What Is an Independent Contractor?

An independent contractor is a self-employed person or entity contracted to perform work for—or provide services to—another entity as a nonemployee. As a result, independent contractors must pay their own Social Security and Medicare taxes. In addition, an entity that uses the services of an independent contractor is not required to provide them with employment benefits, such as health insurance and employer-sponsored retirement accounts, that the entity might otherwise provide were the contractor an employee. The payer must correctly classify each payee as either an independent contractor or employee. Another term for an independent contractor is “freelancer.”

Key Takeaways

  • Independent contractors are not employees, nor are they eligible for employee benefits.
  • They do not have taxes withheld from their paychecks but instead must pay estimated income taxes in advance through quarterly payments.
  • Freelancers can reduce their gross income through the use of allowed business deductions, thus lowering their tax bill.

Understanding Independent Contractors

Doctors, dentists, veterinarians, lawyers, and many other professionals who provide independent services are classified as independent contractors by the Internal Revenue Service (IRS). However, the category also includes contractors, subcontractors, writers, software designers, auctioneers, actors, musicians, and many others who provide independent services to the general public. Independent contractors have become increasingly prevalent in the rise of what has been dubbed the “gig economy.”

Independent contractors must keep track of their earnings and include every payment received from clients. Clients are legally obliged to issue 1099-MISC forms to their contractors if the amount they paid warrants that expense. If an independent contractor earns more than $599 from a single payer, that payer is required to issue the contractor a 1099 form detailing their earnings for the year.

Independent contractors must decide how much freedom they need versus how much risk they are willing to assume.

How to Pay Taxes as an Independent Contractor

In the United States independent contractors are considered sole proprietors or single member limited liability companies (LLCs). They must report all their income and expenses on Schedule C of Form 1040 or Schedule E if they have profits or losses from rental properties. Further, they must submit self-employment taxes to the IRS, usually on a quarterly basis, using Form 1040-ES.

However, as sole proprietors, independent contractors do not necessarily pay taxes on their gross earnings. Applicable business expenses can reduce their overall tax obligation. The difference between gross earnings and business expenses is the net income, the amount on which taxes are due.

For tax year 2020 independent contractors pay 12.4% in Social Security contributions on the first $137,700 of their net income (in 2021, it's the first $142,800 of net income) and 2.9% in Medicare taxes on all net income. Single filers must pay an additional 0.9% Medicare tax on self-employment income that exceeds $200,000 ($250,000 for married couples filing jointly). Some independent contractors may also have to pay state sales taxes, depending on the product they are producing.

Pros
  • Independent contractors can set their own hours and choose their own work.

  • They are not limited by an annual salary as to how much money they can earn.

  • Often they can save money by working from home.

Cons
  • Independent contractors are responsible for all of their business expenses.

  • They must fund their own healthcare.

  • They aren’t eligible for unemployment insurance or workers’ compensation.

The Pros and Cons of Being an Independent Contractor

The pros of being an independent contract generally relate to the greater freedom they enjoy. They can set their own hours, pursue work that they love, and decide what work they will and will not accept. Those who can work from home may save money on both transportation and the wardrobe needed to work in an office. They may also get the home office tax deduction that allows them to deduct the business portion of their bills for such things as insurance, rent, repairs, security systems, and utilities and services.

They have complete control over building their business, from hiring and firing to choosing clients. Unlike employees who have a set annual salary, there's no limit on how much money they can earn. Finally, they can enjoy the sense of pride and accomplishment in building a successful business enterprise that belongs to no one but them.

The cons of being an independent contractor are related to the risk involved. They aren’t supported by a regular salary when business is bad. They are responsible for all business costs—no reimbursable expense reports for them—and if working alone, they lack the support and camaraderie of coworkers.

Independent contractors are not eligible for employer-provided healthcare plans, so they must completely fund their own healthcare. They must also pay both the employee and the employer parts of Social Security and Medicare taxes. They are not eligible for employer-sponsored 401(k) plans or for matching contributions from those who employ them. While they do have access to some alternative retirement plans, such as a SEP IRA, SIMPLE IRA, and solo 401(k), they must fund these all by themselves, and they have no access to unemployment insurance or workers’ compensation payments.