Both independent contractors and sole proprietors are self-employed people who haven’t set up formal business entities, like limited liability companies or corporations. They file business taxes using a Schedule C and have to pay self-employment taxes.
The difference between the two designations is how they earn income:
Independent contractors do specific tasks for clients for a set fee.
Sole proprietors may do contract work, but may also have other revenue streams, like selling their own products to customers.
You don’t have to choose between being a sole proprietor and an independent contractor; many people fall into both categories. The more important decision is when to formalize your business, which can become necessary as it grows.
What is a sole proprietor?
A sole proprietorship is a one-person business that hasn’t registered with the state or the IRS as a business entity, like a corporation or LLC. If you earn income from your business, you’re a sole proprietor.
A sole proprietor might do work as an independent contractor and receive a 1099 tax form from their clients at the end of the year. In that sense, they’re also an independent contractor.
If you’re a sole proprietor, the IRS considers whatever business income you earn to be your personal income. You’re personally responsible for any debts the business incurs, too.
What is an independent contractor?
An independent contractor does work for one or several companies on a contract basis. The person who hires an independent contractor can tell them what to do, but not when or how to do it. Many freelancers, like IT consultants, graphic designers and web designers, are independent contractors.
If an independent contractor hasn’t created a separate business entity, they file a Schedule C, like sole proprietors.
Companies that hire independent contractors don’t have to withhold income tax, Social Security or Medicare payments, so independent contractors usually need to make estimated tax payments throughout the year to cover income tax and self-employment tax.
Should you be a sole proprietor or an independent contractor?
You don’t have to choose one designation or the other. Lots of self-employed people are sole proprietors and independent contractors, depending on the type of work they do.
For example, a musician might earn money from performing shows, teaching lessons and selling merchandise. If they haven’t set up a formal business entity, they’re considered a sole proprietor because they’re earning business income.
If that musician agrees to compose original music for a corporate video for a fee, then they’re also earning income as an independent contractor.
Both sole proprietors and independent contractors have to:
Fill out Schedule C when they file taxes.
Pay self-employment taxes, which cover the Medicare and Social Security taxes that an employer would normally withhold.
Make estimated income tax payments to the IRS and their state government if they’ll owe $1,000 or more in taxes when filing their return.
When should you create a business entity?
The larger your business becomes, the more important it is to create a formal business entity. Here are some signs that it’s time to move from being a sole proprietorship or independent contractor to a different business structure, like an LLC or corporation:
You want more separation between your business and personal finances. It’s important for business owners of all sizes to separate their business and personal finances. Sole proprietors have access to some important tools, like business bank accounts and business credit cards. But with a business entity, you can take steps like developing a business credit history and credit score, which limits lenders’ reliance on your personal credit.
You want more protection for your personal assets. Neither sole proprietors nor independent contractors have business entities that separate their business assets from their personal assets. While business insurance can help if you’re sued or face another unexpected cost, creating a separate business entity can provide extra protection.
You need additional funding. Sole proprietorships tend to have trouble raising money from traditional sources, like small-business loans. Having a separate business entity can make it easier to get financing.