Working as an Independent Contractor FAQ

Quick answers for consultants, freelancers, and contractors.

What is an independent contractor?

An independent contractor (IC) is someone who runs his or her own business. Independent contractors earn their livelihoods from their own independent businesses instead of depending upon an employer to earn a living. Independent contractors are sometimes called consultants, freelancers, self-employed, and even entrepreneurs and business owners.

Unlike an employee who works for one employer, independent contractors typically work for a number of different clients, tackling particular jobs or projects that require special expertise.

What are the benefits and drawbacks of being self-employed?

There can be many advantages to being self-employed:

• You are your own boss.
• You may be paid more than employees.
• No federal or state tax is withheld from your pay.
• You can take increased business deductions.

Despite the advantages, however, being self-employed is no bed of roses. Here are some of the major drawbacks.

• You have no job security.
• You might not get paid.
• You must pay self-employment taxes.
• You may be personally liable for business debts.
• You have no employer-provided benefits.
• You have no unemployment insurance benefits.
• You have no employer-provided workers' compensation.
• You have few labor law protections.

Do I need to use written agreements when I do contract work for clients?

You really should. Using a written agreement avoids disputes by providing a written description of the services you're supposed to perform, when they are to be performed, and how much you will be paid.

A written independent contractor agreement can also help establish that you really are an independent contractor -- not your client's employee. Although an agreement by itself doesn't definitively prove that a worker qualifies as an independent contractor, it will help show the IRS and other agencies that both you and the hiring firm intended to create a hiring firm-independent contractor relationship, not an employer-employee relationship.

How do I decide how much to charge for my work?

When you're just starting out as an independent contractor, it can be tough to figure out what to charge your clients. You'll want to come up with a figure that pays your expenses, adequately compensates you for your time, and allows you to earn at least some profit. And, of course, you'll have to make sure not to charge more than the market will bear -- if freelancers in your area are willing to perform the same work for a much lower fee, you probably won't drum up much business.

Do I have to pay taxes on my freelance income?

When you work as an independent contractor, you have to pay income tax, just like an employee. Unlike an employee, however, you won't have any taxes withheld from your paycheck to cover income tax, Social Security, and Medicare. And also unlike an employee, you can't wait until April 15 to pay all of your taxes due for the previous year. Instead, you have to pay estimated taxes four times a year.

Fortunately, contractors can take advantage of some great tax deductions; for instance, the home office deduction can effectively take some money off your rent or mortgage.

How can I make sure that my clients pay me?

Many consultants find that they spend way too much time acting as a collection agency, going after deadbeat clients who refuse to pay their bills. The best way to avoid this problem is to use a written client agreement, clearly setting forth your fees (including late charges) and a payment schedule.

If a client still won't pay, you should start turning up the heat by persistently demanding payment and pursuing your legal options, if necessary.

Who decides whether I'm an employee or an independent contractor?

Initially, it's up to you and each hiring firm you deal with to decide whether you should be classified as an independent contractor or an employee. But this decision is subject to review by various government agencies, including the IRS and state workers' compensation and unemployment compensation agencies.

The IRS looks at a number of factors when determining whether a worker is an employee or an independent contractor. The agency is more likely to classify as an independent contractor a worker who:

• can earn a profit or suffer a loss from the activity
• furnishes the tools and materials needed to do the work
• is paid by the job
• works for more than one firm at a time
• invests in equipment and facilities
• pays his or her own business and traveling expenses
• hires and pays assistants, and
• sets his or her own working hours.

For more information on the criteria used to determine whether a worker is an employee or an independent contractor, see Preserving Your Status as an Independent Contractor.

What happens if a government agency decides that I am an employee?

If a government agency determines that you should have been classified as an employee, you'll suffer some consequences. For example, the hiring firm may decide not to use you any more because it doesn't want to pay the additional expenses of treating you as an employee. Or, the hiring firm may insist on reducing your compensation to make up for the extra employee expenses. And reclassification as an employee could create additional tax burdens for you, if you have to forego some of the tax deductions to which you were entitled as a contractor.

In addition, the hiring firm can suffer severe consequences. The IRS may impose substantial assessments and penalties on the firm. At the very least, the firm will have to pay 20% of the Social Security and Medicare taxes that should have been withheld from your pay, 100% of the Social Security, Medicare, and federal unemployment taxes the employer should have paid, a penalty equal to 1.5% of your compensation, interest and sometimes other hefty penalties as well.