Independent Contractor: Definition, How Taxes Work, and Example

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 non-employee. 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 may otherwise provide to its employees. The payer must correctly classify each payee as either an independent contractor or an 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 bills.
  • Independent contractors must arrange for their own insurance and retirement.
  • The category for independent contractors is very broad.

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 $600 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 every quarter, 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, on which taxes are due.

For the tax year 2022, independent contractors pay 12.4% in Social Security contributions on the first $147,000 ($160,200 in 2023) 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 need to pay state sales taxes for producing products, but it can depend on the type of product being made.

Pros and Cons of Being an Independent Contractor

The pros of being an independent contractor generally relate to the greater freedom they enjoy. They can set their hours, pursue work they love, and decide what work they will and will not accept. Those who can work from home may save money on 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 a 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 of going bankrupt and the opportunity cost of a regular career. They aren't supported by a regular salary when business is terrible, and their income is unpredictable and highly volatile month over and year over year.

This income fluctuation undermines them vis-a-vis banks and lenders for mortgages, car loans, and other types of loans. 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 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 matching contributions from those who employ them.

  • 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.

  • 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.

Example of an Independent Contractor

One example of an independent contractor would be an interior designer who works for themselves and has a roster of clients who hire them to decorate their homes. The interior designer might even work on a contract for an architecture firm that employs them to work closely with their clients throughout the building process of a new home.

While they have access to 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.

The designer, an independent contractor, would work out how many hours, payment, and ideas with the architects (who they are contracted to work with) on the project but might work closely with the client during the decorating process. At the same time, the interior designer might be working for other clients and working on various homes simultaneously, versus being an in-house designer and only working for clients of the architecture firm.

How Do You Become an Independent Contractor?

You can become an independent contractor by working for yourself. Many freelancers in a gig-centric economy transition to independent contractors who work on a contractual basis to provide goods or services. Independent contractors may have a registered legal business name, earn any necessary certifications or licenses, and pay their estimated taxes quarterly to the IRS.

What Is the Difference Between an Independent Contractor and Self-Employed?

An independent contractor is the same thing as being a self-employed worker. An independent contractor could be a dentist who owns their own business, for example, which would be different than someone who knits hats and occasionally sells them at holiday fairs, which would be more like a freelancer, as they usually provide a good or service on a contractual basis.

How Do You Fill out a W9 as an Independent Contractor?

If you are an independent contractor and hired by a company or person to perform a service, chances are they will ask you to fill out a W-9 form. You must verify information, including name, address, and tax identification number. All the pages of the W-9 are available on the IRS website, which also provides step-by-step directions on how to fill it out.

How Do You Fill out a 1099-MISC Form for an Independent Contractor?

Form 1099-MISC is available on the IRS website for anyone who needs it. There are 18 boxes to fill out on the form, plus you must include the payee's name, address, a tax identification number for both the payee and recipient, plus the recipient's name and address. In addition, the IRS provides step-by-step instructions on how to fill it out.

How Do You Pay an Independent Contractor?

You pay an independent contractor just like you would pay any freelancer either by the hour, by the project, or by a flat fee. You can pay an independent contractor by check, Venmo, PayPal, or cash.

The Bottom Line

Working as an independent contractor can be a great way to earn a living for people who desire flexibility, don't mind inconsistent earnings, and who can manage their time while potentially juggling multiple clients.

In addition, independent contractors must be comfortable with filing their taxes quarterly with the IRS and paying for their own insurance, plus retirement savings. For some, the freedom to choose projects, and the flexibility of working for themselves, make the challenges worth it.

Article Sources
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  1. Internal Revenue Service. "Independent Contractor Defined."

  2. Internal Revenue Service. "Reporting Payments to Independent Contractors."

  3. Internal Revenue Service. "Instructions for Schedule E," Page 1.

  4. Internal Revenue Service. "Instructions for Schedule C," Page 1.

  5. Internal Revenue Service. "Form 1040-ES," Page 1.

  6. Social Security Administration. "Contribution and Benefit Base."

  7. Internal Revenue Service. "Self-Employment Tax (Social Security and Medicare Taxes)."

  8. Internal Revenue Service. "Questions and Answers for the Additional Medicare Tax," Select "When are individuals liable for Additional Medicare Tax?"

  9. Internal Revenue Service. "Here's What Taxpayers Need to Know About the Home Office Deduction."

  10. Internal Revenue Service. "Retirement Plans for Self-Employed People."

  11. U.S. Department of Labor. "Chapter 1, Coverage: In General," Page 11.

  12. The Hartford. "Workers’ Compensation for Self-Employed & Independent Contractors."

  13. Internal Revenue Service. "About Form W-9, Request for Taxpayer Identification Number and Certification."

  14. Internal Revenue Service. "Form 1099-MISC; Miscellaneous Income."

  15. Internal Revenue Service. "Instructions for Forms 1099-MISC and 1099-NEC."

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