Do you dream of working on your own, being your own boss? Some 23 million Americans have taken the leap into work as sole proprietors.
What does it mean to be a sole proprietor? How is that different than working as an independent contractor?
If you aspire to be your own boss, work on your own, or even start your own business, it’s important to understand the nuances between a sole proprietor and an independent contractor.
Read on for everything you need to know about work as an independent contractor and a sole proprietor and how they are different.
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Working as an Independent Contractor
An independent contractor is a worker or business that provides services for another business and is paid for their services. The independent contractor could be set up in various business models, including being a sole proprietorship.
The independent contractor is contracted through an agreement with a business to do work and is paid for their services based on the contract or agreement they set up for the work completed.
While working as an independent contractor, you provide services for another business, you are not considered an employee of the business. Often you might hear the worker referred to as a 1099 worker. This is because the business paying you for your work will provide you with a 1099 tax form, but they don’t pay taxes for you. More on taxes for independent contractors later.
Working as a Sole Proprietor
Ever heard a business owner claim they are a one-person show? They might just be operating as a sole proprietorship.
A sole proprietor is a worker who works alone but is not registered with their state as a business entity. This can have some legal ramifications. Anything the business is responsible for, like debt or possible damages the individual would be responsible for. There are a variety of business structures to avoid this scenario, more on this later too.
If you work as a sole proprietor, keep track of income and expenses separately from your personal affairs, you still pay your taxes as a sole proprietor if you don’t register your business in your state.
Independent Contractor vs. Sole Proprietor
Can you be both an independent contractor and a sole proprietor? The answer is yes. In both models, you do a few things, including:
- Keep business expenses separate from personal expenses
- Pay taxes on the income that comes from the business
- File taxes with the IRS using the Schedule C form
- Working on their own instead of as an employee
The key difference between the two is how the income the worker gets is reported. The sole proprietor will need to report their own income to the IRS, while the independent contractor will get the 1099-MISC from the business they contract with.
How Can You Become an Independent Contractor?
Here’s the great news about becoming an independent contractor. You might already be doing it. The key is to get yourself working. Once you’re working with a business, you establish an agreement about your services or work. There’s the contract part.
Remember, the key component in being an independent contractor is that you’re not an employee of the business but instead under a contractual agreement. The business will provide you with the 1099-MISC form at the end of the year.
Benefits
If working for yourself sounds like a dream come true, you might truly appreciate the life of an independent contractor. There are some real benefits to consider.
You have the autonomy to run your business the way you see fit. There isn’t a boss giving you directions or making decisions on your behalf. You get to have the independence that many independent contractors love.
You also get the profits from the business. There’s an incentive to work hard, knowing what you make is yours to keep. The other part of the profits is that you get to decide how to use them. Do you want to take them all as income for yourself? Do you want to use profits to reinvest back into the business?
Being an independent contractor also allows you to take some deductions at tax time. More on this later.
Drawbacks
There are few things to consider as potential negatives when you become an independent contractor. Just like you get all of the profits, you must also be accountable for the losses too. If you don’t feel like working on a particular day, there is no income. Taking a week of vacation when you want sounds great, except remember there isn’t any income coming in then either.
As an independent contractor, you don’t get the benefits provided by many companies. This might include healthcare coverage, retirement plans, or other insurance protections like disability insurance, for example.
Taxes, called self-employment tax, are your responsibility. You need to pay your Social Security and Medicare taxes yourself instead of the employer doing it for you.
Acting as an Independent Contractor, Things to Do
Still, think working as an independent contractor sounds right for you? There are some things you should do to establish yourself as an independent contractor.
Remember, you can start working and making money in your field. You don’t technically have to register yourself right away. You would just be considered a sole proprietorship. But if you want to become an independent contractor, here are some of the things you should do to set yourself up correctly for personal business success.
Business License
One of the first things you should do is do some research into the type of work you do. Will you need some type of license to do the work in your state?
For example, in most states, to work as a cosmetologist on your own, you would need to have a registered license with your state. However, you might work as a bookkeeper and not need a license.
You want to know if your trade requires a special license and make sure you have it registered with your state.
You also want to consider how you will protect yourself as a business. You want to avoid personal liability and get the business insurance you need to protect yourself and your assets.
Register Name
How can you grow your business without people knowing about you? Before you jump gung-ho into your branding, though, take some time to research your business name.
