In accordance with the Internal Revenue Service (IRS), sole proprietors and independent contractors fall under the “self-employed” category. In addition to annually filing your tax return, as a self-employed individual, you are also required to pay your estimated tax on a quarterly basis.
Self-employed individuals, such as sole proprietors and independent contractors have not created formal business entities like that of a Limited Liability Company (LLC) or corporation.
As with any business entity, when you go down the sole proprietor or individual contractor route, there are legal and tax elements that need to be considered. For example, sole proprietors and independent contractors will fill their taxes using Schedule C (Form 1040)A and will have to pay self-employment (SE) taxes in addition to income tax.
While neither a sole proprietor nor an independent contractor will receive a set salary for their work, the distinguishing factor between the two popular forms of self-employment is how the money is earned.
With that said, let’s dive deeper into the distinctions between a sole proprietorship vs. independent contractor and self-employed vs. independent contractor entities.
What is the Definition of “Self-Employed” in the U.S.?
In alignment with the IRS’ definition, you are self-employed if one of the following applies:
- You carry on a trade or business as a sole proprietor or an independent contractor
- You are a member of a partnership that carries on a trade or business
- You are otherwise in business for yourself (including a part-time business or a gig worker)
Self-employed professionals don’t earn a consistent salary or wage from a specific employer; instead, they earn a living through their independent pursuits of work.
Self-employed individuals are typically skilled in a particular area of work and contract out their products or services through a wide and varied assortment of trades, professions, and occupations. It is worth noting that a self-employed person can hold a variety of self-employed occupations.
Self-employed individuals who are not independent contractors or freelancers have a variety of business structures to choose from, of which one of the common structures is a sole proprietor.
While being self-employed may run a greater risk of employment and volatile income. However, it continues to be a popular form of employment because of the vast amount of autonomy, flexibility, and freedom being an employee lacks.
Advantages of Self-Employment
The many advantages of self-employment include:
- Having the ability to setup your own schedule
- Set and manage your own workspace
- Flexible working hours
- Flexible lifestyle
- No approval process is needed for vacation
- Creative freedom
- Claiming business expenses
- Higher earning potential
- Create a work-life balance
- Job satisfaction
- Choose the professionals you want to work with
Disadvantages of Self-Employment
While there are multiple benefits of being self-employed, it's beneficial to also consider the disadvantages associated with self-employment.
Some of these disadvantages include:
- Fewer employment benefits (i.e pension contributions, paid annual leave or health insurance)
- Financial uncertainty or erratic pay schedules
- Client retention may prove difficult
- Multitasking
- Experience is essential in order to find adequate project opportunities
- Towing the line between work and personal life
- No structure (i.e no definitive end and start day)
- Self-employment taxes
- Acquiring business insurance, along with other necessities, such as establishing an accounting process and ensuring compliance with all applicable rules and regulations
As you can see, there are upsides and downsides to self-employment. We’ll now explore the sole proprietorship vs. independent contractor deliberation in more detail.
Who is Considered a Sole Proprietor?
In the United States, sole proprietor owns and operates a business by themselves. In terms of business structure, sole proprietorships operate as an unincorporated business structure that, while operated by a single individual, can have employees as needed.
There is no legal requirement to acquire a business license or register a business name in order to be fully operational. Sole proprietors are personally liable for their business expenses, losses, debts, legal obligations and taxes.
Sole Proprietor Taxation
Self-employment tax, which is inclusive of social security and medicare taxes, is the responsibility of the sole proprietor. Combined with income taxes, the amount to be paid is calculated based on net income or the total income after the cost of goods, expenses, appreciation or depreciation.
Mandatory Sole Proprietorship Guidelines
As a general guideline, it is mandatory for sole proprietors to:
- Determine their taxable income (subtract expenses from total income)
- Deduct business expenses from their business income, which has the dual effect of lowering their overall tax liability
- File a personal tax return using Form 1040
- Report their business income using Schedule C
- Pay self-employment business taxes on their business outcome
Self Employment Taxes: Common Taxation Forms for a Sole Proprietor
While the fundamental tax forms required will vary based on the nature of the work being carried out, common forms include:
- Form 1040-ES: Estimated Tax for Individuals
- Schedule C: Profit or Loss From Business (Sole Proprietorship)
- Schedule SE: Self-Employment Tax
The IRS has a comprehensive list of sole proprietor forms you can review.
Does An Individual Sole Proprietor Get A 1099?
The 1099 form, also known as the Information Return form, is sent to you at the end of the tax year by an entity or person that provided you with an income.
Receiving this form does not ultimately mean you owe tax on the income received; however, it is essential to report it to the IRS when you file your tax return.
Please note, that there isn’t one single 1099 form that encompasses all your tax requirements. Based on the type of income being earned, there are specific forms that need to be completed.
For example, if you are an individual sole proprietor, it’s unlikely that you will be asked to fill out a 1099 form unless you have completed work for an independent contractor. In this case, you could receive a form from the client for whom you completed the contracted work.
