If you’re an independent contractor, you may not be aware of your options when it comes to taxation.
When an independent contractor hires professional help for their taxes, they’re often surprised to hear that they’re also classified – and taxed – as sole proprietors. How can I be a small business owner by accident? Aren’t I a contractor?
Well, chances are you’re both.
What’s an independent contractor?
An independent contractor is a self-employed person who performs work for another entity (person or business) as a non-employee. Specifically, an independent contractor receives compensation through anything other than W-2 wages. Instead, they’re paid a fee established through a contract.
A wide range of occupations can fall under the independent contractor umbrella, from Uber drivers to freelance graphic designers to high-priced business consultants.
The IRS maintains three standards to evaluate if someone can be legally classified as an independent contractor.
- Behavioral: Are you in charge of your own workflow, hours, dress, etc?
- Type of relationship: Are you getting benefits? Is your work crucial to the normal operations of the business? Is there a specific time frame for your working relationship?
- Financial: Do you cover your own work expenses? Can you pursue other work?
It can be a fine line, so if you think you’ve been misclassified, the IRS can clarify (although it can take a while). But whether or not you should be classified as an independent contractor, the “anything but a W-2” standard is the easiest way to establish if you’re currently an independent contractor.
What’s a sole proprietor?
Sole proprietors are also self-employed, but in a different context. Sole proprietors are the owners of sole proprietorships: businesses run by one person, without a legal distinction between the owner and the business. Specifically, sole proprietorship affects how your business income is taxed: on your individual income tax return, using a form known as a Schedule C.
It's also possible for other types of business, such as a Single Member LLC, to choose to be treated as a sole proprietorship for tax purposes.
Sole proprietorships are the most common form of independent enterprise in America, with over 27 million operating in 2019 according to IRS statistics. And it’s easy to see why. Most of the time, there’s no need to formally register your business, so many people own sole proprietorships without ever knowing.
How am I taxed as an independent contractor?
Independent contractors can choose to be taxed in a number of different ways.
Most likely, you’ll be receiving your payment directly as an individual, and reporting anything you earn as an independent contractor as part of your individual tax return using Schedule C.
Some independent contractors form an LLC – more on that later – which allows them to choose between continuing to file taxes as a sole proprietor (with Schedule C), converting to a partnership, or electing instead to be taxed as an S corp.
Could I be both at the same time?
Technically, all independent contractors are small business owners. And since the default business structure is a sole proprietorship, most independent contractors are also sole proprietors. There’s no need to register, no form to fill out. Just start doing contract work and you’re a business owner.
In fact, you need to fill out forms to not be a sole proprietor. Independent contractors can form an LLC, and that’s often the first step when an independent contractor wants to turn their side hustle or freelance gig into a full-fledged business.
But if you’ve never registered as another type of business or spoken to an accountant, you are probably both an independent contractor and a sole proprietor. Congratulations on your small business!
Should I consider an LLC?
| 📝 Note: We are tax and accounting experts, but we are not lawyers. We’re just talking about business structure, not giving anyone legal advice. |
Most independent contractors operate as sole proprietors, with no legal division between themselves and their business, but that’s a risky proposition. Without creating a separate business entity, you’re leaving yourself vulnerable to potential complications.
The simplest way to solve this is to form an LLC. This one move creates a business entity that can redirect lawsuits, debt collection, and other threats away from your personal assets. That’s the “LL” in the name: limited liability. It’s not bulletproof, but it’s a lot safer than the unlimited personal liability that comes with sole proprietorship.
In addition to the legal protection, forming an LLC offers more tax flexibility than continuing on as a sole proprietor. You can either file your taxes as an individual with Schedule C or start filing a separate business return instead. This can save you quite a bit of money, depending on the circumstances, and your accountant can help you figure out which tax election is best for you.
An LLC comes with a little extra complication, and some up-front costs for registration and other fees, but for most independent contractors it’s more than worth it.
Bottom line
So, what’s the difference between an independent contractor and a sole proprietor? These two terms both describe an aspect of self-employment: “independent contractor” describes how you’re paid, and “sole proprietor” describes how you’re taxed.
Though it’s not the only option, an overwhelming majority of independent contractors are also sole proprietors whether they know it or not. It’s the default option for self-employment, and if you use a Schedule C form when you’re paying taxes, you’re a sole proprietor.
But you really should consider creating an LLC. It’s the simplest way to legally protect yourself from the everyday hazards of self-employment, and it leaves you with more options on the table when tax season rolls around.
If forming an LLC sounds too complicated, why not give us a call? We’re experts at structuring small businesses, and we can help you improve your legal protection and tax flexibility so you can focus on the work that really matters to you.
