What Is an Independent Contractor, and What Does That Actually Mean?

One of the things I find with new dental graduates is that they will tell me, “I got a job and they’re paying me $800 a day as a 1099.”

Okay. But what does that actually mean?

The first thing to understand is that being an independent contractor is fundamentally different from being an employee. If you are legitimately working as an independent contractor, the IRS generally considers you self-employed. In practical terms, you have entered into a business relationship with the dental practice rather than a traditional employer-employee relationship.

In other words, whether you realized it or not, you are now a business owner.

That distinction affects your taxes, your expenses, your benefits, your retirement planning and a whole bunch of other things. I have written about this issue before because I have seen new graduates get themselves into trouble by accepting an independent contractor position without understanding the tax consequences.

What Does “1099” Mean?

People tend to use the terms “1099” and “independent contractor” interchangeably, but technically they aren't the same thing.

A 1099 is simply a tax form. For most independent contractors providing professional services, the relevant form is Form 1099-NEC, which reports nonemployee compensation paid to you during the year.

Let's say you are a dentist working as an independent contractor and the practice pays you $200,000 during the year. Subject to the applicable reporting rules, the practice will generally issue a 1099-NEC reporting the amount it paid you.

Most people would say, “I made $200,000.”

That's fine in normal conversation. But from a business standpoint, I think it's more helpful to think of that $200,000 as business revenue.

Why does that distinction matter?

Because revenue and profit are not the same thing.

Revenue Minus Expenses Equals Profit

Imagine you collected $200,000 for providing dental services during the year.

You also had $20,000 of legitimate business expenses associated with operating your business. Maybe those included professional licensing, malpractice insurance, continuing education, accounting fees, legal fees or other ordinary and necessary business expenses.

You don't simply ignore those expenses and pay federal income tax as though the entire $200,000 were your business profit. A sole proprietor generally reports business income and deductible business expenses on Schedule C.

So, very simply:

$200,000 business revenue - $20,000 business expenses = $180,000 net profit

That $180,000 is much closer to what we mean when we talk about the income your business actually produced.

Obviously, what qualifies as a deductible business expense is a tax question. Buying a $2,000 laptop doesn't automatically make it deductible just because you have a business. This is one of the reasons I generally recommend that independent contractors work with a CPA or other qualified tax professional.

The Simplest Business: A Sole Proprietorship

You don't necessarily have to create an LLC or corporation to be a business owner.

The simplest structure is a sole proprietorship. The IRS defines a sole proprietor as someone who owns an unincorporated business by themselves.

Basically, you and the business are not separate legal entities.

You will also hear people refer to this as being a “Schedule C.” Technically, Schedule C isn't a type of business. It is the tax form titled Profit or Loss From Business that a sole proprietor generally attaches to their individual Form 1040. But when someone says, “I'm just a Schedule C,” this is usually what they mean.

The Schedule C is where the math happens.

You report the revenue from your business. You report your deductible business expenses. If revenue exceeds expenses, you have a net profit. If deductible expenses exceed revenue, you may have a net loss, subject to various tax rules.

That profit or loss then feeds into your individual federal income tax return and is part of the calculation that ultimately determines your adjusted gross income and taxable income.

And Then There Is Self-Employment Tax

This is one of the areas that surprises new independent contractors.

When you are an employee, you see Social Security and Medicare taxes withheld from your paycheck, and your employer generally pays an employer share as well.

When you are self-employed, there isn't an employer sitting on the other side of the table paying that employer share for you. Most independent contractors with sufficient net earnings from self-employment are subject to self-employment tax, which consists of Social Security and Medicare taxes. It is generally calculated using Schedule SE.

There is also generally no employer withholding federal income taxes from the money being paid to you. Depending on your situation, you may need to make estimated tax payments during the year.

This is why I don't want a new independent contractor looking at $15,000 that just landed in their checking account and thinking, “Great, I have $15,000 to spend.”

You don't.

Some of that money may belong to the IRS and your state government. Some may need to cover business expenses. What's left after all of that is a much better representation of what you actually earned.

What Tax ID Goes on the 1099?

If you are operating as a sole proprietor, you can generally use your Social Security number as your taxpayer identification number. A sole proprietor can also obtain and use an Employer Identification Number, or EIN, in many circumstances.

So I would make one small correction to the way this is sometimes explained: a Schedule C does not necessarily mean the 1099 has to be issued under your Social Security number. A sole proprietor may have an EIN.

This becomes a little more complicated once you start creating business entities.

What About an LLC or Corporation?

At some point, your CPA or attorney may recommend establishing an LLC, professional entity, corporation or another structure, depending on your state's laws and your individual circumstances.

This is where people sometimes get confused because legal structure and tax treatment are not necessarily the same thing.

For example, a single-member LLC is generally treated by the IRS as a “disregarded entity” for federal income tax purposes unless it elects otherwise. That means you can have an LLC under state law while the business activity still generally appears on Schedule C for federal income tax purposes.

An eligible LLC can also elect to be taxed as a corporation. And an eligible corporation or LLC can potentially make an S corporation election by filing Form 2553. With an S corporation, business income, deductions and other tax items generally pass through to the shareholder's individual tax return, although the mechanics are quite different from simply operating as a sole proprietor.

This is where I'm going to stop.

Not because these things aren't important, but because this is the point where a simple explanation of independent contracting turns into an article about entity selection, payroll, reasonable compensation, S corporations and tax planning. Those decisions should be made with a CPA and attorney who understand your particular situation.

One More Important Point

Getting a 1099 doesn't automatically make someone an independent contractor.

Worker classification depends on the actual relationship between the worker and the business. The IRS looks at factors involving behavioral control, financial control and the relationship between the parties. A practice can't necessarily turn someone who is functionally an employee into an independent contractor simply by calling them one in the contract and issuing a 1099.

That's particularly important for dentists because the details of these working relationships can vary quite a bit.

So What Does Being an Independent Contractor Really Mean?

The simplest way I can explain it is this:

You didn't just get a job. You started a business.

Someone is paying your business for professional services. The money coming in is business revenue. Your legitimate business expenses are deducted from that revenue. What remains is your business profit, which ultimately flows into your personal tax situation.

You are also responsible for things an employer would normally handle for you. That can include taxes, retirement benefits, insurance, licensing and other pieces of running a business.

None of this means being an independent contractor is good or bad. In some situations, it can work very well. But it does mean you need to treat it differently than a normal W-2 job.

If you are considering an independent contractor position, particularly coming right out of dental school or residency, make sure you understand what you are agreeing to before you sign the contract. A CPA, attorney and financial planner can each play a different role in helping you get things set up correctly.

And as always, every situation is a little different. If you have questions about how independent contracting fits into your financial plan, feel free to reach out