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Key Takeaways
Think of independent contractors and self-employment like roses and flowers: all roses are flowers, but not all flowers are roses. Similarly, all contractors are self-employed, but many self-employed individuals, like small business owners, aren’t independent contractors.
In this guide, we’ll break down the key differences, tax implications, and business structures to help clarify this distinction – plus, how to stay compliant if you’re hiring independent contractors – with some specific takeaways for businesses based in the U.S.
What is an Independent Contractor?
An independent contractor provides services on a contractual basis for specific projects or timeframes. As they’re not employees, they have control over how they perform their work, offering employers flexibility and cost savings.
Many employers rely on hiring independent contractors because of the flexibility and cost savings they can offer – the gig economy as a whole has boomed in popularity in recent years. However, as an employer, it is important to know the key differences between contractors and employees.
There are a number of tests that exist for this purpose, including the common-law tests in the U.S. which asks questions around the following areas:
Behavioral Control: Independent contractors decide how to complete their work, whereas employees follow specific directions from their employers.
Financial Control: Contractors manage their own expenses and business operations and are not economically dependent on any one client, whereas employees are economically dependent on their employer.
Relationship: Independent contractors work on a project-by-project basis and typically have no long-term commitment, unlike employees who usually have continuous employment contracts.
The Risks of Employee Misclassification
Misclassifying workers as independent contractors rather than employees can lead to serious legal and financial consequences, including unpaid employment taxes and penalties. Businesses should be clear on the distinction to avoid issues with social security and Medicare taxes, as well as potential lawsuits related to worker rights.
Free eBook on Employee Misclassification
Classify your workers compliantly with our comprehensive guide on avoiding misclassification risks.
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What Does It Mean To Be Self-Employed?
Being self-employed means you work for yourself and are responsible for generating your own income. This includes independent contractors, but also a range of other business types and arrangements, from freelancers to small business owners. For example, someone running a sole proprietorship or a small graphic design business might be self-employed but is not necessarily an independent contractor.
Self-employed individuals may own a business and provide goods or services to a broader market, and can have multiple income sources from various clients or customers.
Common Self-Employed Business Structures
Self-employed individuals often choose to set up their own businesses, for tax advantages, to clearly separate their personal and business finances, or to boost their professional credibility. There are a few different types of business structures they can choose, which affect their legal and financial obligations:
Do Independent Contractors Need to Register Their Own Business?
Independent contractors don’t always register their own businesses. Many independent contractors work as sole proprietors without the need for formal registration.
However, if they want to protect their personal assets or take on higher-risk work, they might form an LLC or get general liability insurance. Depending on the industry, such as construction, hairstyling or medicine, and depending on the state, licensing requirements might also apply.
How Do Independent Contractor vs Self-Employed Taxes Work?
Unlike full-time employees, independent contractors and self-employed individuals pay their own income taxes. In the U.S., they are responsible for both the employer and employee portions of social security and Medicare taxes (hospital insurance tax), collectively known as self-employment taxes.
Here’s a breakdown of key tax forms for independent contractors and self-employed individuals in the U.S.:
Independent Contractor vs. Self-Employed Examples
Example 1: Freelance Designer
A freelance designer working on a contractual basis for various clients is both an independent contractor and self-employed. They are responsible for managing their business and paying their own taxes.
Example 2: Small Business Owner
A self-employed individual running a small business (e.g., a bakery) is not necessarily an independent contractor, as they do not work under a contract for another company, but rather run their own business entity.
Example 3: Sole Proprietor
A sole proprietor offering consulting services might take on projects as an independent contractor, but if they expand and hire employees, they are self-employed without being classified as an independent contractor.
Checklist For Employers Hiring Independent Contractors
Hiring independent contractors or self-employed individuals can offer businesses flexibility, but it also comes with potential compliance risks. Here's your checklist of what you need to do as an employer to sidestep these risks:
1. Set Up Clear Contractual Agreements
Always have a written contract outlining the scope of work, payment terms, and project deadlines. This helps to establish the contractor’s independence and can help protect both parties in case of disputes.
2. Avoid Exerting Behavioral and Financial Control
Employers should not exert the same level of control over independent contractors as they do with employees. For example, employers should avoid dictating the contractor’s work schedule, tools used, or specific methods. The more control exerted, the higher the risk of misclassification.
3. Verify Licensing and Insurance Requirements
Depending on the industry and state, some contractors may need to have certain licenses or general liability insurance. Employers should verify that contractors meet these requirements before starting work to reduce the risks with non-compliance.
4. No Employee Benefits or Withholding Taxes
Independent contractors are responsible for their own taxes and benefits. Employers should not withhold income taxes or provide benefits such as health insurance, as this could indicate an employee relationship.
5. Issue Form 1099-NEC for Tax Purposes
In the U.S., employers must issue Form 1099-NEC to independent contractors who are paid $600 or more in a tax year. This is crucial for tax reporting and compliance with IRS regulations.
6. Understand Worker Misclassification Laws
Misclassifying an employee as an independent contractor can lead to significant penalties, including unpaid wages, back taxes, and fines. Employers should regularly review contractor relationships (and not just focus on how the relationship is labeled) to ensure they comply with state and federal worker classification laws.
ABOUT THE AUTHOR
Marcelle van Niekerk
Marcelle is a skilled Content Manager at Playroll, a leading global HR platform. With a passion for storytelling and a keen eye for trends, Marcelle specializes in crafting insightful content about remote work, global employment, and the evolving dynamics of the modern workforce.
Independent Contractor vs Self Employed FAQs
Do independent contractors and self-employed individuals file taxes the same way?
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Yes, both independent contractors and self-employed individuals file taxes similarly as they both are considered self-employed by tax authorities. This means they need to report all income, can deduct certain business expenses, and are responsible for self-employment taxes.
What are the benefits of being an independent contractor versus self-employed?
Independent contractors benefit from the flexibility of working on specific projects for different clients without the administrative burdens of running a standalone business. They often enjoy defined projects and timelines, whereas self-employed individuals manage their own business operations, including client acquisition and billing. Both offer flexibility, but an independent contractor arrangement can mean less operational responsibility compared to running a self-employed business.
Can an independent contractor be considered self-employed?
Yes, independent contractors are typically classified as self-employed since they operate independently of a company’s payroll. They work on a contractual basis and retain control over how they fulfill their work obligations.
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