Self-employed individuals own their businesses, but not all business owners are self-employed. Here are the essential differences.
- Business ownership can look a few different ways. For instance, business owners can hire other people to work for them or be sole proprietors.
- Self-employed individuals work for themselves and include independent contractors, partners, sole proprietors, and members of an LLC.
- The key differences have to do with the type of business, the way it’s taxed, whether there are other employees, how owners get paid, and other factors.
The surge of the gig economy has made freelancing or starting up a business more common and desirable. Pew Research reports that about 16 million US workers identify as self-employed today. This means, according to the IRS’s definition of self-employed individuals, that any of the following conditions apply to them:
- They carry on a trade or business as a sole proprietor or independent contractor
- They are a member of a partnership that carries on a trade or business
- They are otherwise in business for themselves, including a part-time business
Nevertheless, many people confuse self-employment with business ownership. They may assume that any kind of business owner is self-employed because they started or still run the business. But are they always considered self-employed? What about shareholders of corporations?
Here’s a guide to distinguishing these classifications:
What is business ownership?
Business ownership can look a few different ways. For example, a sole proprietor or freelancer technically owns their business, as does a shareholder who owns a stake in a company. A business owner may have founded the business and still manages day-to-day operations, or they may be removed from it completely. Entrepreneurs may also hire employees and contractors to work for the entity.
Owners get paid either by taking draws or distributive shares. A draw is taken from the business and put into a personal account, which is how a sole proprietor gets paid. A distributive share is money that partners earn in the form of shares, which is outlined in partnership or operating agreements. Dividends are funds received by corporate shareholders, determined by the business’s board of directors.
Business ownership and its different varieties are closely connected with how the entity will pay taxes, so the IRS rules essentially determine ownership types. For example, a sole proprietor and LLC owner will pay self-employment taxes, but not S corporation owners or corporate shareholders.
What is self-employment?
Someone who is self-employed doesn’t work for one employer who compensates them with a regular salary or wage like a traditional W-2 employee. Instead, self-employed workers are often freelancers (or independent contractors) who individually and directly contract with a company (or companies) to provide a service.
Self-employed individuals don’t have access to employer-sponsored benefits like paid time off or health insurance plans, and tax isn’t withheld from their earnings. They have to manage all these moving parts independently and are responsible for paying their taxes every quarter.
However, independent contractors can generally set their own schedule and decide what clients to work with or projects to take on, allowing for immense flexibility. Self-employed individuals may be independent contractors, sole proprietors, owners of an LLC, or members of a partnership.
Key differences between owners and the self-employed
Any self-employed person also owns their business. But, you can’t turn it the other way—not all business owners are self-employed. Self-employed workers both own their companies and are usually the only ones managing operations. But corporate shareholders, for example, often don’t have that kind of personal involvement in everyday business concerns.
Another way to define a self-employed worker versus a business owner is to determine how each of them gets paid. Typically, a self-employed individual will earn money from work they’re actively doing. In contrast, a business owner can make money from a larger system or company they bought into or created.
Independent contractors, sole proprietors, and single-member LLCs are self-employed, but many large shareholders of corporations are not. This is why S corporation owners don’t pay self-employment tax on business earnings.
Again, taxes are impacted significantly by the type of business someone decides to create. For example, sole proprietors, LLCs, and partnerships have pass-through taxation, meaning the entity itself isn’t taxed, and income is reported on owners’ individual tax returns. And owners still have to factor in self-employment taxes.
Corporations can get into a situation of double taxation, where the entity has to pay income taxes on profits, and then the shareholders have to pay taxes on dividends received. But opting to become an S corporation can help avoid double taxation while maintaining the owners’ separation from the company from a liability standpoint.
Questions about business ownership?
If all of this sounds complex, it can be. If you own a business, it isn’t always easy to understand how the different structures will impact your taxes. But tax professionals can guide you through the pros and cons, helping you find the option that meets your goals.
Provident CPA and Business Advisors assists our clients with minimizing taxes and business planning. Contact us today to learn more.