Sole proprietor vs. independent contractor: What’s the difference?
Sole proprietor vs. independent contractor involves tax structure
Starting a small business is an increasingly popular career option today, with sole proprietors and independent contractors enjoying the flexibility and tax deductions that full-time employment doesn't typically offer. Sole proprietors and independent contractors are different names for the same business owner, but which term applies to your business depends on the situation.
What is a sole proprietor?
Sole proprietors are individuals who go into business for themselves without registering their business as a special entity such as a corporation, a partnership, or a limited liability company (LLC). Sole proprietors report their business income to the IRS on their personal tax returns by attaching Schedule C, Profit or Loss from Business (Sole Proprietorship) to their Form 1040 or 1040-SR.
As a sole proprietor, a business owner can report both personal and business tax liabilities on a single return and save time and money. The downside is that there is no separation between a sole proprietor’s financial risks and personal finances, so if they cannot pay off debts, creditors can target the owner’s personal assets.
Business owners who register as corporations must file both a personal tax return and a corporate tax return, essentially exposing themselves to double taxation – once on their salary and again on the dividends they receive from their corporate profits. The benefit is that the owner shields their personal money from third-party claims.
What is a self-employed independent contractor?
The term “independent contractor” describes the relationship between a client and a self-employed person who provides services as an autonomous business rather than as a full-time employee. Although full-time employment has its advantages – a steady paycheck, benefits, and office space – it also typically offers less freedom than independent contractors enjoy.
Taxation is significant when deciding whether to work as an independent contractor. Independent contractors receive a 1099-MISC tax form from each customer at the end of the year and report the income on Schedule C of their 1040 form. They then transfer their bottom-line Schedule C business profit to Form 1040, Schedule SE, Self-Employment Tax. This schedule determines their total Federal Income Contribution Act (FICA) taxes.
Full-time employees pay only half of their Social Security and Medicare payroll tax liability, and employers cover the remaining half. Independent contractors must pay for all Social Security and Medicare taxes, which they should factor in when determining their budgets.
Can a small business owner be both a sole proprietor and an independent contractor?
It’s common for small business owners to operate as both sole proprietors and independent contractors, depending on the nature of the business relationship and the taxation structure.
For example, a software developer who decides to start their own business quickly and easily might choose to operate as a sole proprietor, which does not require setting up a separate corporation and allows for the filing of personal and business tax liabilities on Form 1040.
If the developer outsources their services to corporate clients, the customer might establish an independent contractor relationship, which means:
- The employer is not responsible for withholding the developer’s payroll taxes.
- The developer must pay for both their own share of payroll taxes and the employer’s share of Medicare and Social Security taxes.
- The employer reports what it pays the developer’s business to the federal government via Form 1099-MISC.
If the software developer decides to create and sell an iPhone app on the side, they are not an independent contractor for Apple but a merchant who receives a payment each time someone downloads the app. Because the developer is not an independent contractor, they don't receive a Form 1099-MISC and instead reports the app-related revenue on Schedule C (Form 1040).
At tax time, the developer pays income and payroll taxes based on having received both 1099 income from corporate clients and non-1099 business income from sales of the iPhone app.
What are the insurance implications of being a sole proprietor vs. an independent contractor?
Sole proprietors have less tax complexity than independent contractors but risk exposing their personal assets to business litigation, debt collection, or bankruptcy proceedings. Sole proprietors should be fully insured to protect against the major risks of doing business, such as:
Lawsuits: Sole proprietors can be sued for several reasons, including unsatisfactory work, failure to meet deadlines, injury to a third party at a client’s work site, and damaged customer property. To guard against such risks, sole proprietors should consider purchasing errors and omissions insurance (also called E&O or professional liability insurance) and general liability insurance.
It’s also important to protect business assets with commercial property insurance, particularly for sole proprietors who rely on tools and other equipment to generate income.
Injuries: Personal health insurance doesn’t cover work-related injuries or illnesses, so sole proprietors should strongly consider buying workers’ compensation insurance for themselves, and some clients might require it. Having workers’ comp coverage reassures clients that they won’t have to pay for your medical care if you get hurt while working for them.
Car accidents: Personal auto insurance may not cover accidents you have while driving a company car. If you injure another driver, you could be sued, and without commercial auto insurance, you could be personally liable for this expense. Sole proprietors who drive their personal cars for business purposes should opt for hired and non-owned auto insurance (HNOA).
Sole proprietors who double as independent contractors also need business insurance, and if they are working as a service provider for a company, it could be a requirement. So if a contractor hurts someone or damages a third party’s property, the contractor’s insurance policy pays for damages rather than the client’s insurance.
If you work exclusively or partially as an independent contractor, it’s important to analyze your major business risks to determine which insurance policies you should buy. General liability insurance and errors and omissions insurance should be part of your business risk management plan. And while sole proprietors don’t often hire employees, those that do will likely have to purchase workers’ compensation insurance.
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