Independent contractor vs sole proprietor vs LLC: What's the difference?

For many entrepreneurs, the legal aspects of starting a business loom large. One of the first things you’ll have to figure out when opening your business, and reconsider as you grow, is whether you’re an independent contractor, LLC or sole proprietorship. This can be intimidating. but we’re here to explain why it’s not as complicated as it might sound. Let’s start with a short introduction to each category:

Sole proprietorship

A sole proprietorship is single-person business of any kind. If you aren’t registering your business with the state but do have income and expenses that are separate from your regular household expenses, then you have a sole proprietorship. This includes people who make things, teach classes, sell products or provide services of any kind.

Independent contractor

An independent contractor is someone who works for someone else, but not as an employee. The primary difference between an independent contractor and a sole proprietor is that an independent contractor usually provides a service rather than a product. He or she may be brought on as a consultant or to work on a specific project. In many cases, independent contractors, like consultants or creative professionals, provide expertise rather than specific products. If you provide a contract to your client before beginning your work, chances are good you’re an independent contractor. If your customers buy products you’ve created in advance, then you’re probably a sole proprietor but not an independent contractor.

LLC

LLC stands for Limited Liability Company. By registering yourself as an LLC, you cut off the direct connection between your business and you as an individual. Your business is a completely independent entity and your personal finances aren’t on the line for any future business debt. Being an LLC can also help convince wary clients that your business is stable.

Where this gets messy

The catch is that you can be both a sole proprietor and an independent contractor at the same time, which brings up some questions: is an independent contractor a sole proprietor? Yes. Is a sole proprietor an independent contractor? Sometimes. Sole proprietor refers to how you pay taxes, whereas independent contractor describes how you receive income. So if you make and sell artisanal soap online, you’re a sole proprietor. Let’s say a cosmetics company hires you as a consultant to design a new line of artisanal soaps – now you’re also an independent contractor. An independent contractor vs. LLC is a much clearer division because an LLC is registered through your state government. Although it’s not complicated and can cost as little as $100, registering as an LLC can offer your business a little more flexibility than a simple sole proprietorship while maintaining many of the tax advantages. Is the question of Sole Proprietor vs Independent Contractor vs LLC starting to make more sense? We hope so.

It comes down to taxes

First, you have to understand the difference between an independent contractor and an employee. At the end of each year, an independent contractor receives a 1099 form from all their clients instead of the W-9 they would receive as an employee. The 1099 lists all the year’s income and the independent contractor pays taxes on it the same way any other sole proprietor does: using a Schedule C alongside self-employment taxes. These take the place of FICA payments that come out of your paycheck when you’re an employee. But keep in mind, in the case of an employee, the employer also pays into FICA. As a sole proprietor, you’ll be paying both the employer and employee’s share. In terms of taxes, an LLC lies somewhere between an independent contractor and a corporation. An LLC can help more than one owner avoid the double taxation that sometimes comes with being a corporation. If you are the only owner of your LLC, you file taxes with a Schedule C, just like a sole proprietorship. If you share ownership, there are a few additional requirements including a 1061 and K-1s for each owner.

Insurance: know your options

The type of insurance you need is not directly tied to whether you have a sole proprietorship vs LLC, but there is a connection. For most businesses, liability insurance is critical and professional insurance may be worthwhile, and especially contractors insurance if that’s what you do. However, the factors are a bit different if you own an LLC. Your personal finances are not on the line if someone decides to sue your business. On the other hand, taking on partners and employees may mean more specific LLC insurance requirements. For example, some states will demand you provide workers compensation. While this can seem like an overwhelming decision, keep in mind that the question and differences between independent contractor vs sole proprietor vs LLC are minor and probably won’t affect you when you’re just starting out. You can also change your business structure at a later date if you need to.