Legal

What's the difference between an independent contractor and a sole proprietor and does it matter when hiring?

Learn how to distinguish between the two.
October 4, 2021
Oyster Team
What's the difference between an independent contractor and a sole proprietor and does it matter when hiring?

In just the United States alone, tax authorities consider both independent contractors and sole proprietors as self-employed, yet both can be treated differently tax-wise.

So, when tapping into a workforce of almost 16 million self-employed Americans—not including the global workforce—it is imperative to turn in the correct tax documentation and avoid costly legal complications later down the road.

In this article, you’ll learn what is the difference between an independent contractor and a sole proprietor and when the distinction matters when hiring.

What is an independent contractor?

In short, an independent contractor is a person who provides services on an hourly or per project basis, as determined by the contract.

(Important side note: They’re not employees, and actually misclassifying employees as contractors can land your company in a lot of trouble.) 

Independent contractors have control over how and when they work to fulfill the terms of the contract, using their own tools and resources as necessary. They also pay their taxes and benefits. 

For example, let’s say your company hires a copywriter to write a white paper, and the contract lasts 3 weeks. This freelance copywriter is acting as an independent contractor by providing a service to your company. The copywriter has control over how they execute on the deliverable, to be turned in at the agreed time. 

How to handle taxes with an independent contractor

For reference, the US Internal Revenue Service (IRS) considers independent contractors to be self-employed. Thus, contractors pay both employer and employee taxes. 

This means that when your company hires an independent contractor, you don’t withhold payroll taxes. They pay their own (income, Social Security, Medicare, and unemployment taxes).

Quote that says the IRS considers independent contractors to be self-employed, meaning they both pay both employer and employee taxes

Unemployment insurance—and other benefits—are also paid by the contractor.

To pay taxes, contractors collect a Form 1099-NEC from clients who have paid them over $600 in the last fiscal year. The contractor submits these forms to the IRS. Then, they need to file self-employment taxes using Form 1040-ES. 

(Recently, the IRS reintroduced Form 1099-NEC for independent contractors instead of box 7 on Form 1099-MISC which had been in use. Box 7 on Form 1099-MISC will report on product sales worth $5,000 or more.)

To reiterate, the above example covers just the US’ specific tax laws for independent contractors. These laws vary from country to country.

Check our Global Hiring Guides to learn about local employment regulations and employer/employee taxes in over 50 countries.

What is a sole proprietor?

In the US, a sole proprietor is a person who owns and runs an unincorporated company. 

Because the owner and the business are one legal entity in the eyes of the law, the sole proprietor earns all profits the business accrues, and they are responsible for all debts as well. 

Let’s solidify this concept with an example. 

Imagine a developer builds a mobile app and sells it on different app stores, like Android’s Google Play and Apple’s App Store. 

If the app is a flop, and users don’t purchase it, as the sole proprietor, the developer loses money and bears the loss. On the other hand, if the app is a success, the developer earns income. 

In the US, sole proprietors can use their own names as the name of their business. They can also use a trade name, which requires registering the name with local authorities. Business owners can also use their social security number as the Employer Identification Number (EIN).

How to handle taxes with a sole proprietor

A sole proprietor’s personal and business incomes are the same in the US, and the sole proprietor is directly responsible for filling the Schedule C Form 1040 to report profit and losses from business activities. 

Similar to hiring independent contractors, you don’t pay the employer’s share of taxes. Sole proprietors in the US fill Schedule SE Form 1040 to file their own self-employment taxes. 

You have to remit Form 1099-NEC if you’ve paid the sole proprietor over $600 in the last fiscal year. 

How the difference between an independent contractor and sole proprietor matters when hiring

The difference between independent contractors and sole proprietors matters when hiring. Depending on if a service is provided or a product is purchased, tax documentation varies.

Let’s go over both situations: 

When a service is provided

If you’re a US company hiring a national independent contractor or sole proprietor to fulfill contracted work, you’ll fill out Form 1099-NEC, which you’ll provide a copy of to the worker. Said worker then files their own paperwork—and pays their own taxes—to the IRS. 

Your company should also request Form W-9 (Request for Taxpayer Identification Number) from the worker. If they live outside the US, ask for them to fill out Form W-8BEN.

Going with an example here, this would be the case if your company hires a graphic designer to redo your logo for your company. 

While the graphic designer could be incorporated as a sole proprietor, their business relationship with your company is that of an independent contractor. Therefore, your company fills out Form 1099-NEC and returns it to the worker. 

When products are sold to you

On the other hand, if a US worker sells products to your company—instead of fulfilling contracted work—then your obligation is only to pay for the products delivered. 

Returning to the graphic designer example, if your company buys customized team shirts from the designer online, your company pays for the products and reports it accordingly as a business expense.

Your company does not need to emit any further tax documentation for the purchase of the goods. 

Key takeaways

When hiring independent contractors and sole proprietors in the US, you don’t need to pay their taxes (they both pay employer and employee shares), but you do need to emit 1099s if they have earned more than $600 from you for that tax year. 

A key difference comes into play when the business owner is selling products, rather than providing services, to your company. In which case, you pay them for the products delivered, and that’s it. 

Nevertheless, when it comes to international hiring, employment regulations and taxes vary. So, it’s important you have a thorough understanding of each country’s regulations, and always seek an expert’s help before proceeding.

If you’re concerned about documentation needed to compliantly hire international talent, you can use Oyster for handling everything from hiring to payroll.

Disclaimer: This blog and all information in it is provided for general informational purposes only. It does not, and is not intended to, constitute legal or tax advice. You should consult with a qualified legal or tax professional for advice regarding any legal or tax matter and prior to acting (or refraining from acting) on the basis of any information provided on this website.

About Oyster

Oyster is a distributed HR platform designed to enable visionary HR leaders to find, hire, pay, manage, develop and take care of a thriving distributed workforce. It lets growing companies give valued international team members the experience they deserve, without the usual headaches or the expense.

Oyster enables hiring anywhere in the world—with reliable, compliant payroll as well as great local benefits and perks.

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