There are two common forms of providing small business services as an individual in the US: sole proprietor vs independent contractor. What’s the difference and which one is right for you?
In this blog post, we will provide you with an in-depth guide as we compare sole proprietors vs independent contractors.
What is sole proprietorship?
A sole proprietorship is a legal business structure in the US, like an LLC or partnership or corporation. It’s owned and operated by one person and is the simplest and most common business type. You as the owner keep all the profits, but you’re also personally responsible for all aspects of the business, including tax, debts and legal liabilities.
What is an independent contractor?
An independent contractor is a self-employed individual who provides services to clients. It is not a legal business structure; it’s what you become when you enter into a contract of services with a company. You are not considered an employee of that company and you are responsible for your own taxes and benefits.
Differences between a sole proprietor vs independent contractor
Although they may sound very similar, there are key differences between a sole proprietor vs independent contractor.
Understanding these differences is important because it affects your tax obligations, legal liabilities, and even your business’s overall identity. Here are the most important things you should know:
Business setup
Sole Proprietorship: Although sole proprietors don’t usually need to register with the state unless they’re using a formal business name, you are considered to automatically be operating under this type of business structure if you’re selling goods or services in your personal capacity.
Independent Contractor: An independent contractor is not a type of business structure. It’s someone who typically provides services to other companies under a contractual arrangement.
Revenue generation
Sole Proprietorship: Sole proprietors may earn revenue from doing contract work for other companies, but they can also generate revenue by selling their own products or services.
Independent Contractor: An independent contractor makes their money with clear service contracts between themselves and a company.
Legal liability and protection
What risk is involved in sole proprietor vs independent contractors? Both have no shield between their personal and business liabilities. This means you are personally responsible for all business debts and legal issues.
This is an important risk to understand if you’re running a small business. For example, a creditor can make a legal claim against your personal property or assets, as a result of outstanding debts in your business.
Tax implications
Another key difference to understand between a sole proprietor vs independent contractor are the tax obligations.
Sole Proprietor:
- Sole proprietors determine their self-employment tax obligations using Schedule SE, paired with Form 1040.
- Business earnings and expenses are reported through the Schedule C Form.
- They complete their yearly tax obligations with Form 1040, given that their personal and business finances are one and the same.
Independent Contractor:
- If a client pays an independent contractor $600 or more within a tax year, they’re required to provide the proper Form 1099. The form must be given to the contractor and submitted to the IRS by the deadline set by the government.
- Independent contractors are responsible for paying their own self-employment taxes, which cover Social Security and Medicare. This is done using Form 1040-ES.
Clients working with US-based independent contractors should obtain the IRS Form W-9. For contractors operating outside the US, either Form W-8BEN or W-8BEN-E should be used.
State-specific taxation considerations
Both sole proprietors and independent contractors need to be aware of state-specific tax rules. For instance, Texas business owners might have unique tax considerations based on their industry. For example, some services and most products require the collection and payment of sales tax.
Insurance implications
Both sole proprietors and independent contractors need insurance to protect against potential risks and liabilities. Types of insurance policies to consider include:
- General liability: offering protection against accidents, injuries, and claims of negligence.
- Professional liability insurance: also known as Errors and Omissions (E&O), which shields businesses from claims related to malpractice or service provision errors.
For those in the construction and contractor sectors, for example, considering state-specific insurances, such as commercial auto or property insurance, can be crucial in guaranteeing a comprehensive coverage.
If you’re a business in Texas you should always make sure you are aware of special considerations for your specific industry.
Preparing for success
Don’t worry too much about classifying yourself as a sole proprietor vs independent contractor. Most people running a small business fall into both categories. The most important thing is that you understand your tax obligations, manage your bookkeeping and finances well and as you grow, establish a clear business structure that protects you.
If you need assistance managing your bookkeeping, reach out to us for a free consultation
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