Contractors vs sole proprietor: Understanding the difference

Self-employment has become a popular model in recent years, as it offers greater flexibility than full-time or even part-time employment. Self-employed individuals are free to negotiate payment, decide on their work timings, and even choose the kind of projects they will be working on. 

When discussing self-employment, two terms are frequently used: sole proprietor and independent contractor. Both of these business models enable an individual to operate a business and provide their services independently, but there are several notable differences. 

In this article, we will discuss the main differences between sole proprietorship vs independent contractor, including their definitions, business structure, and tax responsibilities.

Who is a sole proprietor?

According to the Internal Revenue Service, a sole proprietor is someone who owns an unincorporated business by themselves. The owner is entitled to all profits, but is also responsible for the losses, liabilities, and debts of their business. It has been a popular choice among small businesses. 

They usually start as sole proprietorships and either remain that way or expand their operations, transitioning into what we call a limited liability corporation. 

Pros	Cons
Complete autonomy in making business decisions.	It can often get difficult to raise a vast amount of capital.
A greater feeling of pride and satisfaction than most other business models.	It’s harder to sell or hand down the business to someone else in the event of the death of the owner.
Complete ownership of all profits arising from business operations.	All debts and obligations rest with the proprietor.

Who is an independent contractor?

Moving on, an independent contractor can be defined as an individual who is engaged in an independent trade, business, or profession, offering services on a contract basis. 

According to the IRS, the best way to differentiate between an employee and an independent contractor is to find out if the person for whom the services are performed has the right to control/direct only the result of the work, and not what will be done and how it will be done. 

Pros	Cons
Contract workers generally earn more than employees.	Independent contractors are required to withhold their own federal, state, and local taxes.
Independent contractors have greater control over the work they accept.	Independent contractors typically do not receive benefits such as health insurance, retirement plans, or paid time off.
Independent contractors can diversify their income sources.	Unpredictable contract durations and payment schedules.

Sole proprietor vs independent contractor: what’s the difference?

Both sole proprietors and independent contractors are not considered employees, meaning they do not work for a specific employer and do not receive monthly wages or salaries. Instead, these individuals earn their income by contracting and providing goods and services to multiple clients. 

But when it comes to filing taxes or personal liabilities, there are a few significant differences.

1. Tax responsibilities

Independent contractors are required to report their payments on Form 1099-NEC, Nonemployee Compensation. It typically includes the details of the contractor’s income, similar to an employee’s W-2 form, and is provided by the clients. 

Sole proprietors, on the other hand, are not required to report their payments on Form 1099-NEC. Instead, they track their business expenses and file their taxes. 

But, both independent contractors and sole proprietors are required to file for the SE (self-employment) tax through Schedule SE (Form 1040). 

It consists of Social Security (12.4%) and Medicare taxes (2.9%). Furthermore, an additional Medicare tax of 0.9% is levied on individuals whose self-employment income exceeds a certain threshold. 

Filing status	Threshold amount
Married individual filing a joint return	$250,000
Married individual filing a separate return	$125,000
All others	$200,000

2. Personal liabilities

As already mentioned above, in a sole proprietorship, there is legally no distinction between the owner and the business. 

The business is essentially an extension of the owner’s brand. This means that the owner will be liable for all the business debts and obligations. 

If the business incurs a debt or if it faces litigation for unsatisfactory work, the personal assets of the sole proprietor will be at risk.

But this is not usually the case with independent contractors. They often have lower risk exposure.  This is because most of these individuals typically operate under a separate legal entity, such as an LLC or an S corporation, meaning their assets, including their home, car, or bank accounts, are better protected from business debts and liabilities. 

Even if the business is sued, creditors can only pursue the company’s assets, not the personal assets of its owners.

3. Business model

Independent contractors typically work under formal agreements with their clients that outline the type of work they are required to perform, how they will complete the job, and the compensation they will receive. These agreements are legally binding documents that form the foundation of the professional relationship. 

While independent contractors enjoy some autonomy, they are still required to adhere to client-based guidelines. In some instances, they may also be required to follow a specific schedule until the work is completed. 

Sole proprietors, on the other hand, do not typically follow a contract. They run their own business, offering products and services directly to clients based on their needs. They generate income through direct sales and client orders, and get to enjoy more autonomy in business operations. 

Manage contractors with Payoneer Workforce Management

Payoneer Workforce Management is a comprehensive workforce management platform that offers support to onboard employees and independent contractors from over 160+ countries, while helping you stay compliant. Some of our many offerings include,

• Global contractor payments in 70 currencies
• Support to mitigate misclassification risks
• Assistance with creating compliant independent contractor agreements

Ready to get started? Talk to us today!

FAQs

1) Is a freelancer the same as a sole proprietor?

Freelancers are typically considered to be sole proprietors, unless they establish a different business structure, such as an LLC or corporation.

2) What are the disadvantages of sole proprietorship?

Unlike independent contractors, sole proprietors have unlimited liability for debts, since there is essentially no legal distinction between private and business assets. Furthermore, sole proprietors often face difficulties in raising capital from external sources.

3) What type of business is best for a sole proprietorship?

Consultants, bakeries, personal trainers, and photographers are some of the most common sole proprietorship businesses.