Independent Contractor vs. Sole Proprietor: What's the Difference?
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Self-employment is a popular way of doing business for those who prefer greater freedom and flexibility than full-time or part-time employment. As a self-employed person, you can work on your terms, set your hours, and work without fear of micromanagement. As a trade-off, self-employed individuals are responsible for filing their own taxes, purchasing liability protection, and keeping tabs on their income.
Two of the most common self-employment classifications are independent contractors (ICs) and sole proprietors (SPs). Both ICs and SPs do business without setting up formal business entities, like limited liability companies or corporations. It is essential to know which classification best aligns with your way of working, as this will determine your legal rights and responsibilities.
What is an independent contractor?
An independent contractor (IC), often referred to as a freelancer, is an individual hired to perform specific jobs for another business entity.
What is a sole proprietor?
A sole proprietor (SP), also referred to as a sole trader, is a single individual who owns and operates their own business, also known as a sole proprietorship.
Let’s explore the key differences between the two classifications below.
So in terms of business structure, IPs work for companies as individuals while SPs work for companies through their individually owned businesses.
A sole proprietorship business structure is especially popular with small business owners who do not intend to grow. This type of business is simple to maintain and doesn’t require you to obtain a business license or register a business name as a legal entity with the state, as no financial or legal filings are required.
Notably, an SP can also work as an IC on the side, which we explain in the following section…
ICs are often service providers that perform contractual work for clients for a set fee. However, SPs may also perform contractual work for clients for a set fee, but they may have other revenue streams, like selling their own products or services directly to customers.
Let’s look at three scenarios below to see how different ways of making an income dictate whether you’re an IC, SP, or both:
Scenario one: let’s say you’re a copywriter, contractually obliged to write three blogs per week for a company. You’re not classified as an employee because you have control over how you do the work, and the money you receive is not a salary or wage. It’s “workers’ compensation” sent through invoices. In this scenario, you are an independent contractor.
As an IC, a company pays you for your services, but it’s not responsible for paying your taxes on your behalf. You are responsible for reporting your income and paying your taxes at the end of the tax year.
Scenario two: now, imagine a different scenario where you write and publish your own book. You’re not classified as an employee because you don’t work for another company. You’re also not considered an independent contractor because you’re not receiving compensation from a client. In this scenario, you are a sole proprietor.
As an SP, you generate your income directly from customers and are responsible for reporting your income and paying your taxes at the end of the tax year, just like an IC.
Scenario three: finally, let’s imagine a scenario where you do both. You provide your writing services to another company, and on the side, you write and publish your own book. In this scenario, you are both an IC and an SP.
Falling into both categories means generating income from your writing services as an IC and your book sales as an SP. Like the two scenarios above, you are responsible for reporting your income and paying your taxes at the end of the tax year.
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Tracking income for tax purposes
An IC will receive Form 1099-NEC from the client, documenting their total income earned during the tax year if it exceeds $600. In contrast, an SP must track their own business income to calculate and file tax payments.
If you are both an IC and SP, you will receive a 1099-NEC from the client documenting total income earned during the tax year if it exceeds $600. (The 1099-NEC replaced the 1099-MISC form in 2020 for independent contractor income reporting.) In addition, you will be responsible for tracking any income you make from other revenue streams. The easiest way to do this is to have different bank accounts to separate your personal and business finances.
As a general rule, both ICs and SPs should keep track of their income and business expenses regardless of their work classification to ensure their financial information is accurate. This will come in handy when filing your personal and business tax return at the end of the year.
Both ICs and SPs will need to file estimated tax payments throughout the year.
- ICs based in the US will need to report their personal income and expenses to the IRS on their personal income tax returns using tax form Schedule C (Form 1040) and pay self-employment taxes
- SPs based in the US will need to report their business income and expenses to the IRS on their personal income tax returns using tax form Schedule C (Form 1040) and pay self-employment taxes
- If you are an IC and an SP, you should file both your business taxes and your personal tax return to the IRS using tax form Schedule C (Form 1040) and pay self-employment taxes
Self-employment taxes include FICA (Medicare taxes and Social Security taxes) which an employer would usually withhold from your paycheck as “payroll taxes” if you were their employee. Since ICs and SPs are non-employees, they have to set aside money to pay this themselves.
Read our guide on independent contractor taxes for more information.
The final difference between ICs and SPs is the level of risk involved and how this impacts personal finances and assets.
Both ICs and SPs can be held responsible for their work. This includes mishaps while providing a product or service for a client or customer. However, SPs’ stakes are much higher since their business is directly linked to their funds and personal assets. This means SPs are liable for any business debts and legal obligations the business incurs.
Both ICs and SPs can benefit from purchasing liability insurance to safeguard their personal funds and assets. ICs should also sign thorough independent contractor agreements to minimize unexpected penalties should a conflict arise.
Get your work classification right the first time with Deel
Are you self-employed, trying to figure out your worker classification? Or perhaps you own a business looking to hire independent contractors and classify them correctly. In either case, Deel is here to help.
Deel has heaps of helpful resources about independent contracting, employer and self-employment taxes, and more on our blog. Alternatively, book a free consultation, and we’ll show you how we can make global hiring, payroll, and compliance easier for your team.