What Is an Independent Contractor?
Definition & Examples of an Independent Contractor
An independent contractor is an individual in business for themselves, providing goods or services to another individual or business. There are differences between an independent contractor and an employee and each type of work has its pros and cons. Your personality might be better suited to one style of working over the other.
What Is an Independent Contractor?
An independent contractor is someone who is contracted to perform a service for another business as a nonemployee. Generally, an independent contractor has direction over the work being done, and an employer can't control how it's done—only the expected results.
The IRS has established specific tests to determine whether a worker fits the description of an independent contractor or an employee, which factors into how the individual and the employer, if applicable, need to handle taxes on wages or contractor payments.
How Independent Contractors Work
The independent contractor is a separate business entity and is not considered an employee. Independent contractors can work in a variety of roles, such as consultants, agents, or brokers. Others might be creative professionals or technical/IT types.
Most employees don't have a written employment contract unless they work under a union contract or are highly-paid executives, but an independent contractor should always have a contract. It's a good idea to get a written contract from each person or business you work for because it defines when the work period is over, what happens if one party wants out, and what happens if one party can't fulfill its obligations. A contract can settle many disputes before they start, and you can take a contract to court to get paid, if necessary.
Benefits of Independent Contractors
There are major benefits to being an independent contractor, including the following:
- Being independent
- No tax withholding
- Business expense deductions
For many people, the main reason to consider becoming an independent contractor is the freedom that it can present. As an independent contractor, you don't have to work for someone else; you may set your own hours and complete work assignments whenever you choose, depending on the type of job. You should be able to negotiate pay rates and a payment schedule, but you may still have to keep a timesheet if you are working on an hourly rate.
Some people consider it a benefit that the payments you receive as an independent contractor don't have any federal or state income tax withheld, or any FICA taxes (Social Security and Medicare taxes). However, you must instead pay these taxes on your personal income tax return, and since you won't have an employer to share FICA taxes with you, you will have to pay a self-employment tax.
All the expenses you must pay to run your independent contractor business are deductible to you as business expenses. That includes business travel and the costs involved with having a home-based business. You'll have to file a business tax return to take the deductions, but it's worth it to minimize your income and income tax liability.
Disadvantages of Independent Contractors
There are some significant negatives to working as an independent contractor, especially regarding financial stability and a lack of benefits. Some drawbacks include:
- No guaranteed income
- Business expenses
- No benefits plans
Being independent also means you don't get a regular paycheck. If you are lucky enough to work for one or more clients who pay you regularly, that's great, but the money can stop at any time, even if you have a contract. If there's no work for you to do, there's no money. It's important to have savings to tide you over if your clients don't have immediate work for you to do.
The initial business expenses can also be a turnoff. If you work for someone else, they typically provide the office, computer, and everything else that goes with it. While you can deduct these expenses, you still must have the money to pay for them first. Some business expenses may not be deductible, and some might be deductible on a limited basis.
One of the main reasons people stay as employees is to have employee benefits, like healthcare, paid for by their employers. If you need health insurance, you can get it if you work independently, but you will have to pay for it yourself—which can be quite costly.
As an independent contractor, you will need to declare all the income from your work on your tax forms, and you must pay taxes on that income. In addition to paying federal and state income taxes, you must also pay those Social Security and Medicare taxes.
If you're a contractor, the Social Security and Medicare taxes are called self-employment taxes.
Since no taxes have been withheld from your payments, you must pay these taxes by the tax deadline, along with your personal income tax return. You will need to make estimated tax payments throughout the year quarterly to avoid interest and penalties.
Independent Contractor vs. Employee
|Works for multiple clients||Typically works for one employer|
|Can set their own work hours||Company sets work hours|
|Decides how the job is done||Employers decide and monitor how the job is done|
|Not eligible for company-sponsored benefits||Eligible for employment benefits|
- Independent contractors are self-employed people who work for other people or businesses as nonemployees.
- Independent contractors must pay self-employment taxes.
- Independent contractors are responsible for making estimated tax payments quarterly.