), corporation, partnership, etc. However, usually, an independent contractor is a sole proprietor.
Keep in mind, there are a few differences mostly regarding paying taxes, so we advise you to take a deeper look into our independent contractor vs sole proprietor guide.
How to become an independent contractor
In the United States, a person needs to become a sole proprietor or establish a single-member limited liability company (LLC) to work as an independent contractor. Being self-employed and starting a business is universally praised in the US, especially if the value is created through innovative products and services. Still, self-employed professionals have some legal peculiarities that distinguish them from other business entities and regulate their rights and obligations.
First of all, independent contractors need to file their income on the 1040 Form along with quarterly submissions of their self-employment tax (SE tax). SE taxes are social security and Medicare taxes for the self-employed. These payments are usually submitted on a 1040-ES Form.
An important aspect of tax liability for contractors is that they don’t pay taxes on their gross income. Business expenses, where applicable, can substantially lower the tax obligations. For these business owners, tax is due on the net income, which is calculated as the difference between the gross income and deductible business expenses.
Since 2019, independent contractors pay a rate of 12.4% for social security taxes and 2.9% for Medicare taxes on the first $132,900 of their net income, with an additional 2.9% on their net income after those $132,900. Some freelance workers may also have to pay the state sales tax, depending on their business activity, but they don’t pay unemployment taxes.
As an independent contractor, keeping track of client payments and earnings is mandatory.
Does an independent contractor need a business name?
Although you can usually operate under your personal name, it might be a good idea to come up with a business name. It feels more professional and you can use it in your business communication as well as on invoices and other business documents. If you are using a business name, you probably need to register it. If you choose to do so your business name will be referred to as your assumed name or a DBA "doing business as". When choosing a business name, independent contractors usually add a word or two after their legal names such as John Smith Accounting or something similar.
Does an independent contractor need a business license?
Usually yes, but the business license permits for independent contractor bary per country and state. Some states require independent contractors to have a business license even if they are working from home. It would be best to check the US Small Business Administration website to see what business licenses are needed for your profession.
Does an independent contractor pay taxes?
While employees pay FICA taxes, commonly known as payroll taxes, independent contractors pay the self-employment taxes and income taxes. Here's a short overview of how to file taxes as an independent contractor.
Self-employment tax for independent contractors
Simply put, the self-employment tax is the contractors' version of the FICA tax paid by employers. Self-employment tax (SE tax) covers your Social security and Medicare contributions. The rate of the SE tax was 15,3% in 2019, and you are expected to pay the full amount. However, you can get a deduction for half of your SE tax when you file the tax return. There is also an additional surtax for Medicare amounting to 0,9% for high earners.
Income tax for independent contractors
The second tax on your list is the federal income tax. In the United States, the tax system is progressive, which means you pay more when you earn more. There are seven tax brackets in 2020, and you can calculate which one you are in by subtracting deductions from your business income. The federal income tax rates range from 10% to 37%.
Take a look at our complete guide to independent contractor taxes.
Tax forms for independent contractors
Clients working with independent contractors based in the United States need to obtain the Form W-9 or Request for Taxpayer Identification Number from their independent contractors. If the independent contractor is based outside of the United States, a From W-8BEN or W-8BEN-E needs to be submitted. Forms W-9 and W-8BEN(E) are necessary for issuing Form 1099-NEC if clients paid more than $600 for the services of the contractor within a tax year. Form 1099-NEC is standard for reporting non-employee compensation, and it covers the payments made to both independent contractors and freelancers.
Note: Non-employee compensation was previously reported with Form 1099-MISC in Box 7.
What tax deductions can I claim as an independent contractor?
Unlike full-time employees whose income, social security, and Medicare taxes are automatically deducted from their salaries, as an independent contractor you need to deduct those from your generated income. However, you can claim tax deductions on several things, such as:
- Home office expenses
- Legal, accounting, and tax professional services
- Cell phone bill
- Equipment depreciation
- Travel and car expenses
Take a look at the full list of independent contractor tax deductions.
Do independent contractors get employee benefits?
Employers commit to paying employee's health insurance, potentially sponsor a pension plan, provide sick leave, 401(k) contributions, and paid time off. US Labor Law is designed to protect the employees. However, employers don't cover any benefits for their independent contractors - the contractors pay for them independently.
Because employees work for employers regularly, they are entitled to receive the benefits stated in the Fair Labor Standards Act, such as minimum wage. Contractors, on the other hand, charge their products and services based on market fees.
Can an independent contractor file for unemployment benefits?
No, independent contractors cannot collect unemployment compensation, worker’s compensation benefits, or other expenses mandated in the employment laws. This is because independent workers, their clients, and customers don't pay state or federal unemployment taxes. However, Congress has passed the Coronavirus Aid, Response, and Economic Security Act, also known as CARES Act. As a result, you are be entitled to unemployment benefits. To qualify, you must certify that
- you or a member of your household has been diagnosed with COVID-19
- you had to quit your job as a result of COVID-19
- your workplace was closed as a direct result of a COVID-10 public health emergency.
You can find the details of the CARES Act here.