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How to become an independent contractor

At a glance:

  • What is an independent contractor?

  • Advantages of being an independent contractor

  • Disadvantages of being an independent contractor

  • Get your business licenses and certificates

  • How to choose a name for your business

  • Get your business taxes in order

  • Summary of how to become an independent contractor

Nearly everyone has at least thought about it — waving goodbye to the boss and thinking, "I could do this better on my own."

Or you walk by a friend's small business and imagine yourself in her shoes. Or maybe you feel life is calling you to strike out on your own and make it that way.

While many of us leave these thoughts to the safety of our imaginations, others do take that extra step into the unknown.

Dajae Gilliard uses her mobile phone and laptop in Philadelphia. (Photo: Jeff Fusco/AP Images for Comcast)
Dajae Gilliard uses her mobile phone and laptop in Philadelphia. (Photo: Jeff Fusco/AP Images for Comcast)

Some deliberately become independent contractors, while others gradually ease into it. Some are already independent to some extent without even knowing it.

Being your own boss has its benefits and drawbacks. The benefits include setting your own hours. Regarding the drawbacks, a pundit once said, "I am my own boss, and I can work any 23 hours a day I choose."

Weigh the advantages and disadvantages carefully to prepare for your choice, and visualize yourself handling both.

What is an independent contractor?

An independent contractor is a person or business that provides goods or services to others under terms spelled out in a contract or other agreement. An independent contractor does not work regularly for an employer, as an employee does. Rather, he works for himself.

The IRS definition

The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.

You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.

The distinction is important partly for tax purposes. Independent contractors do not have taxes taken out of their earnings, and they must pay additional Social Security and Medicare tax. These latter two taxes are together called self-employment tax.

Are you an independent contractor?

It is not always easy to determine whether you are an independent contractor or an employee. To make a determination, the IRS advises that you look at three factors: financial control, behavioral control, and the relationship between the parties.

Even when it seems clear-cut, sometimes there are fine lines. For example, some companies will dictate your schedule or require certain purchases from them, despite legally treating you as an independent contractor. In some cases, the IRS will have to step in and make a determination.

The Small Business Administration provides additional information here.

Advantages of being an independent contractor

Many who have struck out on their own, often after several years of debating the pros and cons, say that self-employment is one of the best things they ever did. Here are some of the advantages that they cite:

Freedom

Independent contractors can set their own hours, their own rules, their own pay, and their own place of work. If they are working from home, they can choose to work in their pajamas if they like (and some do).

You answer to no boss but yourself

Perhaps the most enthusiastically given reason for going out on your own is the ability to answer to no one but yourself. You don't have to ask for a raise — instead, you can raise your own pay.

Greater earnings potential

At a regular job, your earnings are dictated by the company, with raises on a schedule and determined by the health of the company. On your own, they are dictated by you and are often subject to prevailing market trends.

Independent contractors typically earn more doing on their own what they would have done for an employer. For example, a house painter might earn $15 an hour for an employer but $50 per hour on her own.

One reason independent contractors charge more is that they have to pay for their own benefits and their self-employment tax. Some even factor periods of downtime into their charges.

What you earn can be negotiated between you and your prospective client and will depend upon your experience, your reputation, and your skill at negotiating.

You get to deduct your expenses

With a regular job, you're stuck paying for gas on your way to work. As an independent contractor, you can deduct your travel expenses. You can deduct office expenses, professional fees, insurance, and many other expenses, subject to IRS rules.

As a result of deductible expenses, you may end up paying lower income taxes than you would if you were employed. This difference may be more pronounced during the first few years that you are in business, when you may have many startup costs to deduct. IRS Publication 535 provides more detailed information on what is deductible.

Royalties

If you are an artist, author or other creator of a tangible work, you get to have copyright ownership of the work and any royalties that arise from it. As an employee, those rights would belong to the company.

Bigger retirement plans

As an independent contractor, you can set up retirement plans for yourself. SEP-IRAs and Keogh plans let you save more than you could under an individual retirement account or under the employee portion of a 401k or 403b. Another benefit of these plans is that you can shelter even more of your income from taxes.

Disadvantages of being an independent contractor

You should have a firm grasp of the disadvantages of striking out on your own before you do so. It is not for everyone. As your own boss, you will have to bear risks that you were protected from as an employee.

Unpredictability

If you don't have a job to do, you don't get paid—in other words, no job security. But as an employee, you can still get paid as long as you are employed.

As an independent contractor, you do not get a regular payday, and you are at the whim of your customers or clients. Some may pay you late, and others may not pay you at all unless you drag them into court. It is important to draw up contracts for just this purpose.

As part of this unpredictability, you may find yourself working on weekends, at night, or even at 3 o'clock in the morning. Also, there is a "feast or famine" nature about being self-employed.

You might have more work than you can handle, or you may be out of work for weeks at a time. Keep some savings handy for the down times.

Your taxes will get harder to do

Independent contractors have additional tax forms to fill out, such as Schedule C (for self-employment income), Schedule SE, Form 8829, and a possible host of other forms.

You may find it very helpful to sit down with a tax professional to learn about receipts to keep, forms that need filling out, and how to organize your records.

Liability

You bear more liability for debts, failures, and any other unfortunate occurrence. Independent contractors are personally liable and could lose personal property if they get sued.

Less protection under the law

Employees enjoy protections from discrimination and other things. Independent contractors get very few such protections. Also, you are not entitled to workers' compensation or unemployment, either.

No employer benefits

Employees can enjoy health insurance, sick leave, retirement plans with employer matching, bonuses, paid vacations, and other perks. But as your own boss, you're out of luck.

You have to set aside your own money or find some other way to finance these things. Indeed, there are some business owners who haven't had a day off in years.

