A business may choose to hire an independent contractor or employee for very different reasons. Paying your independent contractors can be a significant point of confusion. We’re here to clear that up. Let’s walk through some of the critical points of confusion and general topics you’ll need to be familiar with to handle payroll without setbacks.
What is an independent contractor?
An Independent contractor is a broad category with several types of workers included under its umbrella.
You might hire people for specific tasks, such as babysitters, caterers, event planners, and software developers. Consultants are often utilized for advisory roles based on their background or profession in legal, healthcare, or finance. Tradespeople may be needed because of their trade specialties, such as plumbers, electricians, and carpenters. Artists may be engaged for their creative ability to contribute design elements, or glass, wood, or ironworks.
A contractor covers a variety of professions and tasks. You can also hire a contractor to do just about anything you might hire an employee for, such as assistants, bookkeeping, sales, and managers.
What are the main differences between a contractor and an employee?
There are a few key differences between the contractor and employee classifications. It isn’t just about the paperwork you complete. If you treat a contractor like an employee, they will be entitled to the benefits of an employee, which can be enforced and comes with state and federal penalties.
By deciding on the classification before hiring your workers, you’ll be able to get the work you need, pay your people, and pay your taxes without any confusion.
When trying to decide whether you want to hire a contractor or employee, consider these differences.
- You set your employee’s work hours. Contractors decide when they work.
- You can delegate responsibilities to your employees. Contractors stick to their wheelhouse and can say what they will and will not work on.
- Your employees work for you. Contractors can choose to have multiple clients and decide who they will be.
- You are able to dictate how you want your employees to carry out the work you’ve assigned. Contractors can decide to subcontract work.
- You provide employees with the tools they’ll need to get their work completed, such as a computer, internet, headset, software, etc…. Unless previously agreed upon, contractors need to have the tools required to complete their work.
In terms of paperwork, employees typically sign an employment contract. They work either hourly, on a stipend, or salary. And when they are hired, employees will complete a W-2. Depending on your agreement with them, they may accrue vacation time and often earn benefits, such as healthcare, retirement plans, and sick leave. When it comes to payroll, you’ll withdraw taxes for them, and you’ll pay insurance.
Contractors, on the other hand, will have a different type of contract. Typically it’s something that lists tasks or projects they’ll complete along with a timeline and rates. They’ll complete a W-9 when they begin working with you, and you’ll later report their earning on a 1099 for independent contractors. And even though they may work hourly, for a flat rate, or on retainer, contractors don’t typically earn any benefits like vacation time, healthcare, or retirement. When it comes time to pay, independent contractors invoice for their work, and you pay based upon your predetermined agreement. They have to pay their own taxes and withholdings.
For more about the difference between employees and independent contractors, the IRS provides details about classifications, forms, and obligations.
The IRS also offers a helpful 20-question test to help you determine whether your worker falls under the employee or independent contractor classification.
Independent contractor payment terms
You’ll want to determine payment terms together, ahead of work being completed, just like you agree on the work being completed and the timeline. Here are a few standard options:
- Pay ahead of time. This is the least common option. It’s best only to do this if you know and have had a long-term relationship with the contractor. It does occur more often when there are costs that the contractor must absorb to get the work completed.
- Pay after the job. This might mean paying after a significant project or after the entire job is completed. While this is what employers are used to because they pay employees after an entire day of work is completed, when it comes to contractors, they also need to have a long-time relationship with their client in order to feel comfortable with this option.
- Pay as you go. This can mean paying by milestone, where clients pay at predetermined intervals of a project. It can also mean clients make a partial good-faith payment upfront with the rest coming due at milestones and/or at the end. Some contractors will also charge when the bulk of the work is completed, with details and delivery of work being wrapped up shortly after payment.
Your comfort level with each other, the timeline for the project, and the type of work will all help determine which payment terms are best for both parties.
Independent contractor payment methods
There are several ways to pay your independent contractors, and the decision will come down to what you and your contractor are most comfortable with. What’s most important is keeping track of everything in case either of you is audited or needs to verify payments with each other or the IRS.
- Escrow options
- Digital Payments
For some projects, you and the contractor may want to put funds in escrow. This is a safe way to show your independent contractor that you have the funds to pay them, while only releasing the funds once work is completed. Most escrow companies also offer arbitration should a disagreement about the work completed and payment become a discussion in need of a third party.
Right now, there are two companies that companies and independent contractors regularly rely upon for payments and escrow services.
Escrow.com is used by a variety of companies around the world. Clients deposit money once a contract is in place. Then they release funds after having time to review the work completed by their independent contractor.
Cash, check, credit card
For those who aren’t interested in escrow protection, you and your independent contractor will have to decide on a simple process of invoicing and payment.
Some companies choose to pay their in-person contractors with cash. It’s important you still get an invoice and payment receipt for your records.
You can also pay by check, either the paper kind or with a digital check. Most companies have a business account that can write and send checks in the mail or to an email. The independent contractor can connect their email with their bank account to receive funds and have them deposited for them.
Credit cards are also accepted by many independent contractors, although this is more common for contractors who are selling physical or digital goods over services.
While you both need to agree on a method, there are a few factors to consider:
- Country and currency
- Fees and penalties
- Processing time
- Transfer limits
What to do and not do right now to pay your independent contractor correctly
- Use the IRS 20-question survey to determine that your worker is indeed an independent contractor and not an employee.
- Have your independent contractor complete a W-9 and work out the details of your agreement through a contract and an understanding about payment amount and method.
- You do need to prepare a 1099 form to report your payments to your independent contractor unless you pay them less than the $600 in one year, in which case you do not need to report payments. Note that you need to use a 1099-NEC form in 2020 for 2021 taxes.
- You won’t need to withhold Social Security/Medicare tax, federal or state income tax. Independent contractors are obligated to pay their own income taxes and self-employment taxes. However, there are two additional regulations to be aware of.
- If the independent contractor does not provide a social security number or EIN on their W-9, or if the number they provide is incorrect, you’ll need to withhold what’s called backup withholding. A total of 24% of your payments to the independent contractor will be reported to the IRS using form 945 Annual Return of Withheld Federal Income Tax.
- If you are headquartered in California, there is currently a law called AB-5, which arbitrarily limits the number of individual tasks an independent contractor can complete for a company in a one-year year period. Many companies are experimenting with ways to comply with this law while still maintaining long-term relationships with their contractors.
While compliance with the law is of the utmost importance, how to pay independent contractors is also heavily dependent on the relationship you have with your worker. Bookmark this guide to double-check your process and to take the steps necessary to keep your company compliant. Always work closely with your contractor to ensure you both understand terms, preferences, and to develop communication best practices. These steps will ensure a long, trusting relationship.