How to Set Up an Independent Contractor Business

Independent Contractor working on mechanical drawing in their shop.
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Maybe you have taken a job as a contractor within the company where you used to be an employee. Or maybe you were hired as an independent contractor or freelancer to do work for a company. In any case, as a freelancer or independent contractor, you are not an employee. You are self-employed. Being an independent contractor seems easy, right? You just go to work and collect the money. But there are a few easy steps to making your business real. 

The Reality of Self-Employment

As an independent contractor, you will have income, probably in the form of a 1099-MISC, which you must pay taxes on. If you don't set yourself up as a business entity and start keeping a record of expenses so you can deduct them, you will have to pay tax on the entire amount of your income.

Since you don't have an employer to withhold federal and state income taxes from your income, so you will need to do your withholding. You must pay self-employment tax (Social Security and Medicare) on your income from self-employment. No one pays this for you, so you must plan to set aside this money (15.2 percent of your profits) to pay with your tax return.

Most importantly, you will have no one to pay your insurance (health insurance, liability protection), so you will have to pay it yourself or do without.

The Benefit of Setting up a Business Entity

If you set up a business entity such as a sole proprietorship, or better, a limited liability company, you can deduct legitimate business expenses to minimize your tax bill. You can also use the deductions to minimize your profit and lessen your self-employment tax burden.

You can use your business entity to purchase insurance and take the deductions for this expense, again minimizing your tax bill. Setting up an entity minimizes the chance that the IRS will say your business is just a hobby or deny your deductions.

You can set up simply as a sole proprietor, or you can go the next step and register as a limited liability company or other entity. In any case, taking your business to the next level by establishing a business entity separate from your personal finances is worth your time and trouble.

Now that we have that out of the way let's talk about starting your independent contractor business. First, understand that there are a lot of things you DON'T NEED to do when starting a business, like having employees and registering with your state. But there are three things you should do to start off right: 

Select and Register a Business Name

When you have selected a business name, don't rush out and buy business cards and stationery yet. First, check to be sure no one else is using that name. You may need to file a fictitious name (trade name or d/b/a) statement if your business name is different from the name of your company. Learn more about these steps in registering your business name here.

Once you have a business name, you can get a business location and begin to create all the marketing and promotion items you'll need, like a website, business cards, and advertising brochures. Your business name and address can also be used to apply for an Employer ID (tax ID) for your business. The Employer ID is necessary for most types of businesses, even if they don't have employees. 

Get a Business Checking Account

Getting a business checking account will help establish that separate business entity, so it is clear to the IRS - and anyone else who cares - that you and your business are separate entities. 

Once you have a business checking account, you can put money in as your own investment and begin paying for all the things you need to get started in your business. And of course, if you have money coming in you can put it into your business bank account to pay for startup costs. It's best to use a business account instead of a personal account so you don't get the payments and income confused. 

Set up a Simple Business Recordkeeping System

Capture the information you need to support your use of legitimate business deductions. Making sure you keep track of business income and expenses will help you know how your business is doing, and you will be able to deduct those expenses from your income at tax time. 

You should create a business startup budget to see what you'll need to spend to get started. Then, keeping records also means you can tell how your business is doing, by preparing and reviewing your business financial statements each month, including a profit and loss statement and balance sheet.