Self-Employed vs. Independent Contractor: Know The Difference
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The Internal Revenue Service states that independent contractors *are* self-employed. However, not all self-employed people count as independent contractors.
As it turns out, there are some important differences between these two that can impact the way you perform work and pay taxes.
Here's how to confidently distinguish between independent contractors and self-employed for legal purposes. We'll go over the following:
- What is an independent contractor
- What is self-employment
- The difference between independent contractors and self-employed
- How to classify yourself
- Taxes, licenses, and insurance for independent contractors and self-employed
- What kind of business structures are available to independent contractors and self-employed
What is an independent contractor?
An independent contractor is a person who provides the general public (companies or individuals) with goods or services.
Independent contractors, as their name suggests, have a great deal of independence in their work. US labor laws classify the differences between independent contractors and employees into three major categories:
- Behavioral control — Independent contractors are in charge through and through and have a great degree of control. Working hours, location, tools, equipment, and means of work, as well as the creative process in its entirety, are determined by an independent contractor. Additionally, they can pick each task as they please, according to the contract they’ve signed with the other side.
- Type of relationship — independent contractors are hired for a set period of time to perform non-crucial tasks for a client. For example, a law firm may seek a design expert to improve their marketing materials, as a one-time engagement.
- Financial control — independent contractors are in charge of the business aspect of their work. This means that they have the ability to decide how they will invest their business income into their equipment and training'
What is self-employment and how does it compare to independent contractors?
Self-employment is a general classification of how someone earns their income. Being self-employed means not working for any particular company. Self-employed individuals might contract-based work for multiple clients. They might use freelancer websites, LinkedIn, browse job websites or rely on their reputation, recommendations, and word of mouth to find new clients or be contacted by them. They might have their own business, or only work part-time.
Independent contractors are a type of tax classification within the self-employment space. That's why all independent contractors are self-employed, but not every self-employed person is an independent contractor.
As an analogy, let's compare the terms "Olympic swimmer" and "swimmer". An Olympic swimmer has a precise definition: a person who competes in an Olympic swimming event. A swimmer is more general: any animal that moves in the water. So Michael Phelps could be considered an Olympic swimmer and a swimmer, but a dolphin is just a swimmer (though it'd probably pick up a couple of gold medals if it could compete).
Both independent contractors and self-employed workers can freely choose what they’ll do, how and when they’ll do it, and define their rates. They enjoy flexibility with their work and time.
However, independent contractors and self-employed people miss out on significant employee benefits and protections that full-time employees enjoy. They need to cover taxes and social contributions by themselves. There’s no paid time off, sick leave, pension, and 401k plans, or health insurance available.
Similarly, FLSA (Fair Labor Standards Act) standards don’t apply to non-employees, so there’s no minimum wage guaranteed, no unemployment coverage, or workers’ compensation.
Exception: Due to the pandemic, Congress passed the CARES Act (Coronavirus Aid, Response, and Economic Security Act) in 2020, which entitled independent contractors to unemployment benefits.
Independent contractor vs self-employed worker: examples
There are many similarities between independent contractors and self-employed workers, so much that they may seem the same.
Independent contractors are self-employed. At the same time, not all self-employed workers may classify as independent contractors.
One way to explain this is through an example of two scenarios:
Scenario 1: Imagine you’re a fashion designer and work for multiple brands at the same time. You sign contracts with different brands and design a limited collection of clothing items, or work for them for a set period of time. This is typical independent contractor work (and you'd also count as self-employed).
Scenario 2: You work as a fashion designer, but strictly for yourself. You do it all on your own: warehousing, workshopping, designing, sewing, and shipping. The main difference with scenario 1 is that you are your own boss but have no working-relationship contracts with other business entities. Your income is self-made, hence self-employed, but you would be better classified as a small business owner.
It's also possible to be an employee and an independent contractor at the same time. For example, a skilled developer who writes in their spare time may offer content writing services to earn extra income.
Employer tip: Make sure to avoid misclassifying your employees as independent contractors! 20 Factor Test can also help determine the independent contractor's legal status in the US and prevent employee misclassification.
Taxes and tax deductions for independent contractors and self-employed
Taxes are usually a straightforward process for employees because their employers automatically calculate income tax withholding each pay cycle. Non-employees on the other hand, need to figure out their own taxes and make appropriate tax payments on their own. Because self-employed workers don't pay payroll taxes, they also need to contribute self-employment taxes.
