Self-employed workers usually fall under one of two categories: independent contractors or sole proprietors. In some cases, a worker could wear both hats at the same time. What differentiates independent contractors from sole proprietors is how they structure their companies and earn income.
An independent contractor (IC) is a worker who is employed by one or more companies on a contract basis. Unlike the definition of a traditional employee in a company, contractors only work when their services are required.
4 Major Differences between Independent Contractors and Sole Proprietors
The difference between sole proprietors and independent contractors can be explained in four ways: making an income, income reporting, business structure, and financial risk.
A sole proprietor (SP), sometimes referred to as a sole trader is a one-person business that isn’t registered as a corporation or limited liability company. If you earn income from your business, you’re a sole proprietor.
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Making an income
How self-employed workers earn money will determine whether they’re independent contractors or sole proprietors.
Imagine you’re a classical pianist who teaches children how to play the instrument. If you haven’t set up a formal business entity, you’re considered a sole proprietor because you’re earning a business income.However, if you agree to compose an original music score for a film for a fee, then you’re also earning money as an independent contractor. As you can see, in this scenario, the pianist could make money as an independent contractor, a sole proprietor or both.
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Income reporting
Income reporting refers to the way that earnings are reported. In a typical state in the US like Maine, for example, a sole proprietor must track their income as and when they earn it for tax purposes. Whereas independent contractors will receive a 1099 form that outlines the income earned during the previous calendar year.
As was the case with your small business of homemade cookies, sole proprietorships aren’t formal business structures. That means that there’s usually little to no paperwork to complete before you launch your business. Independent contractors, by contrast, have more to do in the beginning. In the UK, for example, you can either operate as an employee of an umbrella company or by starting your own limited company and working as a self-employed freelancer for income tax purposes.
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Business structure
Working for an umbrella company is ideal for those who want to avoid the paperwork involved with running your own limited company. As an “employee” of the umbrella company, you’ll be paid a net salary directly from the company. While they’ll take care of the administrative tasks, you won’t receive the tax benefits associated with traditional independent contractors.
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Financial risk
Finally, sole proprietors and independent contractors can be differentiated by the level of risk each one takes on. In a sole proprietorship, the risk level is greater as the sole proprietor’s business funds are directly linked to their personal funds and assets. So while a sole proprietor takes home all business profits, they are also liable for all business debts.
The legal structure of LLCs or umbrella companies means that independent contractors have a safety net for their personal funds and assets. In other words, any business debt belongs to the business and not the individual who runs the business.
What do independent contractors and sole proprietors have in common?
Sole proprietors and independent contractors are both self-employed workers who aren’t classed as employees. Instead, they provide services or goods to clients but do not receive a set salary for their work. Other similarities between the two are that they:
- Work for themselves rather than an employer.
- Separate their business expenses from personal expenses.
- Pay self-employment tax on business income.
Can a sole proprietor also be an independent contractor?
Yes, sole proprietors can be independent contractors and vice versa, depending on the type of service you provide.
Just like the aforementioned pianist, lots of self-employed people can earn money as independent contractors and sole proprietors.
If you haven’t set up a formal business entity, you’re considered a sole proprietor because you’re earning business income. If you agree to compose an original music score for a film for a fee, then you’re also earning money as an independent contractor.
Similarly, the sole proprietor of a flower shop might also make floral arrangements for weddings as an independent contractor. In this scenario, the florist would file taxes as a sole proprietor while also receiving a 1099 tax form as an independent contractor from their wedding clients.
The differences between international contractors vs. sole proprietors
Within the umbrella of independent contractors, the concept of international contractors plays a significant role. Independent contractors are self-employed professionals who provide their services on a contract basis to various clients or companies. International contractors, on the other hand, are a specific subset of independent contractors who operate across international borders.
Unlike sole proprietors, who run their businesses within a specific jurisdiction, one of the pros of oversea contractors is that they work with clients from different countries, dealing with diverse legal and tax systems. Their unique position involves navigating cross-border transactions, complying with international laws, and managing the complexities that arise from conducting business on a global scale. This key difference in the geographical scope and operational reach distinguishes international contractors from sole proprietors, making their business ventures more challenging and requiring a deeper understanding of international regulations and cross-cultural dynamics.
Can independent contractors or sole proprietors become payroll employees?
Absolutely. You can even transition from being an overseas contractor to a full-time employee. You’ll need to leave self-employment by contacting the relevant tax authorities. In the United Kingdom, for example, you’ll need to write to HMRC.
If you don’t notify HMRC, you could find that they continue to send you self-assessment tax payment returns after you’ve stopped trading. And if you ignore these returns you could be liable for penalties.
How do sole proprietors and independent contractors differ from an LLCs?
Sole proprietors and independent contractors are both classed as self-employed workers. And in self-employment, the proprietor or freelancer and the business are treated as one legal entity. While for limited liability companies, the business is a distinct legal entity that is separate from its shareholders and directors.
Being self-employed comes with very few formalities. However, limited companies have much more paperwork and legal responsibilities such as registering the business with the relevant authorities such as Companies House in the United Kingdom or Bundesanzeiger Verlagsgesellschaft mbH in Germany.
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FAQs
How are sole proprietors taxed?
In contrast to other types of business entities, such as S corporations and C corporations, sole proprietorships do not tax the business separately from its owner. The owner reports and pays sole proprietorship taxes as part of their personal tax return.
According to the IRS, this type of taxation is called “pass-through taxation” since the tax liability is passed through from the business owner to their personal tax return.
What is form 1099-NEC?
The 1099-NEC is an IRS form used by businesses to report payments to independent contractors, freelancers, sole proprietors, and self-employed individuals.
Does the term 'Independent Contractor' have a formal business structure in any country?
In most countries, an IC is not a business structure, but rather the conventional name of an individual who offers his services via a contract. In some countries such as the US, an independent contractor needs to file specific forms to the tax authorities. In Germany, they have their own business and tax structure identity named ‘freiberufler‘.
When should you create a business entity?
Once your business as an independent contractor grows, it is important to form a business entity. usually, this decision is made in order to separate your business finance from your personal, or that you have personal assets that you want to protect, beyond business insurance.
