Independent Contractor vs Sole Proprietor: Key Differences Explained

Are you considering starting on your own entrepreneurial journey? If that’s the case, then you’re probably familiar with the benefits beyond financial independence – from the autonomy of setting your own schedules to the flexibility of working with your own client base. 

However, before you take the leap, it’s important to understand the key differences between different categorisations, such as being an independent contractor vs sole proprietor. 

While these two roles may seem familiar at first glance, they carry a variety of differences that can significantly impact your business operations and decisions. In this guide, we explore the key differences between sole proprietors and independent contractors to help you make a more informed decision.

What is a sole proprietor?

A sole proprietor is the simplest form of business structure, where an individual operates their business under their own name. Sole proprietors are not registered as business entities like corporations and partnerships, but they’re considered a formal structure that serves for compliance and tax purposes. 

In the sole proprietorship setup, the owner is personally responsible for all aspects of the business, including its liabilities and debts. In simple terms, the business and the owner are not considered separate entities when it comes to legal requirements.

What is an independent contractor?

On the other hand, independent contractors are self-employed individuals who provide services to clients on a contractual basis. Unlike sole proprietors, independent contractors maintain a separate identity from their clients, which means they’re not part of a company and operate as a distinct entity. 

Independent contractors typically work on a project basis and are hired for their specialised skills or expertise. They have greater autonomy in how they perform their work, which also includes the freedom to set their own schedules, choose their clients, and enjoy a greater work-life balance.

Key differences between sole proprietors and independent contractors

Sole proprietors and independent contractors are both individuals who work for themselves. However, there are a few key differences between them in terms of how they earn their income, their tax filing responsibilities, and their relationships with clients and projects. 

1. Income earning

When it comes to income earning, sole proprietors own, operate, and are fully responsible for their businesses. They may offer services or products directly to customers and are responsible for managing all aspects of their business, such as marketing, sales, and operations. Sole proprietors earn their income from the profits generated by their business activities.

Independent contractors, on the other hand, are individuals who are hired by businesses and other individuals to perform specific projects or tasks. Hence, they’re typically hired on a temporary or project basis to provide services such as writing, consulting, or graphic design and earn their income by invoicing clients.

2. Tax filing

Tax filing responsibilities for sole proprietors and independent contractors can vary significantly from one country to another, and it’s very important for these individuals to understand the tax laws and requirements in their own country.

For instance, sole proprietors are responsible for reporting their business income and expenses on their personal tax returns using Schedule C in the US and other equivalent tax forms in European countries, along with their regular income. They must also pay self-employment taxes, including social security and medicare, on their business income.

Independent contractors are also responsible for reporting all income earned from their work on their personal tax returns. The reporting is usually done annually, requiring standard tax forms for individuals, such as Form 1040 in the US. The specific forms and schedules for independent contractor tax filing may differ among countries, all requiring accurate reports on their total income from all sources.

3. Relationships with clients and projects

Sole proprietors and independent contractors manage project and client relationships differently. Starting from sole proprietors, they have more control and direction over their business management and have responsibilities such as finding and maintaining client relationships, managing projects, and delivering services or products. Although they may hire employees or contractors to assist with their work, they’re ultimately responsible for the success of their business. 

On the other hand, independent contractors work on a contract basis for clients, often for specific projects or periods of time. Compared to sole proprietors, they have less control over the overall direction of the project, as they’re typically hired to complete specific tasks. However, independent contractors enjoy the flexibility of working with multiple clients at the same time, and they have more control over their schedules and workloads.

Tax implications

While both sole proprietors and independent contractors enjoy greater autonomy and work flexibility, understanding tax implications is crucial for keeping up compliance. In this section, we explore the key tax responsibilities and their impact on the separate classifications.

1. Income reporting

As their name suggests, sole proprietors are single-handedly responsible for their business operations, including income reporting. This includes detailed reports of all their business income and expenses on tax returns. Sole proprietors are using forms such as Schedule C and its equivalents to report taxes. 

The income reporting procedure is similar for independent contractors, as they’re also responsible for reporting all of the income they receive on their personal tax returns. However, independent contractors may receive FORM 1099-MISC from their clients, which adds an extra layer of documentation to their income reporting. 

2. Self-employment taxes

Self-employment taxes look familiar for both sole proprietors and independent contractors. As sole proprietors are a separate business structure, and independent contractors are not regularly employed by a company, they’re both responsible for covering self-employment taxes.

In other words, both sole proprietors and independent contractors are paying both the employer and the employee portions of social security and medicare taxes. However, when it comes to sole proprietors, the tax is based on their net business income, while in the case of independent contractors on their net self-employment income. 

3. Tax filing processes

Filing tax returns typically occur on an annual base for both sole proprietors and independent contractors. However, sole proprietors are responsible for filing both their personal and business earnings, as they’re not classified as a separate entity from their business. Personal income for sole proprietors includes wages, investment income, and others, while business income includes the profit made from their sole proprietorship.

When it comes to independent contractors, they detail their self-employment income and expenses using specialised tax forms. This includes income earned from various clients or projects and other sources of self-employment income. Independent contractors also deduct eligible business expenses that incurred during their operations to calculate their taxable income. 

