Independent Contractor: Everything You Need to Know
Benefits to working as an independent contractor are an entitlement to full profit, setting one’s own hours, and more flexible control over tax reporting.7 min read
Benefits to working as an independent contractor are entitlement to full profit, setting one’s own hours, and more flexible control over tax reporting. While contractors are subject to federal income tax reporting under Internal Revenue Service (IRS) rules; stipulations for contractors depending on type of business registration, may solely be filing of an independent taxpayer Form 1040, and attendant Schedule C business expense return, and Schedule SE “self-employment” tax reporting. The Schedule SE requires that a contractor contribute to Social Security and Medicare, yet unlike employees, this can be done after net income has been determined. Independent contractors must be quarterly estimated income tax payments.The advantage is that unlike partnerships, where estimated income tax payment obligations are calculated as percentage of proportional capital basis in the partnership rather than actual income, an independent contractor computes quarterly taxation based on actual reporting. Independent contractors are responsible for funding their own benefits, and those expenditures are usually not tax deductible.
How much to charge clients and how to make sure they pay you
Independent contractors by rule of thumb, charge more than the market will bear, however where competition is present, risk persists. Depending on field of practice, the calculus for charging clients a retainer and cost of services fees will obviously vary. Contact a Certified Public Accountant for advice about estimating projects to ensure fees and tender bids are maximizing return on investment where taxation is concerned. Contractors are also responsible for their own billing. Most contractors now establish Web based billing and collections service agreements with reliable third-parties, to issue invoices, receive funds, and to better protect a business from overdue accounts receivables.
Using written agreements when doing contract work for clients
U.S. common law involves a substantial legal area, Contract Law. Legal agreements are a “bargained for exchange” for performance on either written or verbal contract. Written agreements are obviously easier to modify, and enforce should a party breach. Disputes are more easily avoided with written contract as well. Mutual assent is proven with signature on contract. Once a party has sign-on for services in exchange for compensation, and the description of the services is outlined in writing, agreement to perform established reliance. Clients failing to pay have established financial reliance on compensation promised in exchange for performance.
Independent contractors can protect themselves from non-payment by clients under the U.S. Statute of Frauds. Modification of contract agreements must be met with mutual consent; otherwise a contract may be voided in response to breach. Monies owed to the contractor in this case would still bind, if the unconsented to party attempting to modify did not notice the contractor in advance. A written independent contractor agreement can also help establish the legal basis of the independent contractor (i.e. “not a client's employee”). While a contract does not substantiate an independent contractor, it enables the contractor to show that the client/hiring firm intended to form a “hiring firm-independent contractor” agreement, not an “employer-employee” agreement.
Deciding whether someone is an employee or an independent contractor
Status of a worker as an independent contractor of an employee is initially the mutual assent of the hiring firm (i.e. “offeror”) and other party (i.e. “offeree”). The formation of contract permits submission of tax return reporting information to the IRS, and state workers’ compensation and unemployment agencies if the party is deemed an “employee” by agreement. A government agency is more likely to classify a worker as an independent contractor if:
- Earning a profit or suffer a loss from the action
- Furnishing the materials and tools necessary to do the work
- Paid per job
- Working for multiple firms at a time
- Investing in facilities and equipment
- Paying own business and traveling expenses
- Hiring and paying assistants, and
- Setting own working hours
If a government agency determines that you should have been classified as an employee, obligation to payroll contribution to Social Security and Medicare is sustained.Contractor assumption of “self-employment” obliges the worker to filing a Schedule SE with the IRS, and double annual contribution. Independent contractors, however, are eligible for a 50% write-off of SE contributions as a deductible business expense.
When to become an independent contractor
An independent contractor (IC) is an individual who runs their own business.Independent contractors earn a livingthrough their own businesses instead of relying upon employers to earn a living. In addition to IRS tax obligations, licensing and business permits that may be mandatory for operation in a jurisdiction where the contractor business is maintained. Independent contractors are liable for business debts, unless registered as a “limited liability company” LLC or “limited liability practice” LLP in the state of operation. There are also no insurance benefits, nor employer provision of workers’ compensation. Labor law protections of independent contractors usually do not apply.
