Even though the terms “independent contractor” and “sole proprietor” are used in almost the same context of related small business, they have critical differences in their meanings. Before making a decision which one you will be called, you need to know that their crucial points are their taxation liabilities and relations with the clients. At the end of this article, you may have a crystal clear mind because independent contractor and sole proprietorship relations and their differences in many aspects will be discussed.
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What is a Sole Proprietorship?
As the IRS identified, the meaning of sole proprietor is: someone who owns an unincorporated business by himself or herself. In other words, sole proprietors are going into a business without registering their business as a special entity like a corporation, limited liability company or a partnership. Also a sole proprietor is run and owned by one person who will be charged with business and financial duties together.
A sole proprietor will be liable for the outcomes and they take all the profits for themselves. If you are a sole proprietor, you will also be considered as a sole proprietor for income tax purposes and you will be responsible for any business debts and legal obligations.
A sole proprietor is considered as self-employed because they themselves will operate their business. Besides the fact that they do not have to work for an employer who pays a consistent wage, they can rather earn their own income by contracting with and providing services to the clients. Also, a sole proprietor needs to pay own self-employment taxes which consist of Social Security and Medicare taxes. Moreover, when you become a sole proprietor, you should count your business income and expenses separately from personal income and expenses. The important recommendation for you is to keep personal finances tidy and use a different business bank account.
This type of business is the cheapest and mostly non-problematic way to start a business entity.
Besides that, how can a person decide that this business type is appropriate for them or not? The details will be given below after a brief explanation.
A sole proprietorship is not a legal entity on its own; it is tied to the owner in many aspects. It leads to an understanding that there is no legal separation between a sole proprietor and this type of business.
It can be operated under the owner’s name but the owner can also choose a fictitious name which has to be unique.
There are many advantages to setting up a sole proprietorship: it is the cheapest business structure form; it is easy to set up; its expenses can be deductible for business activities; having full business ownership and there is a simple tax preparation.
Benefits of Hiring A Sole Proprietor
The most important things to consider when hiring a sole proprietor are as followings;
- The sole proprietor and the company will be the same legal entity
- The sole proprietors are much lower in set-up costs, taxes and simplicity in terms of maintenance and all of the profits will pass through to the owner
- The biggest threats are personal liabilities and difficulties in acquiring the capital with this type of business
- Personal and business funds should be separated
- All of the business income will account as a personal income and is taxed just like tax returns for business expenses
Guideline For Setting Up A Sole Proprietorship
If you have decided to be a sole proprietor, you need to follow the next instructions:
- You need to go the nearest Small Business Development Center and learn what your particular state requires
- Take with and register a name that you have decided on
- Create a business bank account and a credit card separate from your personal funds
- Get a business license together with all permits
- If you sell taxable products or services, register with the local taxing authority
- If you will hire an employee, file for an EIN
- You should create a domain name and reserve/buy it
- Then lastly, you should obtain business insurance
What is an independent contractor (IC)?
IRS explained that an independent contractor is also a self-employed person servicing clients or working for another entity but not as an employee. The synonymous term for an independent contractor is a freelancer. If you are an independent contractor, you will get paid according to your contract. In general, these contracts are short term and/or a task or project.
An independent contractor agreement is a binding contract for both parties as a legal manner between an independent contractor and the client. The agreement needs to be sensible but without taking into account the duration time or project size.
When you compare with an independent contractor and an employee, the ICs have much more control over their work. Moreover, if there is no specified restriction, an IC can work for more than one employer, meaning, working for different employers can be possible.
This independence brings some liabilities, such as if you are an independent contractor, you will be managing your business and you will have to withhold your own payroll taxes. In reality, you will be responsible for full income taxes and self-employment taxes. Nonetheless, the IRS gives a permission for basic tax deductions for freelancers and independent contractors. The deductions may include things like home office expenses, work equipment costs, classes, courses and other educational material needed to provide a service.
Even if the IRS has a list for ICs, with the developmental world, the list is broadening day by day. Many other professionals can be included to the list as independent contractors.