Are there any other companies using the name you hope to use? How closely does your name compare to potential competitors in your field? Does the name help to identify your services?
Once you have done your homework on your potential business name, you should consider registering the name with your state. If you expect growth and want to protect the business name for branding purposes, you might also consider getting the trademark rights to your name too.
Taxes
Taxes are an inevitable responsibility. It’s best to make a plan right from the start on how to keep track of what you need to pay and develop a system to make sure your taxes get paid.
You will want to apply to the IRS for an Employer ID Number or EIN. This is how the IRS will identify you as a business and what you pay to them in taxes.
Don’t forget you will have other taxes like state taxes, self-employment taxes, possible taxes for employees, and any property taxes if you have a brick-and-mortar location.
Deductions
Taxes are the sort of bad news. The good news is that when you become an independent contractor, you also acquire many potential deductions you can use when you file your taxes.
Establishing a system to keep track of these deductions will be important. You want to be able to be accountable to the IRS for the deductions.
One deduction is actually the self-employment tax you pay. You can actually deduct up to 50% of that tax when you file your taxes. The IRS considers this a business expense when you are an independent contractor.
You can also deduct healthcare costs as an independent contractor. Also, keep track of out-of-pocket costs and prescription drug costs as those are also deductible.
Do you have a vehicle you use for your business? If you use it only for business, then you can deduct its cost entirely. If you sometimes also use it for personal use, you can deduct a portion of its costs.
If you run your business from your home and have a designated home office where you primarily work, you can also deduct a portion of your home expenses for the home office space. This might include things like a portion of your mortgage, homeowners insurance, and even utilities.
Business Banking
As an independent contractor, it’s smart to set up separate banking accounts from your personal accounts. This establishes that you keep business finances separate from personal expenses. In the eyes of the IRS, it also shows your business is actually a business and not just a hobby.
Record Keeping
This is an area where many independent contractors get fouled up. They get busy doing the work and trying to handle all aspects of their business.
Careful record keeping matters to establish yourself as a business entity. You will want the records if you ever seek a small business loan or when it’s time to file your taxes.
Take the time to create a record-keeping system that will help you keep track of your profits and business expenses.
Forming a Sole Proprietorship
What do you need to do to form a sole proprietorship? This is much less complicated, and you simply need to start working and collecting money for the services you provide. As a sole proprietorship, you will not be registered as a business entity with your state. This makes you personally responsible for any liability connected to your work.
The other factor that needs to happen for the IRS to consider you a sole proprietorship is that you need to show a profit. Many sole proprietors start their work after doing something as a hobby. To be considered an actual sole proprietorship in the IRS eyes, you need to show you have made a profit from the work you do.
Taxes Under Sole Proprietorship
As a sole proprietorship for tax purposes, you and your business are the same. When you file your personal taxes, you are also filing as a sole proprietor. Any of the income you make as a sole prop is considered personal income and is filed with the IRS accordingly using Schedule C (Form 1040 or 1040-SR).
Acting as a Sole Proprietor, Things to Do
Like acting as an independent contractor, there are a few things you need or should do. First, remember, you need to make a profit.
You also want to consider if you need any licenses to perform the work you do. And even though you will file the Schedule C and your sole proprietorship is like your personal taxes, it makes sense to set up separate business accounts at the bank. This makes it much easier to show your profit separate from your personal cash flow.
Business Structures
There are several types of business structures that sole proprietors and independent contractors consider as they establish their business model.
A sole proprietor works on their own and can act as an independent contractor. But what if they want to have a business partnership?
You will want to consider establishing a limited liability corporation or LLC. Unlike a sole proprietorship, you have a partner. The benefit of an LLC is shifting liability away from you personally and making the business entity responsible.
When you create an LLC, you then can establish how you will file your taxes with the IRS as either an S-Corp or a C-Corp. The S-Corp lets the IRS know you’re an LLC with a partnership agreement. At the same time, the C-Corp establishes you as a corporation with many shareholders.
Work as Your Own Boss
Still, think working as an independent contractor sounds like the right fit for you? It very well might be; just make sure you understand your financial obligations and the tax implications that go along with them.
It makes sense to protect yourself as a business and get insurance coverage for the work you do and to protect yourself individually from any business-related liability.
If you have insurance questions, we can help. Contact us today to talk about your insurance needs for your sole proprietorship or your work as an independent contractor.
