Who doesn’t want to be their own boss? There is plenty of freedom in working for yourself, and more people are striking out on their own and joining the gig economy as independent contractors. However, there is more to working as an independent contractor than sitting in Starbucks with your laptop. Even if you are working for yourself, you are still running a business, and there are potential pitfalls and financial risks unless you understand what it takes to become a successful freelance worker.
Before delving into the pros and cons of being self-employed, let’s define what we mean by the term independent contractor.
In the eyes of the Internal Revenue Service, an independent contractor is someone who earns their own income and does not receive a paycheck:
The general rule is that an individual is 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. The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.
If you work for an employer or perform services for a supervisor (i.e., “if you perform services that can be controlled by an employer”), then you are an employee, not an independent contractor.
You are an independent contractor if you are working without a formal employment contract. That means you set your own rates, invoice for services, and are paid like any other vendor. It also means that at the end of the tax year, your clients will send you a 1099 form to reflect earnings rather than a W-2.
If you plan to work as an independent contractor, you should also plan to have more than one client or customer. In many states, being a contract worker with one client makes you an employee in the eyes of the government, because they will assume your client is trying to evade payroll taxes. Making your services available to various clients or customers makes you truly independent.
To maintain your independent contractor status, be sure to avoid pitfalls such as:
- Accepting training from the hiring company
- Letting the customer dictate working hours (although you should expect them to set deadlines)
- Telling you where you have to do the work (e.g., at their office or facility)
- Deciding you need to hire an assistant; you manage your own personnel.
The Advantages of Working as an Independent Contractor
The appeal of working as an independent contractor is the freedom it gives you. You can choose when to work, whom you are willing to work for, and what you are willing to do. You get to set rates based on what you believe your services are worth. Perhaps most importantly of all, it makes it easier to maintain a work/life balance so you can make time for your family or the activities that are important to you.
People choose to become independent contractors for a variety of reasons:
- They may be between jobs and are doing freelance work in the interim.
- They may be looking for extra income and taking on contract work as a side hustle.
- They may be looking to change careers or expand their skill set.
- They may be retired and looking for contract work as a new career or to keep busy.
No matter what motivates you to become self-employed, working for yourself can be extremely rewarding. However, whether you work full time or part time, you are still running a business, even if you are the only employee.
You Are Running Your Own Business
Although it can be satisfying, being an independent contractor is often a full-time job. In addition to actually doing the work, you have to run the business as well. That means allocating time to develop new business, handle marketing, and deal with bookkeeping and administrative overhead, none of which is billable to clients.
Present yourself as a business. Set up a website. Get business cards. Consider a listing online or in the local yellow pages. Most importantly, set up the finances you’ll need to run your business.
One of the biggest mistakes that newly minted independent contractors make is they fail to take the time to set up the financial tools they need to manage business financials and cash flow. You need to issue invoices, process payments, deal with business expenses, and pay your taxes. Setting up your finances for self-employment success isn’t difficult, but there are things to remember and actions to take:
- Separate your personal and business finances. Set up a separate bank account to handle business transactions. You need an account specifically to accept incoming payments and pay expenses for the business, including paying yourself. Consider opening a business checking account to take advantage of services such as free money transfers, bill pay, remote deposits, debit card purchases, ACH transfers, and other services that your business may need. You may also consider getting a rewards-based credit card that is exclusively for your business as well.
- Be meticulous about tracking your income. Every check or payment you receive should be recorded so you can determine how your business is doing and what you will owe in taxes. Every client you work for will report what they pay you to the IRS, so your records should match the 1099 forms your clients send you at the end of the year. You will need to pay both income tax and self-employment taxes, so be careful to track income and expenses.
- Understand your operating expenses. Even if you are only working with a phone and a laptop computer, you have operating expenses. Any costs associated with your business should be tracked and compared to income to see if you are making a profit. Be sure to include expenses such as office supplies, equipment, car mileage, and household costs related to the business. Also plan to pay yourself as part of the expenses.
- Track expenses for taxes. Keep detailed records of your expenses for tax purposes. You can use software, spreadsheets, or a paper ledger, but record all business expenses you can deduct from your taxes, including the portion of your home you use as an office, part of your phone expenses, your internet expenses, utilities, and so on. One of the advantages of using a bank account and credit card dedicated to your business is it makes tracking expenses much easier.
- Protect yourself and your business. If you are self-employed, that means you are the business. Take steps to formalize your operation and separate it from your personal assets. Start with a business license. Consider getting an employer identification number (EIN) that is associated with your business so you don’t have to share your Social Security number. If you truly want to set up a separate business entity, consider incorporating, which would mean formalizing your business as a separate legal entity. If you do incorporate, it will protect you from any attempt to sue you for your personal assets, but it also may cost you more in taxes. Talk to a tax professional before you decide.
Consider Your Financial Obligations
When you become self-employed, you are responsible for paying your own payroll and benefits. Be sure to plan for additional expenses that you may not have considered, because they are usually paid for by your employer.
- Put money aside for taxes. As part of your financial strategy, be sure to put money away to cover taxes and unexpected expenses. Remember that you will owe income and self-employment tax, so consider saving at least 25% of every check for taxes. You also may need extra cash in case a client is slow to pay or doesn’t pay at all. Setting up a separate money market or savings account for your business will make it easier to save.
- Make quarterly estimated tax payments. Rather than paying all your income taxes once a year, the IRS lets you make quarterly estimated payments using the 1040-ES. The estimated tax payment is designed to allow you to make income tax payments in increments so you don’t have a big financial obligation come tax time.
- Work with an accountant. Now that you are running your own business, you should have a tax professional to advise you. Working with an accountant makes it easier to claim all the right tax deductions and help you manage income taxes, self-employment taxes, and corporate taxes, if any. A good accountant will save you more than their services are likely to cost.
- Plan for your retirement. When you become an independent contractor, you don’t have the advantages of a 401(k) or corporate retirement plan, but you should set up your own retirement plan. Be sure to take full advantage of IRA contributions, which can lower your taxable income. When you become self-employed, you can set up a simplified employee pension (SEP) IRA. A SEP allows you to put more money away for retirement and deduct it from your taxes. Your financial advisor or tax professional can help you plan for your SEP IRA. Be sure to account for retirement savings when calculating your business expenses.
Your credit union can help you become a successful independent contractor. iQ Credit Union has all the financial resources you need for your business, including business checking, savings, money market accounts, even assistance with SEP and retirement planning and payroll services. If you need help getting your consulting business started, we have credit cards and loans as well. Contact your local iQCU branch and talk to one of our financial advisors about your business banking needs.