Independent Contractors: Everything You Need to Know

  • Accracy
  • 26th Nov, 2023

What exactly does it mean when someone hires you as an "independent contractor?" Is that the same as being a freelancer? If not, what's the difference?

Independent Contractors: Everything You Need to Know
Operations

What is an independent contractor?

An independent contractor is anyone who does work on a contract basis to complete a particular project or assignment.

They can be a sole proprietor, a freelancer with an incorporated business, a professional with a Limited Liability Partnership (like a lawyer)—it really doesn't matter what kind of business entity they run. The "independent" in independent contractor simply refers to the fact that the contractor is a non-employee, and is independent of the company they're doing the contracted work for.

Most people who call themselves "freelancers" are considered to be independent contractors by the IRS—the two terms are basically interchangeable.

If you're doing work for someone, you're not on their payroll, and you signed a contract with them, you're probably an independent contractor.

Independent contractor vs. employee

By definition, an independent contractor is not an employee.

Employees get paid a regular wage, have taxes withheld from those wages, work part or full-time, and have their work and schedule dictated by the employer.

Independent contractors are the reverse. They tend to get paid for projects, they worry about their own taxes, and work when and where they want.

If you're an independent contractor, employers don't have to pay into your health insurance, life insurance, bonuses, stock options, worker's compensation, unemployment taxes, payroll taxes, or 401(k) contributions. Independent also don't get employee benefits, or protection from employment laws, like the Fair Labor Standards Act (FLSA), the Occupational Safety & Health Act (OSHA) and Title VII of the Civil Rights Act.

Independent contractor status usually gives you a lot more autonomy and control over your work. You're your own boss, set your own hours, and make your own tax payments. And if an employer treats an independent contractor as an employee, the IRS might penalize them for "misclassification."

Is an independent contractor self-employed?

Yes.

According to U.S. labor law, independent contractors are not employees—they are self-employed and do work for clients on a contract basis. If you do work as an independent contractor, you are technically working for yourself.

Working as an independent contractor

How to become an independent contractor

Becoming an independent contractor is a little bit like becoming a sole proprietor. All you have to do is start working. You might already be an independent contractor right now without even knowing it!

Clients will usually ask you to sign a written contract before you start doing work for them (that's where the "contractor" part comes from).

If you're looking for a good template contract for an independent contractor agreement, the plain contract is a good place to start.

Does an independent contractor need a business license?

There are different laws for what types of licenses or permits you may need to operate, depending on which state and industry you're working in. Bookkeepers in California don't need a Colorado pesticide applicator license, but exterminators working in the Denver area might.

Check out the Small Business Association's list of Business License and Permits to find out which licenses and permits you may need to do business in your state and industry.

How does an independent contractor pay taxes?

If you're an independent contractor, you have to pay self-employment taxes to the IRS (the current rate is 15.3%—12.4% for social security and 2.9% for Medicare). To do that, you need to file Schedule SE.

Schedule SE is one of many schedules of Form 1040, the form you use to file your individual income tax return.

Before you file Schedule SE, you'll first have to calculate your total self-employment income (or loss) using Schedule C of Form 1040 (On Schedule C, total self-employment income is recorded on line 31.)

If you did more than $600 of work for a particular client, they're required to file Form 1099-MISC and send you a copy of it. 1099-MISC is an "information filing form" used to report non-salary income to the IRS. You don't need to do anything to your copy of 1099-MISC, but if you don't receive one, you should follow up with your client.

Remember that as an independent contractor, you'll have to set aside all of your self-employment taxes, Social Security, and Medicare contributions yourself.

Further reading: Self-Employed Taxes (A Simple Guide)

Things you can deduct as an independent contractor

If you're self-employed and are paying out of pocket for all your business expenses, it's important that you keep records for and deduct as many of them as possible on your taxes.

Some common tax deductions for independent contractors include:

Self-employment taxes, and other taxes

You can deduct 50% of self-employment tax that you calculated on Schedule SE, because the IRS considers the employer portion of the self-employment tax to be a deductible expense.

Health insurance and other costs

In addition to insurance premiums, you can deduct other out-of-pocket medical costs, such as office co-pays and the cost of prescriptions. These costs are included as itemized deductions on Schedule A.

Business use of vehicle

If you use your vehicle solely for business purposes, then you can deduct the entire cost of operating the vehicle. (If you use it for both business and personal trips, you can only deduct the costs associated with business-related usage.)

Home office deduction

If you run your sole proprietorship out of a home office, you may be able to deduct a portion of your housing expenses against business income, provided it's your principal place of business and you use it regularly.

You'll likely need to file Form 8829 along with your Schedule C when taking the home office deduction, which you can learn more about in our guide to the home office deduction.

The Qualified Business Income deduction

The Tax Cuts and Jobs Act of 2017 set up a new tax deduction for pass-through entities (like sole proprietorships) which allows you to deduct up to 20% of net business income earned as an additional personal deduction.

For a thorough breakdown of how this deduction works, check out our guide to the QBI deduction.

Things employers should know

How to pay an independent contractor

Unlike employee wages, which you'll handle through your payroll, you pay your independent contractors like you would any other kind of supplier, via your accounts payable system.

Typically an independent contractor will first send you an invoice, which will specify certain payment terms. Depending on your accounts payable process, you might also send them a purchase order back to confirm the invoice before issuing the final payment.

Can you tell an independent contractor when to work?

According to U.S. labor law, no.

If you train someone, direct their tasks, set specific hours, and dictate how and when the work should be completed, the IRS is likely to see them as an employee.

If a staff member is classified as an employee, you need to withhold, deposit, report, and pay into their payroll taxes, including Social Security, and Medicare taxes. If you don't, the IRS or Department of Labor might consider that "misclassification." (That's when employers hire and compensate someone like an independent contractor, but control their work like an employee.)

The IRS says misclassification is a form of tax evasion, and might come after you for the unpaid employer and employee portions of Social Security, and Medicare if they discover you've done it.

Read more about misclassification and the difference between hiring employees and independent contractors.

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