In the event that sole proprietors are responsible for tracking their own income, it’s not out of the ordinary for independent contractors to provide services to clients and track their income on a 1099 form. Sole proprietors are responsible for tracking their own income.
Who is Considered an Independent Contractor?
In the United States, an Independent contractor is a self-employed individual who carries out work that is not controlled by an employer.
Even if you are given free rein or freedom of action over the tasks you fulfill, and your employer has the legal right to control the details of how the services are performed, then you are not considered an independent contractor.
Similarly, as per the definition of an independent contractor by the IRS, if an employer-employee relationship exists in any capacity, you will not be considered an independent contractor, and earnings will typically not be subject to self-employment tax.
Independent contractors are businesses or individuals that are contracted and paid to execute specific jobs. Examples of independent contractors can include, but are not limited to; doctors, dentists, accountants, lawyers, actors, journalists, and freelance workers.
Note that as an independent contractor, you are limitless in terms of the fields and industries you can operate in and do not need specialized skills.
Due to the fact independent contractors are not considered employees, clients do not withhold taxes from what they pay. Neither the workers' compensation nor the benefits enjoyed by employees are applicable to an independent contractor, and equal opportunity laws also do not apply.
Independent Contractor Taxation
Typically referred to as 1099 employees, independent contractors are often seen working in creative and technical fields, in which they are required to stay compliant and keep record of the tax forms they receive at the end of the year.
For example, if you have earned a minimum of $600 from one of your clients or companies you contract with, you will receive a 1099-MISC form. The form will outline the total income they have paid you for the tax year.
Remember, a separate form will be received from each client or company that you work with if the minimum amount of income is generated. You will have until January 31st of the following year to file the form(s).
Although submitting taxes, as an independent contractor, is arguably more complex than that of a sole proprietor, it is mandatory for independent contractors to submit a self-employment tax form,(Social Security and Medicare tax Form 1040-ES).
For independent contractors residing in the U.S., Form W-9 must be requested from the IRS, and for those outside of the U.S., Form W-8BEN or W-8BEN-E will be required.
Common Taxation Forms for an Independent Contractor
Having the correct independent contractor tax forms is a crucial part of being a 1099 employee. It’s equally important for the clients and/or companies that work with them to accurately track and report payments. Here is a list of the common tax forms used by independent contractors:
- Form 1099-MISC: Miscellaneous Income
- Form 1099-NEC: Non-employee Compensation
- Form W-9: Request for Taxpayer Identification Number and Certification
- Form 1099-K: Payment Card and Third-Party Network Transactions
For companies that are unsure of how to classify their worker, Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) is what you can request from the IRS.
Although the SS-8 form is not mandatory, the line that allows you to distill the sole proprietors vs. independent contractor or self-employed vs. independent contractor definition is not always clear. Therefore, it is always best to seek assistance from the IRS or an appropriate tax or legal expert to avoid misclassification of your worker because misclassifying a worker carries a range of penalties that range in severity.
The IRS has a handy comprehensive list of independent contractor forms for you to check in their Self-Employed Individuals Tax Centre.
Do Independent Contractors Need an LLC?
While you are not required to form a business entity like an LLC, if you are an independent contractor, many consider it for the benefits it has.
Explore the difference between a sole proprietor and a single-member LLC when it comes to independent contractors.
LLCs offer an added layer of asset protection that being an independent contract does not, and they are generally simple and relatively inexpensive to form.
While many LLCs start out as sole proprietorships, they evolve in this small type of business because of the asset protection, tax flexibility, tax savings, and even the professional image due to the heightened credibility it brings.
As with everything, there are cons to this type of business structure as well. The disadvantages include time and financial investment, such as minimum annual taxes and annual maintenance.
Self-Employed vs. Independent Contractor
There’s a thin and often blurry line in knowing the difference between being self-employed and being an independent contractor. Independent contractors are indeed self-employed, yet all self-employed individuals are not independent contractors –this is a fundamental difference.
An independent contractor provides work or services on a contractual basis, whereas self-employment pertains to earning money in the absence of any form of employer-employee relationship.
The nuance is admittedly small; however, it plays a key role in how taxation works because self-employed people can run their business entities in several ways, including partnerships or LLCs. As we have briefly discussed, these types of entities carry their own IRS tax forms to complete. On the other hand, independent contractors primarily take on work on a contractual basis.
Note that, inclusive of independent contractors, if you are self-employed, insurance is a must. There are differing types of insurance based on the nature of business, but regardless, it is an investment that should not be overlooked.
Are You Ready To Speak With Borderless?
Whether you are a business leader or employer looking to engage independent workers and want to learn more about the legalities of doing so, or a skilled worker looking to differentiate between a sole proprietorship vs. an independent contractor in the U.S., the team at Borderless is here to help.
Navigating the subtleties between the definitions and taxation for sole proprietors and independent contractors can be challenging and we are here and happy to help alleviate the burden, so that you can focus your energy where you need to.
At Borderless, we provide you with an all-in-one platform that takes care of all your global payroll needs and ensures you are compliant with the employment laws of the countries you are operating in.
