Independent contractor versus sole proprietor, which is the best designation for your business? The answer might be — both. ‘Independent contractor’ and ‘sole proprietor’ are not opposing forms of business structure. Rather, an independent contractor can operate through several different business structures, one of which is called ‘sole proprietorship’. Here we explain the precise difference between independent contractors and sole proprietors.
1. There is no need for a business to decide on the issue of independent contractor versus sole proprietor: An individual can be both.
2. ‘Sole proprietorship’ is a business legal structure which can be distinguished from other prominent structures such as ‘corporation’, ‘limited liability company’ and ‘partnership.
3. ‘Independent contractor’ is not a business legal structure. Rather, it is what an individual or entity becomes when they or it voluntarily enter into a certain sort of contract, sometimes known as a ‘contract for services’.
4. The most important thing when deciding on sole proprietor versus independent contractor, is to ensure that all legal obligations are complied with.
Independent Contractor versus Sole Proprietor
There are two key ways that individuals make their living — as employees, or by running their own business. Anyone who runs their own business must adopt a certain legal structure for that business. In many cases, this does not even require that the individual who starts the business do anything: A business structure applies by default.
The business structure determines the legal, regulatory and financial obligations of the business. For example, the business structure determines which tax rates apply, and how tax returns should be filed. It may also determine whether the business needs to be registered with a local chamber of commerce or trade office.
In the United States, common business structures include:
- Sole Proprietorship
- Limited Liability company (LLC)
- Partnership, and
- C Corporation.
Why isn’t ‘independent contractor’ in that list? Independent contractor is not a business structure in the United States, nor is it a business structure in most English-speaking countries. Rather, ‘independent contractor’ is the term used to refer to a party that enters into a specific sort of contract or agreement: That individual could operate through any number of different business structures, including an LLC or a partnership. Sole proprietorship is just one such possibility.
In this article we define sole proprietor and independent contractor, and show how exactly the two classifications differ.
What Is a Sole Proprietor?
A ‘sole proprietor’, sometimes called ‘sole trader’, is the legal form taken by individuals who enter into business without incorporating or setting up a separate legal entity of some form.
In many countries, including the United States, an individual becomes a sole proprietor ‘by default’ when they go into business for themselves without setting up another type of structure.
In this structure, there is no legal distinction between the ‘natural person’ and the business: Any contract is between a natural person (the sole proprietor) and another person.
Note, however, that the individual may still operate under a separate business name. This ‘trading name’ may need to be separately registered with various authorities. Furthermore, in some countries, that individual may be entitled to a unique business identifier (such as an ‘Australian Business Number‘ in Australia).
The sole proprietor owns all business assets personally, and takes on all liabilities or debts personally. This means that, while the individual receives all profits, they are also responsible for losses. If the business becomes insolvent, is unable to pay its debts as they fall due and payable, the sole proprietor is at risk of personal bankruptcy.
What Is an LLC and How Does It Differ from a Sole Proprietorship?
One way of mitigating the risk of personal bankruptcy (as explained above) is to establish a limited liability company or (LLC). Where an LLC is insolvent, it is the company (rather than the individual), that is at direct risk of bankruptcy (or ‘liquidation’, as it is called in some countries).
So what exactly is an LLC? In an LLC — the most common alternative to a sole proprietorship in the USA — the business owner or owners become the ‘members’ of the LLC. Through the LLC, their ‘liability is limited’ in the sense that only the assets of the LLC, not the owner’s personal assets, are vulnerable in the case of insolvency. In the US, LLCs are regulated on a state level, with the majority of LLCs being established in Delaware.
In the US, the profits of an LLC are not taxed, and are instead ‘passed through’ to the ‘members’ (i.e., the owners), who pay income tax as part of their personal tax declarations. In addition, the members of the LLC are often required to pay self-employment taxes.
Note, when it comes to tax treatment, LLCs are different than ‘limited companies’ in places like the UK, Australia and New Zealand, as they must pay tax on their profits at the corporate/company tax rate.
In the US, the member (or members) of an LLC may still be considered ‘self-employed’ and required to pay self-employment taxes.
An LLC can elect a particular form of tax registration known as ‘S corporation’, or ‘S corp’, for short. Under this designation, the members are paid a salary and do not pay self-employment taxes. Instead, payroll taxes are paid by the corporation itself, and count as a deductible operating expense. It this feature of an ‘S corp’ which can make it an attractive tax designation.
What are the Benefits and Challenges of Becoming a Sole Proprietor?
