Who is a Self-employed Person and What is Self-employment?
An independent entrepreneur, contractor, or sole proprietor is an individual who does not report to anyone. A self-employed person generates income by pursuing an economic activity such as trade, profession, artistic occupation instead of serving an employer or working for an organization.
Thus, this mode of employment encompasses any profession or occupation where individuals earn independently, such as freelancing, stock trading, law, consultancy, etc. Self-employment allows people to work according to their convenience, giving them enhanced flexibility and control. However, income generated from self-employment can be erratic, and job security is much less than regular jobs.
How Does Self-employment Work?
Self-employed individuals work as independent contractors who collaborate with other organizations to offer their products/services. They are highly skilled in their area of expertise and enjoy complete control over work decisions. Labor laws of any country do not govern such work, and there’s no specific rule for working hours or income. The burden of profits, losses, or liabilities falls on the self-employed individual.
For instance, a freelance writer may choose writing as self-employed working for earning by entering into short-term contracts with companies without being bound by employment rules or work regulations.
Types of Self-employment
There are mainly three types of self-employed work:
- Independent contractors– These self-employed individuals specialize in specific types of services. Since they do not fall under the category of ‘employees’, they are deprived of company benefits such as workers’ compensation, retirement benefits, medical insurance, and equal opportunity laws. Unlike employers, clients hiring independent contractors do not withhold taxes for freelancers, nor do they give them any benefits applicable to employees. Lawyers, doctors, accountants, journalists, freelance writers, designers, marketers, etc., are a few examples of independent contractors.
- Sole proprietors– When an individual owns an enterprise, they are called sole proprietors. In this type of self-employment, the entrepreneur may hire employees. Here, there’s no distinction between the business and sole proprietor, and they are liable for any losses that the enterprise incurs while also enjoying the revenues generated.
- Partnerships– In this category, two or more parties operate and manage a business together and share the profits or losses. Partnerships may be those with equal shared opportunities or those with limited liability.
Challenges to Self-employment
While self-employment allows you to work independently and enjoy its many rewards, there are many challenges to being self-employed.
Here are some of the common challenges of self-employment that you should be aware of:
One of the biggest challenges of being employed on your own is the uncertainty of a regular income. Unlike full-time employees who enjoy regular monthly paychecks, self-employed individuals have no fixed income.
The initial costs of establishing your business is often undefined and unexpected. Running a business demands a continuous cash flow for meeting various business needs.
With self-employed individuals managing everything alone becomes a huge challenge. They must manage the budget, book-keeping, record of inventories, office requirements, hiring, and much more. Thus, managing personal and professional needs can get pretty hectic for an individual.
Uncertainty of work
Marketing your services is challenging if you are self-employed. There’s no guarantee if you will get work consistently. It requires active project/client hunting.
It’s pretty natural for self-employed individuals to find motivation while juggling multiple responsibilities alone. This is particularly difficult when the business isn’t booming or running as it should.
Planning and implementation
Business planning and execution take dedicated efforts, time, and resources. For self-employed people, planning and implementing get cumbersome if they don’t have employees to help them with daily business operations.
Pros and Cons of Self-employment
There are both pros and cons of self-employment that you must know before deciding to become self-employed.
The pros of self-employment are:
- Freedom– One of the biggest driving factors for choosing a self-employed job is the freedom of doing what one loves, setting the working hours according to their convenience, and the freedom to make work decisions.
- Cost-saving– Freelancers working from home can save a lot on traveling and get a tax deduction by setting up a home office.
- No boss– When you are self-employed, you work on your terms. You don’t have a boss over your head to stress you out with work regulations and deadlines. Instead, you can set targets for yourself and work to achieve them.
- Creativity– You can use your creativity in your venture to deliver best-in-class services/products. There’s nothing that can beat the joy of achieving your goals on your own terms. Plus, you get a sense of achievement and pride in doing what you do!
- Work-life balance– Since you work according to your convenience and timing, you enjoy a greater work-life balance. You don’t need to constantly stress about company deadlines or answer to a superior for your decisions.
- Making more money– Being creative and doing what you love makes one more productive and efficient. Naturally, you brainstorm ideas and plans that drive your venture’s growth and success. There’s no fixed cap on your earnings – you can set the bar high and pave the way for increased profits.
The cons of self-employment are:
- As mentioned earlier, one of the biggest cons of self-employment is the uncertainty and risks involved. While some months may bring maximum revenues, it may be followed by intermittent periods of stagnancy. Hence, it’s essential to save enough to sail you through the slower or stagnant months.