As an independent contractor, any client who paid you more than $600 in a year will need to provide you a completed Form 1099-NEC (Non-employee Compensation) at the end of the year. Use Form 1099-MISC to report direct sales of consumer products (exceeding $5,000).
You'll use your 1099s when completing Schedule C (Profit or Loss from Business) to calculate your business's net income or loss for the tax year (if you are a sole proprietor, report your personal income). Your Schedule C will accompany your Form 1040 (U.S. Individual Income Tax Return).
You'll also complete Schedule SE to calculate the self-employment taxes. In summary, self-employed individuals (independent contractors included) pay the following taxes:
- Self-employment tax: this 15.3% tax is a non-employee version of the FICA tax which employers normally pay for employees. It covers Social Security and Medicare.
- Additional Medicare Tax: this 0.9% tax may apply if your income exceeds a certain amount. For single filers, this is $200,000.
- Federal Income Tax: this personal tax rate is based on your income.
For more, read our complete guide to paying independent contractor taxes and tax forms for independent contractors
Self-employed people can reduce their self-employment taxes by claiming various tax deductions which are available for business expenses. These reduce the tax you'll need to pay. Examples include:
- Home office: If you’ve dedicated a part of your home to doing work, you can claim a deduction for a part of your mortgage, electricity, and rent. Claim these on IRS Form 8829.
- Office expenses: for office supplies, utilities, repairs, and maintenance
- Advertising costs
- Business setup expenses
- Licenses and education
- Insurance: health insurance, business insurance
- Travel expenses: including car expenses and payments
Taxes, along with personal use property taxes and sales taxes from buyers, are non-deductible.
License requirements for non-employees
Rules vary from one state to another and also depend on the type of work you perform. Licensing rules aren’t affected by your employment status, and the same applies whether you’re listed as an independent contractor, self-employed worker, freelancer, sole proprietor, or you’re incorporated.
In Washington for example, everybody who conducts a business needs to obtain a license, no matter the profession.
What type of insurance do independent contractors and self-employed need?
Because independent contractors can be held personally liable for their work, it's important to consider getting insured. Coverage for business risks can range from vehicle insurance, commercial property insurance, to more precise and detailed contracts for certain lines of work. To pick adequate insurance, you'll want to review your daily work activities and equipment and consider everything that could go wrong.
Business insurance for independent contractors most often includes one of these:
- General liability insurance or Commercial General Liability Insurance/ Business Liability Insurance: protects you in case of an action that may cause third-party injuries, property damage, or reputation damage
- Professional liability insurance, also called Errors & Omissions (E&O) Insurance or Professional Indemnity Insurance: protects you from error and negligence claims made by clients who have suffered financial losses as a result. It covers the costs of investigating the alleged work errors, legal defense, and false or frivolous damage claims.
Common business structures for independent contractors and self-employed workers
Some self-employed individuals and independent contractors choose other business structures for their work. The available options include:
- Sole Proprietorship
- Limited Liability Company (LLC)
- C Corporation
- S Corporation
A sole proprietorship is the most popular type of business entity in the United States, especially for freelancers, and independent workers. For income tax purposes, it is the default legal entity when starting a business. It’s the easiest and cheapest to create, and it's a one-person business.
As a sole prop, you're legally “conjoined” to the business—that means you're personally liable for business debts, losses, and liabilities. No separate tax filing is required since you report both personal and business tax liabilities on a single return. On the other hand, if you choose to register your business as a corporation, you can be exposed to double taxation, because you'll need to file both a corporate and a personal tax return.
If you plan to open a business that requires more liability protection, a single-member LLC might be a better option. Raising money for business ventures of sole proprietors is difficult, as lenders sometimes deem them too risky. Investment opportunities are limited as well for this unincorporated business because you cannot sell the company stock or sell an interest in the business to acquire capital.
With a sole proprietorship, you aren't required to open a separate, business bank account or to have a business name. However, it's a good idea to keep your self-employment transactions separated from your personal transactions as much as possible so it's easier to claim tax deductions. You can use your own personal name, but if you do want to use a separate name for your business, you can use the "DBA" acronym—short for "doing business as"—and operate with a new business name. Some states require you to file an official DBA before you go into business.
Interested in forming a sole proprietorship in the US? Take a look at our Sole Proprietorship guide that fully covers definition, benefits, taxes, and business registration.
Sole proprietorships have worldwide popularity, but each country has different laws and legal requirements. No matter which country you're in, visit our Deel blog to learn how to form a sole proprietorship in over 150 countries.