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?
What is an independent contractor?
An independent contractor is a business entity — 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.
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.
With this independence come certain legal responsibilities; as companies, they’re doing business with don’t withhold their payroll taxes, independent contractors have to take care of it on their own. They are fully responsible for income taxes and self-employment 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, worker’s 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.
What Is a sole proprietor?
A sole proprietorship is a business run and owned by one person only, whose business and personal finances are tied together; 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. This type of structure is especially popular with small business owners, as it’s simple to maintain and requires no registration.
A sole proprietorship is a default type of business structure: you are considered a sole proprietor for income tax purposes if you start operating but choose not to register as a business entity with the state. In that case, sole proprietors should count their business income and expenses and separately from personal income and expenses — and to keep the personal finances tidy, a separate business bank account is highly recommended. Again, this doesn’t free them from being personally responsible for business debts: these can be collected from sole proprietors’ personal funds and assets.
One way to avoid this and protect 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 (salary) tax returns — but private possessions and money are separated and safe whatever happens with the business.
We also have a full sole proprietorship guide available on our blog.
How are an independent contractor and a sole proprietor different?
The first big difference comes from the way independent contractors and sole proprietors are taxed.
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 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 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 (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...