- When working alone, you cannot enjoy the support and cooperation or even the camaraderie of your co-workers.
- You aren’t entitled to the benefits enjoyed by full-time employees like healthcare plans or retirement benefits.
- You must pay self-employed tax, including social security and medicare taxes.
Taxes for Self-employed
Whether you are a sole proprietor, an independent contractor, or a partner in a partnership business, self-employed people must pay self-employment taxes annually if their net earning is anything more than $400. The tax is fixed at 15.3%, including 12.4% for social security and 2.9% for medicare, calculated based on one’s net income.
For higher-income businesses, there is an additional 2.9% on medicare tax. However, the Social Security tax remains fixed. Thus, the self-employment tax is added to one’s individual tax return and is considered a liability.
Since such people are not employed in full-time positions by companies, no tax is deducted from their wages. However, one may need to pay estimated taxes quarterly or income tax on their net income to avoid penalties.
How do Self-employed Individuals Pay Income Taxes?
Individually employed people must abide by separate tax rules. They pay pass-through taxes, which is the personal tax return. Sole proprietors must fill out the Schedule C form and pay taxes based on their business income. Partners engaged in partnership businesses must file a tax return followed by a Schedule K-1 that shows them as a part of the company, entitled to its earnings.
Moreover, as a self-employed individual, you might also be eligible for an additional tax deduction under the 2017 Tax Cuts and Jobs Act. This is an additional 20% deduction and is referred to as a Qualified Business Income deduction on the net income generated from your business. It applies to sole proprietors, Limited Liability Company owners, partners, or S Corporation owners. Ensure to check your business tax preparation software for any limitations on this type of tax.
Benefits for Self-employed Individuals
Although self-employed people may not enjoy the perks of a full-time employee, they do enjoy many self-employed benefits, thanks to the pandemic. For instance, the Paycheck Protection Programme is a loan available for self-employed individuals. According to this loan program, the amount offered as a loan can be used to pay rent, utilities, or even mortgage interest. One can apply for it via a financial institution or bank.
Paid Sick Leave and Family Leave Tax Credits is a self-employed workers compensation scheme that offers paid leave to self-employed workers who need time off to take care of their family members or children suffering from Covid-19. The calculation of tax credits is determined by the number of leaves taken for a maximum of 10 days. Again, if a self-employed individual requires money for any Covid-19-related issue, they can then reduce the quarterly estimated tax and receive a tax credit on their self-employment taxes for that year.
The Pandemic Unemployment Assistance program is also another feather to the CARES Act of 2020 program that grants special benefits to self-employed individuals who cannot work due to being afflicted by Covid-19. However, you must remember that you cannot get both Unemployment Assistance and Paycheck Protection together.
Self-employment vs. Entrepreneurship vs. Startup
There is a difference between self-employment, entrepreneurship, and a startup. Although these terms are often used synonymously, there is a subtle distinction between the three.
Entrepreneurship refers to any business idea designed, launched, and implemented by an individual or group of individuals. It includes all newly launched organizations that embrace small companies that cannot expand beyond their limited capacities. On the other hand, a startup is a new entity set up temporarily with an aim to expand, grow bigger beyond the company founders, and become a full-fledged company in the future by hiring employees.
If you are a stakeholder in a business, you may be referred to as a business owner, even if you don’t take part in everyday business activities. This is similar to a ‘silent partner’ that sometimes occurs in partnership businesses. However, self-employed people are owners and primary operators of their entities.
Self-employed business or profession has its distinct advantages and disadvantages. However, it is crucial to understand the subtle differences between the different types of self-employed individuals.
When setting up a business, you may find it challenging to gather all documents and adhere to the legal procedures required to set up a sole proprietorship or even work as a freelancer. There are several things to consider before you step into the self-employed domain. Hence, consulting an expert or partnering with an established service provider like Multiplier can make the journey to self-employment easy for you.
Talk to our experts today to know more!
Frequently Asked Questions
Q. As a self-employed business owner who uses his home, are any deductions applicable?
You can seek deductions but they have an upper cap. Additionally, you must be using only a part of your home for business. However, you must use that specific part of the home exclusively for business.
Also, you are eligible for deductions when you offer your home on rental or as a facility for day-care.
Q. If I own a business that is set up as a sole proprietorship, do I enter into a partnership agreement for my wife to be part of the same?
A sole proprietor is the only owner of a business and adding your spouse to it will deem the latter as an employee.
If you want a partnership, you need to make a new registration ad per governing Acts of your area.
Q. Is insurance payable eligible for tax savings for sole proprietors?
Yes, it is, up to a certain limit. Your local tax laws apply in this context.