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You aren’t an employee. You run your own business, perform gig work, sell products or services, or otherwise maintain your own income. But are you an independent contractor or a sole proprietor?
The difference between independent contractor vs sole proprietor will alter how you pay your taxes and how you’re legally classed. In truth, the line between a sole proprietor and an independent contractor is often gray. There are individuals who can be counted as an “independent contractor” or a “sole proprietor” depending on how they want to deal with their taxes.
Regardless, if you get a 1099-MISC form at the end of the year rather than a W2 form, you’re a self-employed individual. You’re going to need to file your taxes accordingly, as well as consider what your classification means for you.
Here’s what you need to know.
What is the Difference Between a Sole Proprietor and an Independent Contractor?
A sole proprietor could be:
- An accountant who sells their accounting services to clients, but operates without a firm.
- An artisan who creates and sells their own jewelry within a one-person shop.
- A gardener who has multiple clients who pay them for gardening services.
An independent contractor could be:
- Someone who delivers food through GrubHub, DoorDash, or other services.
- A childcare provider, who works for multiple families providing childcare services.
- A handyman, who provides discrete handyman services.
As you can see, there’s significant overlap. The confusion between a sole proprietor and independent contractor comes down to the fact that both phrases are used to describe single-person businesses. Someone who does gig work driving for a rideshare service like Lyft or Uber could accurately describe themselves as either a sole proprietor or an independent contractor.
Most sole proprietors are going to operate more like a business; describing their income and expenses and tracking their operations. An independent contractor is more likely to operate like a gig worker, doing discrete jobs in a variety of fields. Conventionally, sole proprietors are also going to have more established or larger businesses. But neither of these definitions are strict ones and both a sole proprietor and an independent contractor can be classed as being “self-employed.”
Self-employed, in fact, is often the most important distinction between an independent contractor and a sole proprietor. Self-employment can mean different things, especially in terms of financial decision-making.
Sole proprietors or independent contractors may be accountants, attorneys, clinicians, professionals, gig workers, cleaners, gardeners, and handymen. But even though an independent contractor or sole proprietor could be the exact same thing, it’s still very important to understand the distinctions. Being self-employed, in itself, means that your tax situation or financial situation might be a little more complicated.
Are There Tax Advantages for Independent Contractors vs. Sole Proprietors?
So, most self-employed individuals could call themselves either independent contractors or sole proprietors. But there is an advantage to either? Many assume that there are tax advantages for independent contractors or sole proprietors, but it’s essentially the same situation.
Both independent contractors and sole proprietors will often receive a 1099 form. 1099 forms describe income to those who are not traditionally employed. The 1099 form will be used to report the income the self-employed individual needs to declare, though ideally, they should be tracking this on their side as well.
Sole proprietors and independent contractors will both report their 1099s on a Schedule C which is filed with the regular 1040 tax return. The Schedule C form is just an additional form included with a regular 1040 that describes self-employment income.
For those who have declared businesses (such as LLCs or CORPs), and who have legally created businesses, the business income and expenses will be declared separately. But for those who are self-employed and who haven’t created a separate business entity, everything is filed under the individual themselves and their 1040.
This is true for both independent contractors and sole proprietors.
Thus, there aren’t any differences between the tax advantages for independent contractors or sole proprietors. But there are advantages to declaring Schedule C:
- It’s simpler and easier. Because everything is just an additional schedule on a regular 1040, most people find the entire process faster.
- It doesn’t require that a separate business entity be created. This can be needlessly complicated for those who are operating a smaller business.
- It makes it easier for you to take losses. With a Schedule C, your profit and loss flows directly into your tax returns, rather than being held with your company.
This also depends on the type of business you have. In some areas, it’s better to incorporate your business and not let your profit/loss flow through to your personal tax return. In others, it’s better to have the option of taking those losses.
Being self-employed can cause some complications, especially when doing things like purchasing a home, opening a new business, or even buying a car. Understanding your rights as a self-employed individual, how you should file your taxes, and how you should track your income can mitigate these challenges.
What is a Self-Employed Individual?
We’ve mentioned that an independent contractor and a sole proprietor are both self-employed individuals. In fact. an independent contractor or sole proprietor is really just another way of saying self-employed. It’s important to understand what “self-employed” means, both legally and financially.
