The Internal Revenue Service states that independent contractors *are* self-employed. However, not all self-employed people count as independent contractors.
As it turns out, there are some important differences between these two, that can impact the way you do your work and pay taxes.
That’s just the topic of today’s article! Here we’ll explain to you how to confidently make a distinction between independent contractors and self-employed for legal purposes. To avoid confusion in your future ventures, you can get back to this article and check:
- What is an independent contractor
- What is self-employment
- The comparison between independent contractors and self-employed
- How to classify yourself
- Taxes, licenses, and insurance for independent contractors and self-employed
- What kind of business structures are available to independent contractors and self-employed
What is an Independent Contractor?
Let’s start with defining these terms, independent contractor first.
An Independent contractor is a person that provides the general public (companies or individuals) with goods or services.
Independent contractors, as their name suggests, have a great deal of independence in their work. US Supreme court/ Common Law rules propose a three-factor test to define who gets to be an employee, and who can be hired as an independent contractor:
- Behavioral control — Independent contractors are in charge through and through and have a great degree of control. Working hours, location, tools, equipment, and means of work, as well as the creative process in its entirety, are determined by an independent contractor. Additionally, they can pick each task as they please, according to the contract they’ve signed with the other side.
- Type of relationship — independent contractors are hired for a limited amount of time, to perform non-crucial tasks for other business entities. For example, a law firm may seek an SEO expert to improve their ranking, as a one-time thing.
- Financial control — independent contractors are in charge of the business aspect of their work as well. This means that they are the only ones to decide how they will invest their business income into the equipment and training, which should then bring them a competitive advantage over other independent contractors and freelancers on the market.
These are the basics of an independent contractor definition. To get the full idea, take a look at these articles on our blog:
Stay compliant with localized contracts
Generate contracts in seconds. We’ll ensure you’re complaint with local labor laws, no matter where your team lives.Learn more
What is Self-Employment and how it compares to Independent Contractors?
Just as independent contractors, self-employed people aren’t employees of any particular company. They do contract-based work for multiple clients; non-employees use freelancer websites, LinkedIn, browse job websites or rely on their reputation, recommendations, and word of mouth to find new clients, or be contacted by them. They can have direct contact with their potential clients and skip the HRs (unless they contact them first on behalf of the company looking for contract workers).
Both independent contractors and self-employed can freely choose what they’ll do, how and when they’ll do it, and for what rates. A skilled developer who writes in their spare time may offer content writing services as well, to earn an extra income and freshen up the working days.
This freedom comes with plenty of responsibilities, otherwise handled by company administration. All non-employees need to sort out their tax payments on their own, for each tax year they perform work that brings them more than $600. Income tax withholding by employers means that employees can rely on their company to handle payroll taxes. On the contrary, independent contractors and self-employed are individual taxpayers who hold tax liability themselves.
In addition to that, independent contractors and self-employed people miss out on significant employee benefits and protections.
US Labor Law only protects full-time employees, not independent contractors, freelancers, or self-employed. This means that they only have their compensation at their disposal and need to cover everything independently. There’s no paid time off, sick leave, pension, and 401k plans, or health insurance available.
Similarly, FLSA (Fair Labor Standards Act) standards don’t apply to non-employees, so there’s no minimum wage guaranteed to them, or unemployment/ workers’ compensation, for that matter.
Important info: CARES Act (Coronavirus Aid, Response, and Economic Security Act) passed by Congress entitles you to unemployment benefits. This applies if you’ve lost your job because of the pandemic, or if you/ a household member has contracted the virus.
Independent contractor vs self-employed worker
There are many similarities between independent contractors and self-employed workers, so much that they may seem the same.
Now we come to the part that puzzles many freelancers who don’t have a full-time employee status — i.e, who work for themselves.
Independent contractors are self-employed, and there are very few exceptions to this rule. At the same time, not all self-employed workers may classify as independent contractors.
How come? Well, the best way to explain this is through an example of two scenarios.
Imagine you’re a fashion designer and work for multiple brands at the same time. Everything is contract-based and limited to certain clothing items, collections, or time-constricted. This is a typical independent contractor work, and you would count as self-employed.
In the other case, you’d work as a fashion designer, but strictly for yourself. Warehousing, workshop, orders, shipment, as well as designing and sewing clothes — all is done by you alone.
