Independent Contractor: Definition & Overview

KEY TAKEAWAYS

• An independent contractor doesn’t work under an employer. They make their own schedule and don’t qualify for employee benefits.
• It’s essential to keep finances and taxes organized as an independent contractor.
• Independent contractors can be in a number of different industries. Artists, freelancers, drivers, designers and more fall under this category.

What Is an Independent Contractor?

An independent contractor is a person that is hired by a business or an individual that has the right to only control the work results but not when and how the work is accomplished. Independent contractors are always self-employed and are often referred to as “freelancers.”

Independent contractors do not receive employment benefits that come with a typical employer-employee relationship. For example, they aren’t eligible for employer-funded health insurance or employer-sponsored retirement accounts. Independent contractors are self-employed, so they are responsible for withholding their income taxes and paying their own Social Security and Medicare taxes.

Many freelance workers value the independence and flexibility their work status provides. These are the main reasons people choose to forgo the standard employee lifestyle. However, it also comes with risks like irregular pay and fewer benefits.

What’s the Difference Between an Independent Contractor and an Employee?

The IRS looks at the following criteria to determine whether a worker is an employee or an independent contractor.

• Behavioral Control

This refers to how much control an employer has over the worker. For example, do they give specific instructions on where, when, and how to do the work? Do they provide training? Do they supply the worker with tools and supplies? 

If the answer to these questions is yes, then the worker is likely an employee, not an independent contractor.

• Financial Control

This refers to the terms of payment. Is the worker prohibited from working for others at the same time? Is the worker paid a full-time employee salary? Is the worker directly tied to the economic performance of the company?

If the answer to these questions is yes, then the worker is likely an employee, not an independent contractor. 

• Type of Relationship

Another factor to consider is how the two parties conduct business with each other. Having a written contract and no benefits isn’t a sufficient reason to be automatically considered an independent contractor. Independent contractors also do not usually contribute directly to a company’s core activities. For example, an interior designer hired to renovate offices in a bank is not considered a bank employee. If a worker is hired for a definite time frame or a project, they would be considered an independent contractor.

 

Example of an Independent Contractor

Independent contractor is a broad term and can include various jobs. These may include:

• Artists
• Building contractors
• Doctors
• Drivers
• Designers
• Other freelancers 

For example, you are a copywriter who works from home. Do you write for several different clients, control how you carry out your work and you have a six month long contract with each of your clients? If so, you are considered an independent contractor. 

You have the flexibility to set your own rates and working hours. When you need a new computer or home office supplies, you will have to purchase those by yourself and can claim them as tax-deductible expenses.

Paying Taxes as an Independent Contractor

As an independent contractor in the United States, navigating tax deductions for independent contractors is essential due to specific tax requirements that differ from employees. 

You might be classified as a sole proprietor or a single-member limited liability company (LLC). This requires you to report all income and expenses on Schedule C of Form 1040. In addition, you must submit self-employment taxes every quarter by using Form 1040-ES.5. 

Independent contractors don’t have to pay taxes on gross earnings. You can deduct applicable business expenses from your overall tax obligation. To determine the amount of taxes due, find the difference between your gross earnings and business expenses.

For the 2022 tax year, independent contractors must pay 12.4% in Social Security contributions on the first $147,000 net income. This number will increase to $160,200 in 2023. 

In addition, there is a 2.9% Medicare tax on total net income up to $200,000 if filing single and $250,000 if filing married jointly. You will need to pay an extra 0.9% for any amount exceeding the two thresholds.

Advantages and Disadvantages of Being an Independent Contractor

Being an independent contractor comes with some advantages and disadvantages. These include:

Advantages

• Independence

Independent contractors enjoy a high degree of freedom that employees may lack. They can set their hours, work their own way in a field they love, and potentially work anywhere.

• Flexibility

Independent contractors get to choose which clients they want to work with. They hold the ultimate decision-making power and can hire or fire as they please. In addition, they can determine their own pricing structure based on billable hours, fixed fees per project, or other metrics.

• No Salary Limit

There’s no limit to what an independent contractor can make in a year. Contracted employees have a set salary. In contrast, independent contractors who work extra hours can increase their income potential.

• Business Expense Deductions

All the expenses that independent contractors pay to run their business are tax-deductible. This includes business activities like setting up a home office or travel expenses. Claiming business expense deductions requires filing a business tax return. Expenses can include insurance, utilities, rent, repairs, and other costs.

Disadvantages

• No Guarantee

While a flexible work situation can be good, it can also create unpredictability. Independent contractors don’t have a fixed salary to rely on when business gets slow. It can be challenging to handle all the different aspects of running a business independently.

• No Employee Benefits

Independent contractors don’t receive employee benefits like health insurance or employer-matched retirement accounts. If the business fails or they get injured on the job, there are no unemployment benefits or worker’s compensation benefits to fall back on.

• Business Expenses

Independent contractors must cover all business expenses on their own. Some of these expenses are tax-deductible. However, expenses require up-front payment.

Summary

Overall, independent contractors enjoy the flexibility of making their own schedule while doing work they’re passionate about. Unlike a salaried employee, there’s no cap on how much money you can make. The drawbacks might seem daunting since you’ll have to cover your own insurance, taxes and business expenses. With the right resources, you can quickly get those important factors under control.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.