In order to differentiate ICs from an employee, the key point will be the degree of control over the work. The controls can be listed as follows:
- Behavioral control
- Financial control
- Type of relationship
Independent contractors, as mentioned before, have to pay self-employment tax. It covers the Social security and Medicare contributions. If you are an independent contractor, you can obtain a deduction for half of your self-employment tax when you file for the tax return. Another tax for you will be the income tax. In the States, the tax system is progressive which means you will pay more if you are earning more. The federal income tax rates range between 10% to 37%.
If your clients paid more than $600 for the contractor’s services, Form 1099-NEC should be included with Forms W-9 and W-8 BEN. Form 1099-NEC is standard for reporting compensations for non-employees.
Even if the full-time employee’s income, social security and medicare taxes are automatically deducted from their wages, you need to deduct those from generated income as an independent contractor.
Benefits of Hiring an Independent Contractor
The client company needs to be careful about hiring contractors and ensuring compliance with local regulations. Otherwise, the remarkable benefits to working with an independent contractor are the following:
- Staffing flexibility
- Global talent pool
- Minimal training required
- Cost savings
How to Become an Independent Contractor?
There are three essential requirements that you need to do to become an independent contractor:
- Selecting and registering a business name
- Getting a business checking account
- Setting up a simple business record-keeping system
When choosing a name for your business, you should first check that no one else is using that name already. If your business name is different from your company’s name, you need to file for a fictitious name statement.
After choosing a name for your business, you can get a business location and start to create marketing items such as a website, business cards and advertising brochures, if it is necessary.
According to the IRS, your business and you are different entities, when you obtain a business checking account. You can keep your money as your own investment but to start paying yourself you need to get started in your business. The most efficient way not to be confused about income is to use a business account instead of a personal account.
You should track your daily business in order not to confuse or forget deductions. The tracking of business income and expenses will help you with that. Also, you can create a budget to see what you will need to spend to get started. Additionally, you can prepare and review your business for the financial statements.
Differences Between An Independent Contractor and A Sole Proprietor
It is mentioned that the crucial difference between an independent contractor and a sole proprietor is taxes. If you are an independent contractor, here is the guideline:
- According to the IRS, the client has to fill out the Form 1099-NEC and give it back to you by January 31st of the following year
- Also, you need to pay your self-employment taxes on a Form 1040-ES
- If you are in the US, your client needs to request Form W-9, and if you are based outside the States, Form W-8BEN or W-9BEN-E should be requested
Form 1099-NEC is used to report the direct sales of consumer products worth $5.000 or more aimed for resale.
The sole proprietors (SPs) are required to have the following:
- Schedule SE with Form 1040 for calculating the amount of self-employment taxes
- Schedule C Form for reporting the business loss or profit
- Form 1040 for annual income tax returns
Along with all this information, to determine which one is appropriate for you, you need to know that if your work is fully or partially based on someone who is earning from you, this type of business is for an independent contractor. However, if all your earnings, profits etc. are based on you and you do not share your salary with anyone like a business or company, you become a sole proprietor.
If you are confused about the process and if you can’t decide which one you are, you can think about whether both of them are applied or not. Let’s make it clear.
In the practice of business and real life, you can be both an independent contractor and a sole proprietor, at the same time. This type can be called a “hybrid”. The thing is you should be careful about the taxes. You will have to pay income taxes and payroll taxes.
Independent contractors and sole proprietors are quite similar:
- They are both self-employed business owners
- Both need to pay income and self-employment taxes, nonetheless they are different with regards to the forms depending on the work they perform
As a sole proprietor, you do not have to make a registration for a legal business entity. In addition to that you do not have to get a business licence or register a name of business with your local government agency if you do not provide services or goods that have to be licenced.
Regardless, some sole proprietors will choose to undertake these processes to protect their businesses in order not to have their business name taken from them.
As an independent contractor, you can set up a business under your own name. It should be helpful towards feeling more professional, it can also be used for business communications, on invoices and any kind of documents that you need. If you choose to make your name a business, it will be referred to as your assumed name or a “trading as”. Independent contractors can add one or two words after legal names.
The business licence is necessary for independent contractors but every county and state has their own regulations for it. Some countries or states require you to have a business licence even if you are working from home.
*This document should not be assumed as legal advice. This information may change, so please make contact with our team of attorneys to confirm.