Self-Employed vs. Business Owner: Legal & Tax Differences

The business status of "self-employed" and "small business ownership" are sometimes used interchangeably and usually indicate you’re your own boss. While certain aspects, such as business model or eligible tax deductions, intersect, they are separate types of entities from a tax standpoint.

Use this blog to determine what each status indicates and their tax implications so you can determine which is the proper classification for your operations so you can stay compliant. 

Self-Employed vs. Small Business Owner: Where Do You Fall?

Many people who operate a business in their first year pay up to double what they should in taxes due to an incorrect entity election. Whether you're self-employed or a small business owner, operating as the correct business entity has serious tax implications. 

Definition of a Self-Employed Professional

When someone is self-employed, it usually indicates that they operate a sole proprietorship or as an independent contractor. These self-employed people may also be referred to as freelancers.

This means that you're the exclusive owner of the business and are responsible for every aspect from top to bottom. You get to keep all of the profits but are also liable for losses and debt.

Unlike other entities where you're required to register the business with your state, self-employed individuals don't have to as a sole proprietor or independent contractor. Fewer hurdles allow you to focus on building your budding business.

Sole proprietors and independent contractors differ in two substantial ways. 

1. Unlike a sole proprietor, an independent contractor is also the description of your relationship with clients via contract. 
2. Sole proprietors and independent contractors are taxed differently.

Definition of a Small Business Owner

When someone is a small business owner, that usually means they operate as a limited liability company (LLC.) Many small business owners started out as self-employed. As they became more successful, they transitioned into an LLC.

LLCs can be owned by a single person or many, called members. They offer personal liability protection that protects members' personal finances, meaning they won't be held personally responsible for business debt. Because LLCs are pass-through entities, members are taxed via their individual returns and aren't subject to double taxation and corporate taxes. 

Beyond the added protections of forming as an LLC, Small businesses differ from the self-employed in that they hire workers to carry out various business functions. They may employ W-2 employees or independent contractors and are responsible for the duties associated with leading workers, such as running payroll and distributing relevant tax documentation. 

Self-Employed vs. Small Businesses: Taxes and Liabilities

Tax Requirements for Self-Employed Professionals 

Self-employed professionals are typically required to file an annual income tax return and pay quarterly estimated taxes four times a year. Similar to full-time employees, they'll also pay a 15.3% self-employment tax to cover Social Security and Medicare contributions. 

Self-employed professionals must determine their net profit or loss for the year. This is done by subtracting your business expenses from your business income. If your expenses are less than your income, the difference is net profit and becomes part of your income on Form 1040 or 1040-SR. The difference is a net loss if your expenses are more than your income. In most cases, you can deduct your loss from gross income on Form 1040 or 1040-SR. But in some situations, that loss will be limited. You would also submit a Schedule C tax form along with your 1040 or 1040-SR.

Your income threshold will determine how you file. If your net earnings were $400 or more, you must file an income tax return. If your net earnings were less than $400, you still have to file an income tax return if you meet any other filing requirement listed in the Form 1040 and 1040-SR instructions.

Tax Requirements for Small Business Owners

Small business tax requirements can be more complex and extend beyond their members.

Because LLCs are pass-through entities, each member would pay taxes via their personal income tax returns. You are also responsible for payroll taxes and distributing Form W-2 to your employees. This form reports your employee's income along with the total amount of federal, state, and local income tax that was withheld.

If you hired independent contractors and paid them over $600, you must send them a Form 1099-MISC or Form 1099-NEC. Unlike W-2 employees, it is not your responsibility to withhold taxes for federal, state, and local authorities.

LLC Tax Classification 

Depending on the elections made by your LLC and the number of members, the IRS will treat your business as either a corporation, a partnership, or as part of your tax return (a “disregarded entity”). A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. For income tax purposes, an LLC with only one member, you're the sole owner, similar to self-employed professionals, is treated as an entity disregarded as separate from its owner unless your business files Form 8832 and elects to be treated as a corporation. For purposes of employment tax and certain excise taxes, an LLC with a single member is still considered a separate legal entity.

If you're confused about which election to choose, 1-800Accountant's tax advisory service can give you the answers you need to make the proper choice.

Personal liabilities and LLCs

There's a variety of insurance policies that small business owners should consider carrying based on the nature of their business.

Insurance policies all small business owners should consider include:

• Commercial general liability insurance. Also known as business liability insurance, it is useful for insuring your business for broad, general risks. 
• Business owner's policy. This insurance is offered to small and medium-sized business owners and protects them against property damage, income loss due to unforeseen events, lawsuits, and other common risks.  
• Professional liability insurance. Also called errors & omissions, this type of insurance protects certain business types from covering the total costs of defending against negligence claims in civil court. 

Adding employees or individual contractors

Small business owners hire W-2 employees and may also use independent contractors to carry out certain business functions. While workers’ compensation insurance is usually a requirement for in-house employees, the rules and best practices tend to vary for independent contractors.

Self-employed sole proprietors and independent contractors should consider getting workers’ compensation for themselves as an extra layer of protection, even if it isn't a requirement. Relying solely on health insurance to cover injuries, especially injuries that occurred while on the job, may not provide the full coverage you need. 

Personal liabilities when self-employed

In addition to worker's compensation, self-employed professionals can also benefit from professional liability and commercial general liability insurance. Like small business owners, self-employed professionals will also benefit from coverage related to their specialized industries.

For example, a self-employed professional who drives for a living must also get automobile insurance.   

Set your business up for success with 1-800Accountant

If you're just starting out as a self-employed professional or are a small business owner, setting yourself up for success from the outset is important. That means making the right tax-related choices now so they don't come back to haunt you while you're building your business. Those decisions can be nerve-racking without the experts at 1-800Accountant, America’s leading virtual accounting firm for small businesses, at your side.

Whether it's payroll, tax advisory, selecting the right business structure with entity formation, or any of our professional accounting services, we have the affordable pricing solutions you need to help your business stay compliant. Schedule a quick consultation – usually 30 minutes or less – to learn more.