Sole Proprietorship vs. Self Employed

While many self-employed individuals start their businesses as sole proprietorships, business growth often necessitates making a change. Understanding that self-employed individuals can be sole proprietors, but do not have to be, is critical when making decisions on structuring your business.

Key takeaways

• All sole proprietors are self-employed.
• Not all self-employed individuals are sole proprietors.
• Self-employed individuals operating as independent contractors must fill out an additional federal tax form called a Form 1099-NEC.
• Registering as a business with the state provides self-employed small business owners greater risk protection than they would have with a sole proprietorship.

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Understanding Self-Employment

Sole proprietorships are businesses that are owned by one person and not registered with the state. All sole proprietors are self-employed. However, not everyone who is self-employed is a sole proprietor. In business, "self-employed" can apply to a wide range of roles and business structures.

Suppose you are a freelancing independent contractor. You are operating a sole proprietorship but wanting to change it to a limited liability company (LLC). Can you incorporate your business as something other than a sole proprietorship? Absolutely. It all depends on what you think is best for your business.

Sole Proprietors and Self-Employed Independent Contractors: Is There a Difference?

While both are self-employed, these terms do not always mean the same thing.

Sole proprietors own their own unincorporated business. These are people who start a business and manage that business's finances but have not registered their business with the state.

The Internal Revenue Service (IRS) treats sole proprietorships as the default business structure for income taxes. That means if you are an independent contractor who has not filed with the state as an entity like an LLC or corporation, the IRS will treat your business as a sole proprietorship for tax purposes.

The term "independent contractor" refers more to the business with which the individual is contracting. These freelancers work for other businesses and provide vital services, but they are not employees. No payroll taxes are deducted from their paychecks.

Independent contractors are required to pay self-employment taxes just like sole proprietors. But they must fill out an additional tax form each year (the Form 1099-NEC) that tabulates the amount of income they have received from the businesses where they have worked. This adds an extra step to the tax process for sole proprietors that choose to be independent contractors.

While self-employed individuals can be sole proprietors, states also offer structural options with greater risk protection. These are discussed below.

Taxation Of Self-Employed and Independent Contractors

Registered or not, all self-employed individuals must pay self-employment taxes on their business income. These are taxes for Medicare and Social Security. Sole proprietors report their business taxes on Schedule C of their personal tax return (Form 1040 or Form 1040-SR) at the end of the year.

This is different from independent contractors, who must also keep track of their income from other businesses through Form 1099-NEC. "NEC" stands for "non-employment compensation," and this form needs to be filled out any time the contractor contracts with a new business.

Without that added step, sole proprietors have less complicated taxes than self-employed individuals that elect a different business structure. This is a benefit to some, but it also lacks certain protections that other business structures provide.

Changing Your Self-Employed Business's Structure

As you can see, independent contractors that have not filed with the state are sole proprietors. So, when are self-employed individuals not sole proprietors? When they have registered their business with the state as its own legal entity. Thankfully, filing as a business entity can be done at any time in your business's life span.

When is it a good time to register your business as an entity type? Here are some circumstances where it should be considered:

• You want to limit your personal financial risk for your business's obligations and debts.
• You expect your business to generate profits and establish long-term growth.
• You want your business to operate independently from yourself.
• You want to hire employees.

Business owners add a layer of risk protection from their business's debts and obligations by registering as one of the following structures.:

• LLC
• C corporation
• S corporation
• Limited liability partnership (LLP)

Self-Employed and Seeking Assistance?

New small business owners often have many questions they need to answer when starting their journey. The added challenges that come with self-employment can make decisions on structure and timing difficult. When you're faced with such challenges, it's always best to contact a small business lawyer who can answer your questions and help weigh your options.

Related Topics

• Small Business Law
• Starting a Business: First Steps
• Choosing a Legal Structure
• Start-Up Tax Issues