Understanding your employment status is key to knowing a number of items that concern your business and income including your insurance needs, tax considerations, licensing, and more. First, if you are paid and have a W-2 form then you are an employee, which makes your employer responsible for payroll taxes and many insurance requirements. If, however, you are paid and have a 1099 form, without payroll taxes - specifically FICA taxes - being deducted, you are most likely self-employed, an independent contractor, or both. Yes, that’s possible.
According to the Internal Revenue Service (IRS), a self-employed individual is someone who meets any of the following criteria:
- A member of a partnership that operates a business.
- A sole proprietor or independent contractor who operates the business.
- Someone who has a degree of control over the product or service offered to your customers or clients.
An independent contractor on the other hand provides services to the general public and is free from any employer-employee relationship. The following are examples of independent contractors:
- Doctors in a private practice
- Lawyers, bookkeepers, accountants
- IT, web designers, programmers
- Auctioneers, traders, public stenographers
An independent contractor is self-employed
In almost all cases, an independent contractor is self-employed, but not everyone who is self-employed is an independent contractor. An independent contractor is someone who is working for someone else to provide services but is not an employee. As the name implies, independent contractors often work for limited time periods according to the terms of a contract. The contract might revolve around the completion of a project or it might be for a limited duration of time, such as a six-month or one-year contract. Because of the limited scope of the time commitment, an independent contractor is considered to be self-employed. They are typically creative or technical professionals like web designers, writers, or IT professionals.
Independent contractors receive the 1099-MISC form instead of the W-2, showing the total income received from the companies the independent contractor has worked for. Since independent contractors are not employees, there are no payroll taxes deducted and the contractor is responsible for paying employment taxes, income taxes, social security, and insurance.
A self-employed worker, however, might be an independent contractor or they might be a merchant, for example, who doesn’t work according to a contract but rather sells goods or services.
Someone who is self-employed is usually hired by a company to carry out a certain service. They work for themselves in a variety of occupations or trades rather than working for a certain employer. They may be involved in variety of occupations, but they are highly skilled at their particular work. Examples of self-employed individuals are lawyers, traders/investors, insurance agents, salespeople, and doctors.
So how can an independent contractor be a sole proprietor too? Independent contractors and sole proprietors are considered business owners. They both need to keep track of their income and expenses, both need to file income taxes, and both need to pay self-employment taxes.
Is a business entity needed?
Choosing to incorporate as a business entity is often optional, but it can provide benefits to a self-employed person or to someone working as an independent contractor. Contrary to popular belief, the tax treatment for business-related expenses often isn’t different whether the contractor is self-employed or incorporated as a business entity. Business-related expenses can usually be deducted either way, although the tax treatment may vary depending on the type of deduction and the type of business entity you choose.
Among the most important distinctions is that by forming a business you establish a separate legal entity for your business. This can help protect your personal assets from business-related liabilities that can arise from claims or lawsuits.
If you're launching a new business, you might want to consider becoming an LLC (Limited Liability Company). An LLC provides not only a formal business structure, but also protection as well. If you don't form an LLC the following could happen:
- You leave your personal finances vulnerable especially when you encounter business-related problems. Everything you own is at risk.
- You lack formal structure, thus crippling your business operations. Many businesses don't think about the responsibilities, profits, losses, or what would happen if someone leaves, but these things will come up eventually. Your LLC operating agreement will set up the framework and the rules, therefore you’ll have a solid business structure that can protect your business later on.
- It’s difficult to borrow or raise money. Investors will instantly reject your business proposal when they discover that you're not an LLC business, and banks are very unlikely to trust giving you a loan. Or if they do, it would be at a much higher interest rate.
- Being an LLC means that you have a unique name that is unique to your business and nobody would be able to use the name except your business. Your business needs a unique name to set yourself apart from the rest.
It is possible not to have a business entity, but the benefits outweigh the hassles of becoming an LLC.
What are the licensing requirements?
State or local licensing may be required depending on the type of work you do but this requirement isn’t usually affected by whether you are self-employed, an independent contractor, an employee, or have incorporated your business. In the insurance industry, for example, states require anyone who binds coverage to be licensed for the state, regardless of whether they work for themselves or for someone else.
According to Small Business Administration, a self-employed individual needs a license but this still depends on the state. In Washington, for example, all persons who conduct business are required to have a license, while other states require only certain professionals like doctors, teachers, or attorneys to have a license. If you want to know if being self-employed in your state requires a license to operate, you should contact your state representative's office. You can also find this information on the state government website.
Local regulations differ from licensing regulations. You can contact the county clerk's office to find out if a self-employed individual needs to register the business locally.
What types of insurance do I need?
As a self-employed person or an independent contractor, your insurance needs will vary based on the type of work you do, what equipment you have, and the types of risks your business might have. Certain types of insurance may be required by law, such as Commercial Auto Insurance or Workers Compensation coverage, while other types of insurance may be required to fulfill contract requirements, like General Liability Insurance . Even if required by an outside entity or as part of a contract like a lease, the insurance you purchase for your business will protect the business you are working to build and can also help protect your personal assets from certain business risks.
Commercial General Liability insurance protects your small business from liability claims of bodily injury, property damage, libel, slander, advertising mistakes, and related liability risks.
If you drive a car for business purposes , then you'll need Commercial Auto insurance. Commercial Auto insurance covers your vehicle from physical damage if it gets involved in a vehicular accident and also covers the personal injuries of the driver and other involved parties.
Whether you operate from a home office or you have a dedicated office, you'll need Commercial Property Insurance. Commercial Property covers your property from perils such as theft, fire, vandalism, and natural disaster.
If you're still unsure about what insurance you need for your business, a Business Owners Policy bundles Commercial Property Insurance and General Liability insurance into one convenient package.
Special tax considerations
As a self-employed individual, you are responsible for paying your own FICA taxes. In an employer/employee arrangement, the employer pays half of your FICA taxes while you pay the other half as a payroll deduction. If there is no employer, you are responsible for the entire FICA tax liability. Additionally, most employers automatically deduct federal and state taxes according to the W-4 you complete when hired. If you are self-employed, there are usually no taxes taken out of your compensation and you are responsible for making quarterly payments based on an estimate of your tax liability.
- A self-employment tax consists of Social Security and Medical taxes. It is similar to the taxes taken from most wage earners.
- As a self-employed individual, you figure out your self-employment tax (SE tax) on your own using Schedule SE or Form 1040. You can deduct an equivalent portion of your SE tax to figure out your adjusted gross income.
- The self-employed tax rate is 15.3%. This rate consists of two parts: 12.4% for social security and 2.9% for medical insurance.
- It is possible to deduct the employer-equivalent portion of your self-employment tax when finding out your adjusted gross income. This deduction only affects your income tax and not the earnings from your self-employment tax. If you file a Form 1030 Schedule C, you can claim the Earned Income Tax Credit (EITC).
- Under section 2042 of the Small Business Jobs Act, self-employed individuals are also eligible for tax deductions for the cost of health insurance.