What Is an Independent Contractor?

Benefits and Drawbacks of Being an Independent Contractor

Being an Independent Contractor
••• JGI/Tom Grill

It's fairly easy to get confused about the difference between being an independent contractor or an employee. Each type of work has its pros and cons, and your personality might be better suited to one style of working over the other.

After working as an employee, you may decide to leave and call your own shots as an independent contractor. You'll be managing your own business, from finding the clients, to doing the work, to producing an invoice for payment.

In some cases, though, your employer might have reasons it needs or wants to reduce its employee headcount, and it gives you the choice to work from home, with the caveat that the company will change your employment status to working as an independent contractor.

Regardless of the reason, understanding some of the main pros and cons of working independently can help you decide whether the move makes the best sense for you and your family.

What Does it Mean to Be an Independent Contractor?

An independent contractor is an individual in business for themselves, providing goods or services to another individual or business. 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. 

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.

Self-Employment: Reaping the Benefits

1. Being Independent: It sounds obvious, but that's probably why you are considering this change. As an independent contractor, you don't have to work for someone else. You may be able to 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 time sheet if you are working on an hourly rate. 

2. No Tax Withholding: 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, nor will FICA taxes (Social Security and Medicare taxes) be withheld either. However, you must instead pay these taxes on your personal income tax return. 

3. Getting a Contract: 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 for which you work. Having a contract spells out "what happens when." For example, it defines when the contract is over, what happens if one party wants out, and what if one party can't fulfill its obligations. Having a contract can settle many disputes before they start, and you can take a contract to court to get paid, if necessary.

 

4. Deducting business expenses: 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 (Schedule C) to take the deductions, but it's worth it to minimize your income and your income tax liability.  

Consider the Drawbacks

1. No Guarantee of Income: 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 in case your clients don't have immediate work for you to do.

2. Paying Business Expenses: If you work for someone else, they provide the office and the 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. For example, meal and entertainment expenses are only deductible at 50 percent of the amount. If you work from home, you can save money on some of these expenses. 

3. No Benefit Plans: One of the main reasons people stay as employees is to have employee benefits, like health care, 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 100 percent of the cost yourself. That's a tough decision to make. You can find health care coverage for self-employed individuals, including Obamacare. 

4. You Still Must Pay Taxes: 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 (in this case, they're called self-employment taxes). 

Since no taxes have been withheld from your payments, you must pay these taxes by the tax deadline (April 15), along with your personal income tax return. If you haven't paid enough taxes during the year, you might need to make estimated tax payments throughout the year. Read more about how to pay taxes as an independent contractor.

Benefits for Both Employees and Independent Contractors

Employees and self-employed individuals can both contribute to retirement savings accounts. Employees can contribute through their employers, and if you are an independent contractor, you can find a retirement savings plan such as a SEP-IRA that fits your needs. 

Talk to your tax and legal advisors before becoming an independent contractor. Before you make that leap to leaving employee status, discuss the benefits and drawbacks and all issues with your tax and legal advisors.