Independent Contractor: Definition, How Taxes Work, and Example

What Is an Independent Contractor?

An independent contractor is a self-employed person or entity contracted to perform work for—or provide services to—another entity as a non-employee.

Independent contractors must pay their own Social Security and Medicare taxes. In addition, an entity that uses the services of an independent contractor is not required to provide them with employment benefits, such as health insurance and employer-sponsored retirement accounts that the entity may otherwise provide to its employees. The payer must correctly classify each payee as either an independent contractor or an employee.

Another term for an independent contractor is freelancer.

Understanding the Category of an Independent Contractor

An independent contractor works with clients on a temporary or contracted basis rather than as a direct employee. This job status has become increasingly prevalent in the rise of what has been dubbed the gig economy.

Doctors, dentists, veterinarians, lawyers, and many other professionals who provide independent services are classified as independent contractors by the Internal Revenue Service (IRS). However, the category also includes contractors, subcontractors, writers, software designers, auctioneers, actors, musicians, and many others who provide independent services to the general public.

According to the IRS, an individual qualifies as 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."

When you work as an independent contractor, you have more control over when and how much you work and are essentially your own boss. You are considered self-employed and are responsible for paying your taxes.

Independent contractors must keep track of their earnings and include every payment received from clients. Clients are legally obliged to issue 1099-MISC forms to their contractors if the amount they paid warrants that expense. If an independent contractor earns more than $600 from a single-payer, that payer is required to issue the contractor a 1099 form detailing their earnings for the year.

How to Pay Taxes as an Independent Contractor

In the United States, independent contractors are considered sole proprietors or single-member limited liability companies (LLCs). They must report all their income and expenses on Schedule C of Form 1040 or Schedule E if they have profits or losses from rental properties. Further, they must submit estimated taxes to the IRS, usually every quarter, using Form 1040-ES.

However, as sole proprietors, independent contractors do not necessarily pay taxes on their gross earnings. Applicable business expenses can reduce their overall tax obligation. The difference between gross earnings and business expenses is the net income, on which taxes are due.

For the 2024 tax year, independent contractors pay 12.4% in Social Security contributions on the first $168,600 of net income and 2.9% in Medicare taxes on all net income. Single filers must pay an additional 0.9% Medicare tax on self-employment income that exceeds $125,000 if they are married and filing separately, $200,000 if they are married and filing jointly, and $200,000 if another tax status applies to them.

Some independent contractors may also need to pay state sales taxes for producing products, but it can depend on the type of product being made.

Advantages and Disadvantages of Being an Independent Contractor

Advantages

The pros of being an independent contractor generally relate to the greater freedom they enjoy. They can set their hours, pursue work they love, and decide what work they will and will not accept. Those who can work from home may save money on transportation and the wardrobe needed to work in an office.

They may also get the home office tax deduction that allows them to deduct the business portion of their bills for such things as insurance, rent, repairs, security systems, and utilities and services.

Independent contractors have complete control over building their business, from hiring and firing to choosing clients. Unlike employees who have a set annual salary, there's no limit on how much money they can earn. Finally, they can enjoy a sense of pride and accomplishment in building a successful business enterprise that belongs to no one but them.

Disadvantages

The cons of being an independent contractor are related to the risk of going bankrupt and the opportunity cost of a regular career. They aren't supported by a regular salary when business is terrible, and their income can be unpredictable and highly volatile.

This income fluctuation can cause stress and make it harder for independent contractors to qualify for mortgages, car loans, and other types of loans. They are responsible for all business costs—no reimbursable expense reports for them—and if working alone, they lack the support and camaraderie of coworkers.

Independent contractors are not eligible for employer-provided healthcare plans, so they must completely fund their healthcare. They must also pay both the employee and the employer parts of Social Security and Medicare taxes—what's known as the self-employment tax. They are not eligible for employer-sponsored 401(k) plans or matching contributions from those who employ them.

Example of an Independent Contractor

One example of an independent contractor would be an interior designer who works for themselves and has a roster of clients who hire them to decorate their homes. The interior designer might even work on a contract for an architectural firm that employs them to work closely with their clients throughout the building process of a new home.

The designer, an independent contractor, would do whatever job is set out in the agreement and bill the architectural firm (with whom they are contracted to work) either an hourly or flat rate for the work executed. To get paid what is owed, the designer must send its client, the architectural firm, invoices. At the same time, the interior designer might be working for other clients and working on various homes simultaneously.

The alternative would be working as an in-house designer and only working for clients of the architectural firm that employs the designer.

The Bottom Line

Working as an independent contractor can be a great way to earn a living for people who desire flexibility, don't mind inconsistent earnings, and who can manage their time while potentially juggling multiple clients. In addition, independent contractors must be comfortable with filing their taxes with the IRS and paying for their own insurance, plus retirement savings. For some, the freedom to choose projects and the flexibility of working for themselves make the challenges worth it.