Get your business licenses and certificates

Every business needs at least one license to operate. Some will need more. Licenses are purchased at the federal, state, or local levels. They are based on your business activity, your location, and other factors such as business form and number of employees. Also, regulations vary widely among the federal, state, and local levels.

Business license

A business license is a license to conduct business within a certain area. It is typically issued by your local government. Business licenses vary greatly among localities, states, and nations.

Tax registration

You must get an employer identification number (also called an employer tax ID) if you will have employees or if you are a corporation or partnership. You can get this from the IRS.

At the state or local level, you may need a tax identification number or license. This may also be called a tax registration certificate or, sometimes, a business license.

Vocational license

Some trades require a vocational license in order to work. For example, furnace installers and barbers need to be licensed before they can offer services. This license can go by different names in different areas, such as professional license or business license.

Local permits

A variety of other permits may be needed. There may be zoning permits, building permits, health permits, occupational permits (for home-based businesses), signage permits, and alarm permits, among many others. They will differ according to local regulations.

You can be fined heavily for not being properly licensed or permitted. It should be noted that sole proprietorships may be exempt from some licensing.

All of these licenses and permits may sound overwhelming. The Small Business Administration provides a good starting point for learning about them here.

How to choose a name for your business

Your business will need a name.

Think carefully about it, because your business's name will help frame how the world sees it. Imagine how it will sound when spoken, how it will look in emails or on signs, and what it might mean when others hear it.

Choose a name that you are completely comfortable with. It could be simply your own name, or your own name with an identifier at the end (e.g., Hailey Payton Research), or a name that does not identify you at all.

How to begin

Your name will also depend to some extent on what type of business structure you choose — sole proprietorship, partnership, C corporation, S corporation, or limited liability corporation.

Choosing a business structure may require the help of an advisor, as there are intricacies and advantages to each one that are not always apparent on the surface.

Before settling on a name, make sure it doesn't already exist. Check all registered and unregistered trademark names. Use these resources:

  • Your state filing office if your business is a corporation, LLC, or limited partnership. This is usually called the Secretary of State's office.

  • A simple Internet search

  • Your county clerk

  • Thomas Register

  • The U.S. Patent and Trademark Office database

If a name similar to your desired name is already in use, it may still be usable. However, your business itself would have to be substantially different from the existing one, such as in location or the service it offers.

Register your business name

Not all business names need to be registered. If you use your full name as part of your business name, you won't need to register it. For example, Carolyn Smith Medical Writing would not need to be registered. But if your business does not use your full name, you must register it as a fictitious (or "assumed") name. The more well-known term in most states is DBA, or "doing business as." You can the name registered at a county clerk's office or a state-level office.

There are advantages to using a registered name. For one, you may have trouble opening up a bank account without one. Also, you have greater legal power with one, including stronger ability to enforce contracts. Third, it makes it easier for the public to contact you (and file a complaint or lawsuit, too).

To begin the process, contact your county clerk.

Get your business taxes in order

Your taxes will get much more complicated once you go into business for yourself. It pays to be prepared here, especially if you want to take full advantage of the pro-business parts of the tax code.

Although taxes can be daunting, remember that you can also enjoy the benefits of various tax incentives that your customers and other Americans are paying for through the U.S. tax code. In other words, you can start getting something back from the IRS.

Determine your business structure

Your business structure will dictate which federal and state tax returns you will file. For example, sole proprietorships are the same as their owners for income tax purposes.

That means you use the same tax return to report both your business and personal income taxes.

However, sole proprietors must submit a Schedule C (Profit or Loss from Business) with their returns. Corporations treat their owners as distinct from the business itself.

Get your tax identification numbers

Most businesses will need to get a tax identification number, also called an employer identification number (EIN), from the IRS. If you are a sole proprietor, you likely can use your Social Security number for this purpose.

Tax IDs are also required at the state level as well. If you are registered to operate within a given state, you may need numbers for income tax, unemployment insurance tax, and sales and use tax … among some others that vary by state.

Sales and use tax permits are required if you sell products within a given state and need to collect sales tax.

Keep records of your expenses

Your tax burden as well as your allowed deductions will be easier to follow if you keep track of your expenses and income carefully and efficiently. Don't let receipts pile up until the last minute.

Joy Davenport sits in her car filling out her tax return. (Photo: Mario Villafuerte/Getty Images)
Joy Davenport sits in her car filling out her tax return. (Photo: Mario Villafuerte/Getty Images)

Employment taxes

As a self-employed person, you must pay double the Social Security and Medicare tax that you paid while you were an employee.

If you have employees, you must withhold income taxes, Social Security and Medicare taxes, and the federal unemployment tax and state unemployment tax. Some states require withholding for additional taxes.

Filing your taxes

As noted earlier, your business structure will dictate which federal and state tax returns you will file. Admittedly, the list of required tax forms can get long.

You will have to file your taxes on a schedule that is determined by the IRS for some taxes and by your tax liability for other taxes. Get in the habit of estimating your tax liability and setting aside money to meet it. If you don't, you will be penalized.

Resources

The IRS maintains its Small Business and Self-Employed Tax Center here. This site provides forms and publications, information on employment taxes, and an A-Z index of topics.

Also, the Small Business Administration maintains a tax section on its site here. Among its helpful areas is a list of tax breaks for small businesses.

Summary of how to become an independent contractor

If, after weighing the pros and cons of striking out on your own, you decide to go for the dream, good luck to you!

Make sure it is something you enjoy doing and that you can do through all the ups and downs. Take classes and attend seminars before you begin. Talk to others in the field. Network online or in person.

The last thing you want is to arrive at old age filled with regrets about what could have been.

The Small Business Administration has resources and advisors to help you get started on the path to pursuing your dream. Give them a call and get started.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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