What is an independent contractor? Should I become an independent contractor?

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

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 not always a 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.

For more information, see Being a Consultant, Freelancer, or Contractor: Pros and Cons.

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. 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 reduce your taxes by a portion of your rent or mortgage.

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.

Who decides whether I'm an employee or an independent contractor? What if a government agency determines that I am an employee?

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 you are an employee or an independent contractor. The agency is more likely to classify you as an independent contractor if you:

• can earn a profit or suffer a loss from the activity
• furnish the tools and materials needed to do the work
• are paid by the job
• work for more than one firm at a time
• invest in equipment and facilities
• pay your own business and traveling expenses
• hire and pay assistants, and
• set your own working hours.

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

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 anymore 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.