Independent Contractor vs. Sole Proprietor: What's the Difference?
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Are you self-employed?
It's a popular way of doing business for those who prefer to work on their own terms and plan their own schedules since it allows you a lot of freedom and flexibility.
Self-employed individuals are, however, responsible for paying their own taxes and contributions, keeping record of their documentation, and more, so it's not all rainbows and butterflies when you run your own business.
A common misconception is that all self-employed individuals belong to the same category, but the reality is different. If you are a self-employed person, you have multiple options regarding the legal entity you’ll register — you can choose to be:
- Independent Contractor
- Sole Proprietor
- Limited Liability Company (LLC)
- S Corporation
- A part of a Partnership
Independent contractors and sole proprietors are often mixed up because they are very similar: both fit the description of a self-employed business owner.
However, there are some things you should know about these two before you make a decision — the most important difference being their taxation duties and relationship with clients.
In this article, we will make a comparison between Independent Contractors and Sole Proprietors, including:
- Definition of an independent contractor
- Definition of a sole proprietor
- How are these two entities different?
- Who should register as an independent contractor/ sole proprietor?
- Can you be both at the same time?
Who is an independent contractor?
An independent contractor is a person hired to provide services or work to another entity, but not as an employee. Independent contractors (ICs) are also called freelancers, and they have become increasingly popular in the current gig economy.
They are paid in accordance with a contract — usually short-term, per project or task. Employers can, however, hire the same freelancers time and time again if they’re pleased with their work, but they're still not on the company's payroll - their wages count as non-employee compensation.
In relation to the employers, ICs retain more control over their work than full-time employees. While employers may demand specific quality levels and give precise outlines for the end product/ result, they cannot dictate working methods, hours, pace, and space where ICs work.
If there’s no conflict of interest present (determined by the contract), ICs can simultaneously work for different employers, so their net income may be higher than an employee's.
With this independence come certain legal responsibilities. Companies don't withhold payroll taxes from the contractors' payments to cover their health insurance, for instance. The independent contractor has to take care of it on their own.
Contractors are fully responsible for their personal income taxes and self-employment taxes (FICA taxes: Social Security and Medicare Taxes). As they’re considered self-employed for tax purposes, they need to pay both employer and employee taxes and deduct these costs from their total income.
However, the IRS allows for basic tax deductions for freelancers and independent contractors. Ordinary and necessary expenses (O&NE) are the costs of doing the business and may include things such as:
- Home Office Expenses — if you work from home, these deductions would include utilities, mortgage interest, property taxes on an annual tax return
- Work equipment costs
- Courses, classes, and other educational material needed to provide the service
The employment laws in the United States do not cover independent contractors; this means that unemployment insurance, workers' compensation benefits, retirement plans, paid leave, etc. aren’t provided by the employers, and independent contractors have to pay for it themselves.
For more information, you can also read our detailed Independent Contractor Guide.
Who is a sole proprietor?
A sole proprietorship is a one-person business type. The sole proprietorship's owner's business and personal finances are tied together in this case; in fact, there is no legal distinction between a sole proprietor and his business. They are personally liable for every outcome, but also get to keep all the profits to themselves since they typically don't hire employees and don't have paychecks to pay out.
This type of business structure is especially popular with small business owners, as it’s simple to maintain. It's an unincorporated business where you are considered a sole proprietor for income tax purposes and you start operating, but choose not to register as a business entity with the state as no financial or legal filings are required.
If you choose not to get a business license from day one, your business name will be equal to your legal full name. You can also secure a DBA ("doing business as") if you register one business name, but want to operate under a different one for any reason. Note that the bank may require a DBA certificate for opening your bank account.
Sole proprietors should count their business income and expenses and separately from personal income and expenses — and to keep the personal finances, credit cards, and tax payments tidy, a separate business bank account is highly recommended.
Again, this doesn’t free them from personal liability when it comes to business debts: these can be collected from sole proprietors’ personal funds and assets.
One way to avoid this and ensure liability protection for personal assets is to register as a corporation instead. This does result in double taxation, as they need to file both corporate (dividends from the corporation’s profit) and personal tax returns (salary) — but private possessions and money are separated and safe whatever happens with the business.
However, when you register as a sole proprietor, you can use a single return to file both personal and business tax liabilities and save a lot of time in the process. And if you want to protect your personal assets while working as a sole proprietor, you can purchase liability insurance.
Note that single-member LLCs are actually sole proprietorships.
We also have a full sole proprietorship guide available on our blog.
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Differences between an independent contractor and a sole proprietor
Both independent contractors and sole proprietors need to pay self-employment taxes, which according to the IRS, in this case, only refer to Social Security and Medicare Taxes. But how are these two categories different then?
The first big discrepancy comes from the way independent contractors and sole proprietors file taxes and pay them.
Taxes for independent contractors
For independent contractors, these are the necessary steps:
- At the end of the year, the clients who paid the independent contractors $600 or more during the respective tax year need to fill out the tax Form 1099-NEC and then give it back to the independent contractors. Independent contractors then need to submit these to the IRS by January 31st of the following year.
- Along with that, independent contractors should submit the self-employment taxes (Social Security and Medicare taxes) on a Form 1040-ES.
- If the independent contractor is situated in the United States, their clients should request the IRS Form W-9 (Request for Taxpayer Identification Number); if they’re based outside the States, Form W-8BEN or W-8BEN-E are requested instead.
Important Notice: This year, the IRS reintroduced Form 1099-NEC instead of box 7 on Form 1099-MISC! Form 1099-MISC is now used to report the direct sales of consumer products worth $5,000 or more aimed for resale.
You can read all about Form 1099-NEC and 1099-MISC Form here.
Taxes for sole proprietors
Taxes for sole proprietors (SP) are simpler as personal and business income is one the same thing, and include the following forms:
- Schedule SE with Form 1040 — calculating the amount of self-employment tax owed)
- Schedule C Form — to report the business loss or profit
- Form 1040 — for annual income tax returns
Now, how to determine do you count as an independent contractor or a sole proprietor for tax purposes? To answer this, we’re reminding you that these two also differ by the type of work they perform!
Let’s say you’re a copywriter, contractually obliged to write three blogs per week for XYZ company. For these purposes, you are an independent contractor.
However, if you write on the side and decide to publish a book, all of the profit goes to you and has nothing to do with XYZ company — you did this all by yourself, for yourself. This means that you are a sole proprietor!
Now we are dealing with another question...
Can I be both a sole proprietor and an independent contractor?
Yes, you can! Following the previous copywriter/ book writer example, we can see that this scenario is possible (and quite usual) in real life.
In this case, the independent contractor/ sole proprietor “hybrid” pays income taxes and payroll taxes — because they’ve received an income from the book sales as well as from writing blogs for a company.
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Independent contractors and sole proprietors are quite similar: both are self-employed business owners who need to keep track of their income, losses, and business expenses. Both need to pay income and self-employment taxes, but the forms vary depending on the work they perform.