One of the most complicated aspects of outsourcing is finding a way to pay your independent contractors. Unlike employees, you don’t add contractors to your payroll, which gives you more freedom — but it also means you’ll need to figure out how to pay them. The good news is once you have a system in place, it will be simple to outsource more work in the future and you’ll be able to pay your independent contractors with ease.
What is an independent contractor?
An independent contractor is a broad category that includes several types of workers. You may contract people for specific tasks, such as caterers, event planners, and software developers. Plus, businesses often use consultants, particularly for receiving legal, marketing, or financial advice. You may also need tradespeople (such as plumbers, electricians, and carpenters) and artists for design work.
What are the main differences between a contractor and an employee?
There are more differences between contractors and employees than just paperwork. In fact, it’s important to be aware of these differences because if you treat contractors like employees, they will be entitled to the benefits of an employee.
Some key distinctions include:
- You set your employee’s work hours. Contractors decide when they work.
- You can delegate responsibilities to your employees. Contractors can accept and decline work.
- Employees work for you. Contractors are independent and can choose to have multiple clients.
- You can dictate how you want your employees to carry out the work you’ve assigned. In some circumstances, contractors can decide to subcontract work.
- You provide employees with the tools they’ll need to complete their work, such as a computer, internet, a headset, and software. Contractors usually have the tools required to complete their work already.
In terms of paperwork, employees typically sign an employment contract and they need to complete a W-2 right after you hire them. They either work hourly or have a salary. Depending on the benefits you decide to offer, the employee may accrue vacation time and may receive healthcare, a retirement plan, and sick leave. You’ll withdraw taxes for your employees and pay insurance.
Contractors, on the other hand, tend to have a contract that lists the tasks or projects they’ll complete along with a timeline and rates. They complete a W-9 when they begin working with you and you’ll report their earnings on a 1099 for independent contractors. Even though contractors may work for an hourly rate, for a flat rate, or on retainer, they don’t typically receive any benefits like vacation time, healthcare, or retirement. You pay independent contractors according to a predetermined agreement and the contractors themselves are responsible for their taxes.
Independent contractor payment terms
You’ll want to determine payment terms together, before your contractor starts working. You have a few options:
- Pay ahead of time. This is the least common choice. It’s best only to do this only if you already have a long-term relationship with the contractor. This method may be necessary if there are upfront costs for the contractor.
- Pay after the job. Whereas employers are used to this method, contractors may be hesitant to start working without a guarantee of payment. Most will only accept these terms if they already have a long-time relationship with you.
- Pay as you go. This can mean paying by milestone — where clients pay at predetermined intervals of a project. Alternatively, you could make a partial good-faith payment upfront and provide the rest at the completion of milestones or at the end of the project.
Your trust in each other, the timeline for the project, and the type of work will all help determine which payment term is in the best interests of both parties.
Independent contractor payment methods
There are several ways to pay your independent contractors. These fall into the categories of:
- Digital payments
For some projects, you may want to put funds in escrow. This is a safe way to show contractors you have the funds to pay them, but you only need to release the funds once the work is complete. Most escrow companies also offer arbitration should a disagreement about the work require third-party mediation.
There are two main companies that businesses and independent contractors rely upon for escrow services.
PayPal is one of the most common payment service providers, but can act as a third-party escrow holder. Be aware that the company does not offer escrow protection for digital goods, such as software.
Many companies around the world use Escrow.com. Businesses deposit money once they have a contract in place and only release funds once they have reviewed the independent contractor’s work.
Cash, check, credit card
If escrow protection is not a necessity, you have some additional options.
Some companies choose to pay in-person contractors with cash. It’s important you still make invoices and payment receipts for your records. You can also pay by check — either the paper kind or a digital check. Finally, many independent contractors accept credit card payments, although this is more common for contractors who are selling physical or digital goods rather than services.
You and the contractor will need to agree on a method — there are a few factors to consider:
- Country and currency
- Fees and penalties
- Processing time
- Transfer limits
Whatever you choose, it’s critical you keep track of everything in case either of you is audited or needs to verify payments with each other or the IRS.
How to pay your independent contractor correctly
- Use the IRS’s helpful 20-question test to determine if 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.
- Prepare a 1099 form to report your payments to your independent contractor. Note: you only need to do this if you pay an individual more than the $600 in one year.
- You won’t need to withhold Social Security, Medicare, or federal and state income tax. Independent contractors must pay their own 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 use backup withholding. This means you’ll report 24 percent of your payments to the independent contractor to the IRS using form 945 Annual Return of Withheld Federal Income Tax.
- If you are headquartered in California, AB-5 limits the number of individual tasks an independent contractor can complete for a company in a one-year period. Many companies are experimenting with ways to comply with this law while maintaining long-term relationships with their contractors.
Now you understand how to comply the law, the next step is to choose a method to pay your independent contractors. We’ve compiled a list of the 10 best ways — appropriate for contractors within the country and overseas. Check it out to find the method that will work best for your contractors.