This goes in line with the independent contractor definition, with one main difference: you are your own boss but have no (other) clients at the same time. There are no contracts with other business entities like there would be in the previous case. You could hire other people to help you if there’s too much work, but keep in mind that this could qualify you as a small business owner.
Employer tip: Make sure to avoid misclassifying your employees as independent contractors! 20 Factor Test can also help determine the Independent Contractor legal status in the US and prevent employee misclassification
Taxes and tax deductions for independent contractors and self-employed
First of all, file Schedule C (Profit or Loss from Business) to calculate the net income or loss of your business. Remember to use Form 1099-MISC to report direct sales (amount exceeding $5,000). As an independent contractor, your client will ask you to fill in Form 1099-NEC (non-employee compensation) for every job that you were paid more than $600. 1099-NEC is collected at the end of the year and will serve your client to do reporting for tax purposes.
Both independent contractors and self-employed individuals need to pay the following taxes:
- Self-employment Tax — This tax is a non-employee version of the FICA tax which employers pay for their employees. This tax covers Social Security and Medicare, as they aren’t held by employers/ clients.
- Additional Medicare Tax
- Federal Income Tax
Here’s our complete guide to paying independent contractor taxes and tax forms for independent contractors, for additional details and instructions.
These taxes, along with personal use property taxes and sales taxes from buyers, are non-deductible.
To relieve the independent contractors and self-employed, there are several tax deductions available for business expenses:
- Home office — if you’ve dedicated a part of your home to doing work, you can claim tax deductions for a part of your mortgage, electricity, rent, interest, real estate, and other similar taxes. Use The IRS Form 8829 and file it along with Form 1040 (U.S. Individual Income Tax Return)
- Office expenses — for office supplies, utilities, repairs, and maintenance
- Advertising costs
- Business setup expenses
- Licenses and education
- Insurance — health insurance, business insurance
- Travel expenses, including car expenses and payments
Read more: Tax Deductions for Independent Contractors & Self-employed
License requirements for non-employees
Rules vary from one state to another and also depend on the type of work you perform. Licensing rules aren’t affected by your employment status, and the same applies whether you’re listed as an independent contractor, self-employed worker, freelancer, sole proprietor, or you’re incorporated.
We should mention that everybody who conducts a business in Washington needs to obtain a license, no matter the profession.
What type of insurance independent contractors and self-employed need?
To pick adequate insurance, you need to have a look at your daily work activities and equipment, and consider everything that could go wrong. Covering business risks can go anywhere from vehicle insurance, commercial property insurance, to more precise and detailed contracts for certain lines of work.
Business insurance for independent contractors most often includes one of these (as they are the most important):
- General liability insurance — or Commercial General Liability Insurance/ Business Liability Insurance protects you in case of an action that may cause third-party injuries, property damage, or even reputation damage.
- Professional liability insurance — also called Errors & Omissions (E&O) Insurance or Professional Indemnity Insurance. This one protects you from error and negligence claims made by clients who have suffered financial losses as a result. It covers the costs of investigating the alleged work errors, legal defense, and false/ frivolous damage claims.
Common business structures for independent contractors and self-employed workers
Some self-employed individuals and independent contractors choose other business structures for their work. The available options include:
- Sole Proprietorship
- Limited Liability Company (LLC)
- S Corporation
As sole proprietorship is in many ways closest to the independent contractors and self-employed, we’ll focus on that type of business entity here.
A sole proprietorship is the most popular type of business in the United States, especially for freelancers, startups, and small businesses. It’s the easiest and cheapest to create, run by one person.
The business owner is legally “conjoined” to their business and personally liable for everything. Raising money for business ventures of sole proprietors is difficult, as banks and investors sometimes deem them too risky. Investment opportunities are limited as well because you cannot sell the company stock or sell an interest in the business to acquire capital.
The good sides of forming a sole proprietorship include full ownership over the enterprise, deductible costs, and cheapness/ simplicity of taxes: sole proprietorship tax forms include Schedule C and Schedule SE with Form 1040.
Interested in forming a sole proprietorship in the US? Take a look at our Sole Proprietorship guide that fully covers definition, benefits, taxes, and business registration.
Sole proprietorships have world-wide popularity, but each country has different laws and legal requirements. This is our jam — Deel blog has instructions that show you how to form a sole proprietorship in dozens of countries!