Independent Contractor Vs. Sole ProprietorDifferences You Need to Know Between the Two!
Both the terms independent contractor and sole proprietor refer to self-employed individuals and, as a result, are frequently confused.
However, though both business structures allow an individual to operate independently without a formal business structure, they have very different meanings in practice.
The most significant difference is how these two informal structures earn income.
Here is a closer look at the differences between these structures.
What Are Sole Proprietorships?
A sole proprietor is a person who owns and runs their business by themselves.
Sole proprietorships are unincorporated business structures that are not registered as business entities with the state or IRS.
Anyone that meets these criteria and earns income from a business is a sole proprietor.
An individual that operates a sole proprietorship is directly liable for their business’s debts and legal obligations.
A sole proprietor must pay taxes for income earned through their business on their personal tax return annually, though they may use Schedule C to report their business’s income and claim deductions for business expenses.
A sole proprietor must pay self-employment taxes which are much higher than those paid as an employee because they essentially include the payments that would ordinarily be made by an employer.
Sole proprietors must track all of their own expenses and make estimated tax payments throughout the year, which include payments for Social Security and Medicare taxes.
Unlike an independent contractor, a sole proprietor does not receive a consistent wage or salary from an employer.
Instead, a sole proprietor provides goods or services to several clients.
In a number of cases, an independent contractor or employee may work as a sole proprietor on the side in order to earn additional income.
This essentially occurs any time that an individual earns money from business activities separately from their personal income.
What Is an Independent Contractor?
Independent contractors are self-employed individuals that provide services to clients or companies on a contractual basis but are not employees.
Independent contractors receive payment by the project or by the hour for the work they provide, depending on the contractual terms.
Unlike regular employees, companies do not need to withhold payroll taxes unless the individual is subject to backup withholding.
As of the 2020 tax year, independent contractors that are paid $600 or more from a specific client will receive a 1099-NEC form from the client.
These must be sent by January 31st in order to give an independent contractor the time to file their taxes.
Before the 2020 tax year, independent contractors received 1099-MISC, and due to the ubiquity of this form, independent contractors are often referred to as 1099 workers.
Like sole proprietors, independent contractors pay self-employment taxes and will make estimated tax payments throughout the year, including Medicare and Social Security taxes.
However, typically an independent contractor will receive a 1099 form from their client, making it easier to track and report income accurately.
Many individuals that primarily work as independent contractors may perform some work as sole proprietors, and both forms of income will be reported on their personal tax returns.
Choosing Between Being a Sole Proprietor or an Independent Contractor
There is no need to directly choose between a designation as an independent contractor or a sole proprietorship.
Many self-employed individuals do work in both.
For example, an individual could work as an independent contractor for a business regularly providing services and work as a sole proprietor on the side providing similar services to a wide range of clients.
Both sources of income would require filing Schedule C with the IRS to report business income, and self-employment taxes would be paid on both sources of income.
For both sources of business income, an individual would typically need to make estimated tax payments throughout the year if they would owe $1,000 or more in taxes, including Medicare and Social Security taxes.
When Is It Time to Create a Formal Business Entity?
As your business grows and earns more income, it grows increasingly important to form a separate business entity.
There are several signs that indicate your business may have moved past informal business structures and could benefit from becoming a formal business entity such as a limited liability company.
- You need greater separation. As a business takes on more responsibility and financial complexity, a greater degree of separation can become necessary. This can simplify personal and business finances, potentially offer greater protection from personal liability, and offer your business the ability to build credit on its own. This can help reduce your business’s reliance on your own credit score and allow it to receive loans and lines of credit on its own.
- You want to protect your own assets. Conducting business under an informal business entity such as a sole proprietorship or independent contractor does not separate business assets from the owners. Though business insurance offers some protection, establishing a corporation or limited liability company can offer far greater protection from personal liability for your business’s debts.
- Your business requires additional funds. Informal business entities often struggle to raise funding from banks or other conventional sources. Creating a formal business entity can help establish greater credibility and offer far more access to business financing.
- Both sole proprietors and independent contractors are business structures that allow individuals to work independently.
- A sole proprietor is an individual that owns and operates their unincorporated business by themself.
- An independent contractor is a self-employed individual that provides services to other individuals or businesses and receives payment from them for their work.
- An individual can perform work both as a sole proprietor and an independent contractor, depending on the work they perform.
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