A self-employed person is someone who is paid by others for their services or products but does not have an established, consistent relationship with the person paying them. The major difference with a self-employed individual is that they need to pay their own taxes. When an employee receives money, they usually already have the taxes taken out of their check. Self-employed individuals have to track this themselves.
There’s actually a gray area between a self-employed individual and an employee. It’s an important legal distinction. Employees get certain benefits that self-employed individuals do not, such as unemployment insurance. The differences between an employee and an independent contractor include:
- An employee works directly for a business and performs critical functions for that business.
- The business that hires the employee controls the way that the employee works.
- The employee works at the company’s location and with the company’s equipment.
- The company controls the employee’s schedule and how much the employee charges.
It can be argued, for example, that an Uber or Lyft driver is an employee — and it can also be argued they are an independent contractor. Some states believe that gig drivers are employees while others don’t. Because it is a gray area, there can be times when people are misclassified. If you believe you have been misclassified as an independent contractor when you’re really an employee, you could have taxes owed to you by the company you work for.
There are advantages to being an independent contractor rather than an employee. Independent contractors are paid upfront and have full control over their income, expenses, and taxes. There can be advantages to being an independent contractor rather than an employee, such as being able to qualify for a SEP-IRA (an independent retirement account). So, some may choose to operate as an independent contractor rather than an employee.
Examples of incorrectly classified independent contractors include:
- Janitors who work directly at a business, using the company’s supplies, and cleaning at a scheduled time.
- Cable or network installers who are specifically forbidden from getting hired at other businesses while working as an independent contractor.
- Truck drivers who are using company equipment and who are told how to complete their routes and how many routes to take.
To start an investigation, an individual can contact the Department of Labor. The penalty of misclassifying an employee can be a fine of up to $1,000 and a year in prison.
Should an Independent Contractor Form an LLC?
Anyone who is self-employed also has the option of forming an LLC, or Limited Liability Company.
The major advantage of forming an LLC is the liability reduction. An LLC can be held responsible for the debts and responsibilities of the business, rather than the company owner. So, if the company ends up in debt, the company owner may not be responsible. (This isn’t strictly true, though; there are always exceptions that need to be discussed by both legal professionals and accounting professionals.) Without an LLC, there is no difference between the individual and the business.
Advantages of an LLC include:
- An LLC limits personal liability. But there are restrictions. If you “pierce the veil” by comingling your business expenses and your personal expenses, it’s more likely that your personal liability will still factor in. Likewise, if you personally guarantee any debts, they will be your debts as well.
- LLCs can be taxed as either a sole proprietorship or a corporation. That means that you get to choose when you create your LLC whether you’re taxed personally on the income/expenses or whether the business itself is taxed on the income/expenses.
- An LLC can distribute profits when desired. This further has a tax benefit, as you can control when you might need to pay income taxes on the debts, and you can control your own finances.
But because the differences between a Schedule C proprietorship and an LLC can be complex, it’s important to consult with a tax professional before making any decisions. The consequences of forming an LLC (or not forming it) could be significant, in terms of the taxes that you pay.
And, of course, forming an LLC means that an individual is not (and cannot) be classed as an employee. The LLC will need to pay its own taxes, whether those taxes flow through to the individual who owns it, or whether it comes directly from the business itself.
Functionally, an independent contractor and sole proprietor are both the same thing, there are simply implications and connotations that come with each. Both independent contractors and sole proprietors are classifications of “self-employed” individuals. A sole proprietor is more likely to be a business owner, who sells products and services. An independent contractor is more likely to be an individual who provides products and services to other businesses. Either way, they are going to file as a Schedule C sole proprietor, with their self-employment income.
There are some tax consequences for those who are self-employed, though it doesn’t strictly matter whether they are an independent contractor or a sole proprietor. For those who are interested in saving taxes, it may be in their best interest to declare an LLC. An LLC makes it possible for a sole proprietor to better control the way they are taxes, as well as limiting their liabilities. But it’s also more complicated to do than simply relying upon a Schedule C sole proprietorship.
Everyone’s personal tax and financial situations are unique. If you have questions about whether you’re a sole proprietor, independent contractor, or self-employed, you should consult with a professional. Consulting with a professional will help you determine the right choices for you — and how you can best save on your taxes.