Employee vs. Independent Contractor: Differences You Need to Know
Independent contractor status has been outlined by common law principles, through enactment of the the Fair Labor Standards Act, and in court precedent.The IRS and many state franchise tax boards have adopted common law principles in shared definition of“independent contractor” as a tax entity. The federal "Economic Realities Test" looks at the dependence of a worker on the business with which he or she works. The “Twenty Factors Test” offers a checklist of qualifications to discern if a worker is an independent contractor.
If an employer does not have oversight over how a party engages work, but only formal requests to perform on contract as outlined in an agreement, the relationship is a formation of contract between an independent contractor and the client or hiring party.Certain factors characterize an independent contractor as a sole proprietorship: (1) no reliance on the other party as the only source of income, (2) working according to agreement, not by internal procedure,(3) being ineligible for employer provided benefits, and (4) retention of control over accounts and independence in election to contract with other parties “at will” at any time. The latter condition of “at will” contract where independent contractors are concerns supersedes “non-compete” agreements unless assented to otherwise.
The condition of “non-compete” must also be materially evidenced as fact, rather than merely stipulated as a general assumption about “competition”. This includes consideration of “type of work” performed by a contractor simultaneously where the “non-compete” agreement is concerned, and also reasonable definition of the terms and conditions to non-compete agreement with basis in reliance. Clients and hiring parties not able to substantiate material reliance (i.e. an entity’s total annual profits), may not oblige an independent contractor to “non-compete” agreement; or cite breach where other identical services or near identical services are performed. Finally, an independent contractor is defined by oral or written contract; and in adherence to certain requirements (i.e. invoicing, licensing, permits).
Employer Tax Liability
An employer's tax liability is largely determined by the worker's employment status. Employers pay state and federal unemployment tax, social security tax and workers compensation/disability premiums to a State Insurance Fund when compensating an employee. Independent contractors do not demand control of payroll processing procedures, but rather payment on billing invoices according to “Net” terms (i.e. 10 days).Independent contractors are considered sole proprietors responsible for Schedule C of Form 1040, or Schedule SE submission, annually; as well as quarterly estimated tax payments on net earnings.
BREAKING DOWN 'Independent Contractor'
Auction, construction, dental, law,medical, veterinarian, and writing professionals are considered independent contractors by the Internal Revenue Service (IRS).
Independent contractors are responsible for filing the corresponding IRS 1040, Schedule C, and Schedule SE to meet IRS 1099 independent contractor requirements. Retaining record of all payments received from clients is required by contractors under federal law. Where an independent contractor earns more than $599 from a single payer; a 1099 form must be issued detailing contractor earnings for the year.
Labor relations are not relevant to independent contractors not hiring employees. Workers’ compensation laws also do not apply to most contractor agreements.
Economics and Social Policy
Economics and social policies support the licensing of contractors as independent businesses. Because compliance often comes at great expense, employers can significantly reduce their liability and increase their profit margin by hiring independent contractors rather than employees.
An independent contractor has far greater control over elements of work than an employee. Independent contractors also benefit directly from their work, the quality of their work. By hiring independent contractors, an employer enjoys the greater ease and flexibility to expand and contract the workforce as demand rises and falls. An independent contractor’s work is typically not integral to an employer’s business for an extended period.
A contractor also has the potential to hire others, purchase materials and equipment, advertise, rent space, and manage time tables may reflect managerial skills that will affect his or her opportunity for profit or loss beyond a current job. An independent contractor typically makes investments that support a business beyond any specific job. The investment of a true independent contractor might, for example, further the business’s capacity to expand, reduce its cost structure, or extend the reach of the independent contractor’s market.
U.S. tort law holds an employer liable for the negligent acts of an employee. When an independent contractor acts pursuant to orders or directions negligently given by the hiring party, the latter will be held liable. Otherwise, the hiring party is not liable for negligence commissioned by an independent contractor. There are a few exceptions to this rule. The hiring party may be liable when a third party is harmed, where failure to exercise reasonable care by a contractor is applied to the hiring party due to agreement. Aside from a few exceptions, hiring parties are at less risk of liability with independent contractors than employees.
The former factor test used by the IRS Section 530(a) of the Revenue Act of 1978 provided for companies to classify workers as independent contractors, even if meeting consideration for employment under the IRS eleven-factor test. This earlier classification was consistent with the best practices standards of most industries at the time. IRS audit has found since that such workers are generally not classifiable as employee. If anIRS opinion letter or ruling supports the classification, the worker has fulfilled the criteria to independent contractor classification.
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