Independent Contractor vs. LLC

Independent Contractor vs. LLC

Introduction

Proper classification of service providers is a critical business requirement for regulatory purposes. In an increasingly digitized and remote work world, boundaries are blurring between conventional and emerging business forms — making a more characterized business classification even more important.  

In a pre-digital, pre-remote world, corporations, limited liability companies (LLCs), and sole proprietors were a few of the many forms businesses could take. Today, independent contractors (or remote workers) who depend on how they are defined in different jurisdictions can be classified as sole proprietors or LLCs. The evolution of independent contracting has made conventional service provider classifications outdated, if not irrelevant.

The question of where you should draw the line between each business form is essential — but not solely — a matter of definition. For example, the LLC vs. independent contractor is a duality you need to understand to avoid regulatory inconveniences and penalties. Similarly, independent contractors can be classified as sole proprietors under certain conditions.

So where should you draw your definition — and tax — line to ensure you are compliant?

Read on to learn where your tax lines can and should be drawn.

Who are independent contractors?

The general rule for an individual to be classified as an independent contractor is that an employer does not control their work except for results.

This broad definition includes a wide range of "independent" professionals, such as lawyers, doctors, accountants, contractors, etc. Narrowing down how each independent service provider can — or should be — taxed is decided on a case-by-case basis. In general, however, an independent contractor is considered a self-employed person and, as such, is subject to self-employment tax.  

If a business owner is hiring independent contractors, they must fill in and report Form 1099-NEC (formerly Form 1099-MISC).

Please note that from now on, the "1099" designation is sometimes used as a short form of "independent contractor" based on Form 1099-NEC's filing and reporting obligations of employers for independent contractors. That said, independent contractors are defined differently in different jurisdictions.

Recent regulatory changes in Spain further define and formalize independent contractor status. By opening up borders for independent contractors, Spain expands even more on what an independent contractor is and who — according to "digital nomad" visa arrangements — can stay and work in-country. These changes make remote working for independent contractors only one option of many.

In New Zealand, distinctions are already made between employees and independent contractors, similar to those in the U.S.

You got it. Depending on where you provide your services and where you are located, learning what is for and against you in your chosen market of operation is critical to staying compliant and avoiding unpleasant and unexpected regulatory penalties.

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What is an LLC?

A limited liability company (LLC) is a commonly used business structure comprised of members who could be individuals, corporations, or foreign LLCs.

Unlike many other business forms, an LLC does not have restrictions on the number of members and, importantly, can be (re)classified in many ways most business forms cannot, including as a corporation, partnership, or separate entity from its owner.

For example, an LLC with at least two members is classified as a partnership — unless filing Form 8832 to become organized as a corporation. And an LLC with only one member is classified as a separate entity from its owner — unless filing Form 8832 to become classified as a corporation.

The most crucial advantage of LLCs is that owners are protected from personal liability, meaning your assets as a member are shielded from risks in cases of bankruptcy or lawsuits. On the other hand, LLC members are, by definition, self-employed and thus subject to self-employment contributions for social insurance and healthcare.

Independent contractors vs. sole proprietors

Independent contractors are individuals whose services are not controlled or directed by an employer. This definition of an independent contractor is often confused with a sole proprietor. In reality, however, each is distinct.

A sole proprietor is someone who, by themselves, owns an unincorporated business. "Unincorporated" means a form of business that does not need to be registered like other more formal business forms.  

Depending on your situation, you, as a sole proprietor, may be required to fill in and report tax forms, including Form 1040, Form 1040-ES (Estimated Tax for Individuals), Form 941, Form W-2, and more.

This definition makes sole proprietors distinct from independent contractors in at least one fundamental way:

Where independent contractors provide services to employers on an independent basis and are required to report independently or via employers their earnings, sole  proprietors are still businesses, informal as they may be, that are needed to fill in and report tax forms generally different from independent contractors.

Independent contractor vs. LLC (1099 vs. LLC)

The case for a single-member LLC is often confused with an independent contractor. But they are distinct.

As noted, an LLC with only one member has considered an entity disregarded as separate from its owner or a " disregarded entity." This characterization of LLC maintains a balance between benefits gained to establish a business entity (e.g., more credibility among lending institutions) and liabilities involved in reporting tax returns for an LLC's owner.

The LLC vs. 1099 — or LLC-contractor duality — is often confusing and needs careful examination on a business and jurisdiction case-by-case basis to correctly classify your business (or employees and contractors) and avoid potential regulatory penalties.

How does the taxation of independent contractors differ from LLCs?

Taxation is seminal in distinguishing between different business and worker categories. Then again, businesses and workers must be appropriately classified before making any distinction based on taxation requirements. This may seem like a chicken-or-egg situation, but in practice, employers and contractors experience conditions where what should be determined first — business form or tax requirements — is often unclear.

Hint: Using an established employer of record, such as Skuad, to classify your employees and contractors properly and report your taxes compliantly spares you, as an employer, much headache.

Theorization aside, independent contractors and LLCs differ in taxation and practice.

For independent contractors classified as self-employed, Form 1040-ES is required.

Moreover, the Self-Employment Tax form is necessary to report Social Security and Medicare taxes.

Form 1099-NEC (formerly Form 1099-MISC) is essential for independent contractors whose employers report to them.

For sole-member LLCs, Form 1040 or Form 1040-SR is required for tax reporting purposes.

Why should independent contractors consider establishing an LLC?

So, LLC or 1099? That's a question every independent contractor will likely need to consider.

Typically, independent contractors are skilled and experienced professionals who provide individual and independent (from any employer) services. This work arrangement allows independent contractors to enjoy a wide range of benefits, including

  • Entitlement to above-market payments in return for rendered services (without having much, if any, deduction)
  • Higher work flexibility compared to employees
  • Self-managed work-life balance.
  • On the other hand, independent contractors are liable for a string of risks, including
  • Unexpected income loss because a client switches to a different provider, economic downturns, etc.
  • Lack of many statutory benefits employees usually enjoy, such as social insurance and healthcare
  • Sharp fluctuations in demand because of uncontrolled factors, such as economic downturns, changes in market structure, or "hottest" services needed

Unsurprisingly, many independent contractors opt-in for an LCC business form to avoid risks inherent in independent contracting. By choosing to become an LLC, an independent contractor gains more benefits, including:

  • Protecting against being held personally liable in cases of solvency and lawsuits
  • Exercising a minimum-risk form of business which, if proven successful, can be expanded
  • Managing finances better by spreading risks away from personal assets and funds
  • Becoming a more credible candidate for loans from lending institutions that are reluctant to fund individuals held personally liable when doing business

Choosing LLC over going independent is, ultimately, a choice contractors should make wisely and based on careful consideration of a wide range of factors, including:

  • The current state of market makeup and hiring patterns (whether in favor of more conventional forms of employment and business or more geared to gig-styled services)
  • The contractor's professional and personal preferences to go on solo or expand their "own business" into a more formalized form
  • Whether local laws and regulations provide enough protections and benefits for employees, contractors, or businesses

If you plan to hire independent contractors, partnering with an Employer of Record platform like Skuad is the best option. 

Skuad enables you to compliantly hire and onboard independent contractors in over 160 countries without setting up a subsidiary. Skuad’s global employment and payroll platform also help you manage payroll and compliance with country-specific employment and tax laws. 

To know more about Skuad, book a demo today.

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