4. Potential liabilities

When it comes to working independently from a company, many entrepreneurs fail to distinguish the line between business and personal finances. Hence, both sole proprietors and independent contractors should have a comprehensive understanding of their liabilities.

For instance, in the case of sole proprietors, there is no legal distinction between personal and business assets. Therefore, sole proprietors are personally liable for any debts or legal claims that are incurred by the business. The situation of independent contractors with potential liabilities is similar to that of sole proprietors. As these individuals are self-employed, their personal assets are also vulnerable to business debts and legal disputes. Without the protection of a separate legal entity, such as a corporation or an LLC, both classifications’ personal finances are directly exposed to any liabilities from business activities, including taxation.

Legal and insurance implications

Starting an entrepreneurial journey always requires understanding the legal and insurance implications for protecting personal and business assets for both sole proprietors and independent contractors. Below in this section, we explore some of the most important legal and insurance considerations.

1. Liability concerns

Operating as a sole proprietorship imposes a direct link between the individual and the business, which means that the owner carries full personal liability for any debts, legal claims, or damages incurred by the business. In the case of a business lawsuit or financial dispute, the owner’s personal assets, such as properties, savings, and investments, are at risk. 

Similarly to sole proprietors, independent contractors also face inherent liability risks associated with their business activities. Without having legal protection that comes with a separate business entity, contractors are personally responsible for any liabilities that come from their work. This includes potential damages, contract breaches, or other legal disputes that could lead to financial loss.

2. Insurance coverage

Insurance coverage is important for both sole proprietors and independent contractors to protect against various types of risks and liabilities that are inherent in their business operations. The following are the essential types of insurance coverage:

• General liability insurance to protect against third-party claims of property damage, bodily injury, or any personal injury made during business operations. In the case of a lawsuit or liability claim, general liability insurance can help cover legal fees and damages and protect personal assets. 
• Professional liability insurance is mostly important for independent contractors who offer specialised services or professional advice, such as consultants and designers. This insurance protects against claims of negligence, errors, or omissions in the performance of professional services. 
• Business property insurance is crucial for sole proprietors who operate from a physical location. This insurance protects business assets, equipment, inventory, and physical premises against loss or damage from events such as fire, theft, or natural disasters. 

3. Risk mitigation

Besides insurance coverage, both independent contractors and sole proprietors should always consider risk mitigation strategies to protect their personal and business assets. For this purpose, many legal and business professionals advise creating a legal separation by forming a legal entity such as an LTD. 

Global platforms like Native Teams can help you set up your own legal entity to separate personal and business assets without the administrative and compliance hassles of the process. 

Utilising this solution, you’re getting your own legal entity wallet with a dedicated IBAN, allowing you to make personal-professional separation, easily control your profit distribution, reduce your taxable income, and save more of your hard-earned money. 

Interested in how our UK Legal Entity solution works? Schedule a free demo call to talk to our team now!

Choosing between independent contractor and sole proprietor

Choosing between operating as a sole proprietor or an independent contractor is a significant decision that can impact many aspects of your work experience. Below, we offer a short guide that will help you make a more informed decision.

I. Nature of work

The nature of your work and the services or products you offer is a crucial considerations when deciding between an independent contractor and a sole proprietor. 

Sole proprietorship is more suitable for individuals who want to establish complete control and autonomy over the decision-making process in their business. Sole proprietors have full authority over business operations and are directly responsible for managing all aspects of their business.

On the other hand, independent contractors work on a project-by-project basis and have greater flexibility in terms of schedules, workloads, payments, and clients. They’re also able to work for multiple clients simultaneously and have full responsibility for the projects and tasks they work on. However, unlike sole proprietors, independent contractors are not included in the decision-making of the specific organisation they work for.

II. Income sources

Another very important consideration is the sources of income for your business, and how you plan to generate revenue. 

For instance, sole proprietors often rely on a single business venture or income stream, unlike independent contractors who are able to work for multiple organisations. Hence, if you have a specific business idea or a venture that you plan to pursue exclusively, sole proprietorship may be a better option to align with your income model.

As already mentioned, independent contractors earn their income from multiple clients, which diversifies their earnings and revenue sources. Therefore, this business model may be more suitable for individuals who prefer the flexibility of working with different clients or industries and generating income from various sources.

III. Personal and business goals

Your personal and business goals are also one of the most crucial considerations when choosing between being an independent contractor or a sole proprietor. 

Individuals who have the goal of building and growing a standalone business that has the potential for expansion and scalability should opt for sole proprietorship. This structure will provide you with the necessary legal and business framework to achieve your objectives, as well as the autonomy to make strategic decisions and develop your business according to your vision.

On the other hand, if you want to provide specialised services or expertise on a freelance basis without establishing a standalone business entity, independent contractor is a better option. Independent contractors can utilise their skills and experience to pursue many opportunities in a variety of industries, while still having the flexibility and autonomy to work on their own terms. 

To sum up

Whether you choose to be a sole proprietor or an independent contractor, know that there are a few factors that are crucial for making the right decision. By considering factors such as the nature of your work, income sources, and personal aspirations, you can determine the most suitable model that will set you on the right path for building an independent business and career.

Remember, both of these options offer their own set of opportunities and challenges, and starting your entrepreneurial journey will give you the ultimate flexibility, independence, and financial freedom for professional growth and success.