Becoming a sole proprietor is the simplest way of starting one’s own business. No ‘overt’ or formal act is usually required on behalf of hte business owner. This simplicity usually transfers through to tax filings. However, there are significant downsides to to going down the sole proprietor route. Most significantly, the business owners has unlimited personal liability for debts. If the owner is unable to pay their debts and becomes insolvent, they may need to file for bankruptcy.
This is one of the chief motivations for setting up a company or corporation. Below we list some of the challenges of a sole proprietorship, besides bankruptcy risk, which mean that an LLC can be beneficial:
What Alternatives Are There to Becoming a Sole Proprietor?
If a business owner wishes to avoid unlimited personal liability, and reap the benefits of an entirely separate business entity, they might consider setting up a separate legal entity. Besides the example, of an LLC, a range of operations may be available, depending on the jurisdiction
What is an Independent Contractor?
An independent contractor is hired by a business to provide services, and are sometimes known as a ‘freelancer’.
Independent contractors, by definition, are more independent than employees. They retain greater control over their work: Certain results are usually expected, but there is usually no specification as to how the contractor is to receive those results.
The independent contractor deals with taxes and files their own taxes with the authorities. Depending on the jurisdiction, independent contractors may need to pay Value-Added Tax (VAT), Goods and Services Tax (GST) and self-employment taxes, as well as income tax.
As they are an independent business, the independent contractor is permitted to deduct many expenses when filing their taxes that employees are not. These may include:
- Utility costs;
- Equipment costs, such as depreciation on computers;
- Home office costs;
- Deductions for insurance contributions.
The specific types of contract entered into by an independent contractor is commonly known as a ‘contract for services’: Just as someone selling goods enters into a contract for the sale of those goods, someone selling services enters into a contract for the sale of those services.
This kind of contract should be distinguished from a ‘contract of service’, which is the type of contract entered into between an employee and their employer.
Through a contract for services, an independent contractor usually enters into a contract with the other party setting out the following matters:
Importantly, the contract for services usually does not include the following:
If a contract were to contain provisions on those matters, there is a risk that the tax and regulatory authorities would interpret the relationship as ’employment’ and consider the contractor ‘misclassified’.
You can read more about employee misclassification at What is Employee Misclassification?
As well as turnover taxes, independent contractors may have separate tax filing obligations. For example, in the United States, independent contractors filing their Schedule C 1040 form, also need to file a 1099-MISC which shows their earnings.
Find out more about hiring independent contractors at How to Hire Independent Contractors.
Independent Contractor versus Sole Proprietor: How Do They Differ?
As discussed, a ‘sole proprietor’ is a type of business structure — a business classification used to determine tax, regulatory and contractual obligations. As a sole proprietorship, a business is distinguished in legal structure from an LLC, a partnership and various other forms of business entity.
By contrast, ‘independent contractor’ is not a business structure: Any business structure, including an LLC, a partnership or a trading trust, might be engaged as an independent contractor. It is simply the conventional name for an individual who voluntarily enters into a contract for services.
This does not mean that there aren’t specific laws related to operating as an independent contractor. For example, independent contractors need to file specific forms when submitting their taxes in the US.
Frequently Asked Questions
Can an Individual Be an Independent Contractor without Being a Sole Proprietor?
Yes. An independent contractor can set up their own legal entity, such as a limited liability company (LLC), through which they can carry out their business. The contractor can make themselves the sole director, employee and shareholder in the company if they wish (and jurisdictional laws allow).
In this case, the contract is between the company and the client, rather than the natural person who ‘runs’ that company.
Similarly, an individual can set up a partnership and operate as an independent contractor via that arrangement.
Can an Individual Be a Sole Proprietor without Being an Independent Contractor?
Yes. For example, a food truck vendor may choose to operate as a sole proprietor. As they would not be entering into ‘contracts for services’ with their customers, they would not count as an independent contractor.
Is Being a Sole Proprietor the Same as Being Self-Employed?
Not necessarily. In the United States, businesses owners that structure themselves as an LLC may count as self-employed and be required to pay self-employment taxes.
Are There any Countries Where ‘Independent Contractor’ is a Formal Business Structure?
Yes. For example, in Germany, independent contractors or freelancers have their own distinct business and tax structure known as ‘freiberufler‘.
How Can an International Expansion Partner Help?
Global expansion partners, such as New Horizons Global Partners, are experts in international business classification. They will be able to advise which business structure is best for your company, and the workers you engage, no matter where they are located. They will also be able to advise on whether it is appropriate to engage workers as independent contractors. For more information, get in touch today.