What Is an Independent Contractor?
An independent contractor is a worker who is under contract to provide services for an organization. This worker is not a direct employee but may be a self-employed person or a business which acts as a third party.
The purpose of hiring an independent contractor vs. an employee is to receive a service on a temporary basis. This may also be done to avoid the added expenses (benefits, taxes, etc.) of hiring a regular employee.
What Are Examples of Independent Contractors?
An independent contractor can perform any kind of work for an organization. Some common professions for independent contractors include:
- Construction tradesperson
- Auto mechanic
- Real estate agent
- Web developer
- Customer support agent
- Freelance writer
- Graphic designer
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What Is the Difference Between an Employee and an Independent Contractor?
An independent contractor is primarily in business for themselves, as opposed to an employee, who's economically dependent on their employer. The US Department of Labor uses the following criteria to determine if a contractor is economically independent:
- Opportunity for profit or loss: An independent contractor runs their own business and can impact their profit outcomes. For instance, contractors can negotiate pay for their services, advertise their business to gain more clients, and hire their own employees.
- Investment in business: An independent contractor can invest in their business, such as spending money on marketing or an office space.
- Permanence of relationship: Contract work typically has a definite duration or is project-based, rather than work that has an indefinite duration with a broad scope of tasks.
- Nature and degree of control: Typically, an independent contractor has the ability to manage their own schedule and oversee the majority of their tasks without external supervision.
- Non-integral part of business: An independent contractor should provide work that isn't integral to their client’s principal business. For example, if a graphic designer is contracted to create a logo for a dance studio, they aren't integral to the principal business of teaching dance classes.
- Skill and initiative: Independent contractors provide specialized skills and don’t need to be trained by the client for their work role. Additionally, contractors use their specialized skills for their own business initiatives, rather than solely for the business initiatives of the client.
A worker is typically classified as an employee of a business if they:
- Are under the supervision of their employer
- Are covered by employment and labor laws, like the Fair Labor Standards Act (FLSA)
- Earn an hourly rate or a salary, according to set pay periods
- Report taxes on the IRS W-2 form
- Are eligible for state unemployment insurance (SUI)
A person or entity may be considered an independent contractor if they:
- Are not supervised by an employer
- Are not covered by employment and labor laws (FLSA)
- Are paid either hourly, daily, or weekly, based on invoices issued after work is completed
- Have control over their schedule and day-to-day work
- Are not generally offered benefits from the hiring employer
- Report taxes on Form 1040 or Schedule C Form 1040 (see below)
- Are not eligible for state unemployment insurance
What Are the Benefits of Being an Independent Contractor?
An independent contractor may be an individual who gets paid for freelance services. It may also be someone who owns an entity, such as a sole proprietorship or limited liability company (LLC). A few of the advantages of being an independent contractor include:
- Being Your Own Boss: While an organization hires a contractor to do work for them, the contractor has full control over how they perform the work.
- Financial Control: Contractors may work for multiple companies at a time and can decide for themselves how much work they take on and how much they charge for their services.
- Schedule Flexibility: Many freelancers and other contractors can choose when, where, and how often they work, creating a schedule that works best for them and their business partners.
- Less Taxes: This is not a guarantee, but contractors can take advantage of tax deductions for necessary business expenses.
What Are the Drawbacks of Being an Independent Contractor?
Being an independent contractor can be highly beneficial for several individuals. But just like other professional choices, there are drawbacks to consider. Some of the disadvantages of being an independent contractor include:
- Job Insecurity: If a contractor doesn’t secure work, they don’t get paid. If a client doesn’t pay, the contractor has little recourse and is liable when debts rack up.
- No Major Employee Benefits: Health insurance, retirement benefits, bonuses, paid vacation and sick time, and profit sharing are generally not offered to independent contractors. However, contractors may be qualified for a self-employed health insurance deduction.
- Limited State and Federal Benefits: In many instances, independent contractors aren’t eligible for unemployment insurance and workers’ compensation.
- No Labor Law Protections: Unfair exploitation and discrimination laws that employers must abide by do not apply to their contracted workers.
How to File Taxes as an Independent Contractor
Annual net earnings of $400 or more are subject to self-employment tax. These taxes are reported to the IRS on either Form 1040 (US Individual Income Tax Return) or Schedule C Form 1040 (Profit or Loss From Business).
The self-employment tax rate for most independent contractors is 15.3%. Of this total, 12.4% is for Social Security and 2.9% is for Medicare. Tax rules apply even if the contracted worker is currently receiving Social Security and/or Medicare. Most independent workers use Schedule C to calculate net earnings from self-employment.
As of 2023, the first $160,200 of the contractor’s income (wages, tips, and net earnings) is subject to a combination of taxes. This may be the Social Security portion of the self-employment tax, Social Security tax, or Tier 1 of the railroad retirement tax. Additionally, all net earnings are subject to a similar combination of taxes: the 2.9% Medicare portion of the self-employment tax, Social Security tax, or railroad retirement tax.
If an independent contractor makes at least $160,200 and the Social Security tax or railroad retirement tax (or both) apply, they don’t need to pay the Social Security portion of the self-employment tax.
Please note: The IRS has special self-employment taxation rules for family caregivers. These apply to in-home aides for older individuals and people with disabilities.
Independent Contractor Taxes vs. Employee Taxes
Independent contractor taxes are handled differently than employee taxes. Businesses that employ contractors do not withhold state and federal taxes in their payments. Instead, independent contractors are responsible for paying the Self-Employment Contributions Act (SECA) tax on what they earn.
Estimated Tax Payments
This tax is usually estimated and paid quarterly to the IRS via Form 1040-ES. The IRS provides a Tax Withholding Estimator tool to help independent contractors gauge how much they’ll need to pay in taxes.
Estimated quarterly payments are required to be made by independent contractors who expect to owe more than $1,000 in taxes for the year.
Employers must file an independent contractor 1099-MISC form with the IRS for each person they’ve paid during the year. They should also ensure an independent contractor agreement is signed.
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