There are many similarities between being self-employed and being a small business owner. Both allow you to be your own boss, for one thing! But in the eyes of the IRS, your formal business classification can mean very different things when it comes to filing your taxes and reporting your business income.
Here’s how to determine which category you fall under as an entrepreneur and how it will impact your taxes.
Self-employed vs small business owner: understanding the difference
The simplest way is to differentiate between being self-employed and being a small business owner is to look at how you run your business. If you’re a small business owner, you run a business and often have other people working for you. If you’re self-employed, you are the business.
Examples of being self-employed:
- Sole proprietor: As a sole proprietor, you are your business. You call the shots, work for yourself, and take your business profits as personal income.
- Independent contractor: As an independent contractor, often called freelancers, you produce work for others, but you are still your own boss. You work on a contractual basis with clients of your choosing, but you are not their employee.
- Partnership: As a partnership, you have all the qualities of a sole proprietorship, but you share ownership of the business with two or more people who are your “partners.”
Characteristics of being a small business owner:
- You hire employees or have other self-employed workers working for you as independent contractors
- Your business can be classified as a separate entity, meaning you have less personal liability
- If you have part-time or full-time employees, you are responsible for collecting their taxes and obtaining workers’ compensation insurance
How are taxes handled differently?
The most significant difference between small business owners and self-employed individuals is how you pay yourself. Naturally, this also affects how each pays their taxes.
If you are self-employed:
- Your business tax deductions, profits, and losses are reported on your personal income tax return using Schedule C
- If you make more than $400 per year, you are responsible for paying self-employment tax to cover your Medicare tax and Social Security contributions
- You might pay quarterly estimated taxes throughout the year to avoid any penalties or a large tax bill at the end of the year
If you are a small business owner:
- Small businesses are taxed differently based on your business type — for example, limited liability company (LLC) taxes can be passed through to the owners, or you can elect to be taxed as a corporation
- If you are taxed as a corporation, you will pay corporate taxes, which is a tax on your profits (your revenue minus the cost of goods sold and other business operating costs)
- You use Form W-2 to report your employees’ incomes and how much federal, state, or local income tax they had withheld
- If you hire independent contractors, you must report any payments of $600 or more using Form 1099-MISC or Form 1099-NEC
When should I transition from being self-employed to being a small business owner?
As your business grows, many self-employed people start wondering when they should create a formal business entity.
You might want to consider changing your business structure if:
1. You want to lessen your personal liability.
Let’s say you are a sole proprietor who reports your business expenses using Schedule C. Lately, your business expenses have been growing. You find yourself adding more assets to Schedule C when filing.
In this case, it might be a good idea to limit your personal liability by structuring your business as a single-member LLC for tax purposes. In doing so, you are forming a business entity separate from yourself, offering more liability protection.
Once you’ve done this, you can elect to tax your business as an S corporation and start using Form 1120-S to report business profits and losses.
2. You are adding additional owners or employees.
Maybe you’ve been riding solo as a sole proprietor and are considering adding more owners to become a partnership or LLC. Or perhaps you’ve been in a partnership with someone else who has decided they want to leave. Whatever the case, a change in ownership can often lead to a change in business structure.
Likewise, adding employees can mean more liability, providing you with another good reason to switch your business type.
In the end, deciding to change your business structure comes down to what is best for you — and your business!