Key Takeaways
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 vs 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.
Independent Contractor vs 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’ on 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 designation, 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. This feature of an S corp 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 the business owner. This simplicity usually transfers through to tax filings. However, there are significant downsides to going down the sole proprietor route. Most significantly, the business owners have 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:
- High Personal Tax Rates
- In most countries, personal income tax rates are progressive, whereas company/corporate tax rates are static. This means that the as the profitability of the business increases, a sole proprietor will pay a higher and higher proportion of its revenue in income taxes.
- As a business becomes more profitable, incorporation usually makes sense.
- Deductions
- In many cases, deductions are only available to businesses that have incorporated. For example, environmental or research & development (R&D) tax credits are often only available to incorporated bodies.
- Restructuring Options
- Incorporated entities may provide for a range of restructuring options to better manage business finances. For example, it may be possible to place assets in a ‘holding’ company, which provides a degree of protection for those assets.
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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
- Trading Trusts
- In some countries, such as Australia and New Zealand, a trust is a very common business structure. A trust is a legal relationship where one person (the trustee) is the legal owner of assets, but holds them for the benefit of others (beneficiaries). A trading trust can be operated in conjunction with a sole proprietorship (in which case the sole proprietor is the trustee of a trust), or an LLC (in which case the LLC is itself the trustee). As trading trusts are generally ‘discretionary’, the trustee or trustees decide entirely for themselves how the trust income is to be distributed to beneficiaries.
- In some jurisdictions, trading trusts have major tax advantages (as beneficiaries can receive income at lower marginal personal income tax rates, rather than the full corporate rate). They can also be a useful asset protection mechanism (as the assets are ‘held on trust’ for the beneficiaries and are not generally available to creditors in the case of insolvency).
- C Corporation
- Besides an LLC, the next most popular form of incorporated body in the United States is the ‘C corporation’. Unlike the LLC, this business structure allows profits to be retained in the business rather than distributed to the owners.
- Perhaps confusingly, a C corp can also be designated an ‘S corp’ for taxation purposes.
- Partnership
- In this business structure, several individuals act together according to the details of a partnership agreement: The partners share in the profits of the enterprise, and in a general partnership (as is common in the UK) can be jointly and severally liable for the debts of the enterprises. A Limited Liability Partnership (LLP), as is common in the US, means that partners are not liable for the debts of the enterprise.
- A key disadvantage of a partnership for many is that, like a sole proprietorship, individuals are taxed according to personal income tax rates.
What is an Independent Contractor?
An independent contractor is hired by a business to provide services, and is 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 are 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:
- A description of the services to be performed;
- How payment will work;
- Liabilities and warranties;
- How the contract will come to an end, and any provision for cancellation or damages.
Importantly, the contract for services usually does not include the following:
- A description of exactly how the services should be performed, such as set hours of work and compulsory tools;
- Provision for employee benefits, annual leave, sick leave and tax withholding.
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
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.
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.
Not necessarily. In the United States, business owners that structure themselves as an LLC may count as self-employed and be required to pay self-employment taxes.
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 Horizons, 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.
