Are you self-employed, a sole proprietor, or both?

For many of the more than 16 million self-employed individuals in the United States, the answer to this question is probably ‘both.’ All sole proprietors are, by definition, self-employed.  But not all self-employed persons are sole proprietors. A little confusing, right?

Don’t let that stop you. There are a lot of titles you might hold as you launch your business dream – and they almost all start with ‘self-employed.’ Getting your terms straight in the beginning can help manage the risks and advantages you’ll greet along the way. Here’s what you need to know if you are starting out.

What is self-employment?

Self-employment is a broad term that refers to the business activity that is generated by sole proprietors, partnerships, and independent contractors. Historically, the greatest number of these self-driven enterprises have either started out or remained unincorporated. In May 2021, the Bureau of Labor Statistics reported that 62 percent of all self-employed businesses were unincorporated.

Simplicity may be the reason behind this trend.  Starting an unincorporated business is the easiest way to enter the business world. It doesn’t require any legal or financial filings. A self-employed business owner is the sole legal entity behind their enterprise. Their assets define its financial base. And their ideas alone define its scope.

That said, a self-employed business owner can recruit help – independent contractors or regular employees – as long as they follow the rules for taxing and paying these workers. Find out more about unincorporated and incorporated businesses from Small Business Trends. 

Sole Proprietorships

A sole proprietorship is what it sounds like: a single-person business.  That roadside lemonade stand you started as a kid?  Sole proprietorship. You used your allowance to buy cups and lemonade. You decided how much profit to plow back into buying a better brand of drink mix. And you, alone, watched the profits roll in.

Until a week of rain squashed demand. Or a road repaving project sent your loyal patrons elsewhere.  As a sole proprietor, the only back-up plan when things go awry is you. So, even when your lemonade business soured, you were responsible for paying for the inventory that didn’t turn a profit. 

Partnerships

Another form of self-employment involves a coordinated venture with one or more persons who independently generate goods or services. So, if your brother started selling cookies at your lemonade stand, that would be a partnership. It’s a great business proposition – who doesn’t like cookies and lemonade together? But, just like you, your brother’s success will rise and fall on his own business acumen. And nothing’s stopping him from switching to a lawn-mowing business at a moment’s notice.

Related: A 7 point checklist for a successful business partnership  

Independent contractors  

Independent contractors  (ICs) are individuals or groups of individuals who sell their services to another person or business. If you are a business owner, you might bring ICs on board to avoid the paperwork, commitment, and cost of a traditional hire. Think: bookkeepers who come in once a year to run an audit or crews that clean your office building.  If you are considering becoming an IC, know that you will be paid like a vendor and your tax liability will be tracked by the 1099 form you filled out. 

The small business advantage: liability protection

When your fledgling venture begins hiring employees, the legal protections and tax advantages of incorporation may out-shine the freedom of your sole proprietorship. Your product, your payroll, your ambitions, and your tolerance for risk may no longer fit into the self-employed business model. Your friends might say you started a business. From a legal standpoint, it’s called a limited liability corporation (LLC).

An LLC is a legal entity that protects the business owner’s personal assets from being seized by creditors to cover business obligations or legal claims made against the business. It also makes the dissolution of your business more difficult.  If your business starts hiring more employees than independent contractors, an LLC can even protect your assets from lawsuits brought by disgruntled ex-employees. Not sure how to launch your LLC? Incorporate.com can help.  

The tax advantage of self-employment

If you remain an unincorporated sole proprietor, you can substantially reduce your tax bill by using some of the many deductions available to the self-employed. The particulars change over time, but the deductions tend to include expenses like office space, office supplies, and other legitimate business costs.  The experts at QuickBooks have come up with a tax deduction guide that can help you calculate yours. 

Related: The most common accounting mistakes made by small businesses and how to avoid them

When you are self-employed, you are responsible for estimating, deducting, and paying your own state, federal, and payroll taxes. As a practical matter, it’s best to pay this off on a quarterly basis to avoid a year-end surprise (including penalties for late payment). If you decide to hire additional employees (not contractors) you will need to obtain an employer identification number (EIN) from the IRS and begin issuing W-2 tax forms to all of your employees. The responsibility for administering, tracking, and depositing their state, federal, and payroll deductions appropriately is all on you.

Smallbusiness.chron.com has put together a list of additional forms you will need for employees. If you decide to use contractors, you must send them a 1099 tax form, but you have no responsibility to withhold or track their taxes. 

Related: Employer’s choice: employees or independent contractors?

When tax time does come around, your filing will remain fairly simple. Your business and personal income taxes will be processed using the IRS 1040 or 1040-SR forms, again with the Schedule C attached. This is convenient and quick, but, as mentioned above, you will need to decide if it’s right for you. Is it worth it to have your personal and business assets so tightly comingled?

 
Managing your risks, so you can live your dream

Ultimately, the decision to move from self-employment to incorporation is one that you, alone can make. What’s important, regardless, is how successfully you manage the risks inherent in either choice. In this regard, both self-employed and small businesses can benefit from partnering with an insurer that has their back. Hiscox is ready to deliver workers comp,  general liability and professional liability insurance coverage that will protect your business and personal assets. Not sure what else you might need? Give us a call at 1-877-761-0245. Our licensed agents can help, Monday – Friday, 7am – 10pm ET.