Have you ever considered hiring independent contractors for your business? If you aren't doing it already, you are missing a great opportunity. Many business owners leverage the gig economy to improve their business by hiring independent contractors. However, there are a few challenges that arise; Apart from hiring independent contractors compliantly, you need to consider the best way of paying them. We have tackled the most important challenges that you can face, the paperwork needed to compliantly hire contractors, as well as a detailed list of all payment systems.
What is an independent contractor?
An independent contractor is a self-employed individual or entity hired to perform a service to a company. Contractors are performing services to the general public. According to the IRS, the independent contractors have the independence of the way the work is being done, allowing the company that hired them the right to control only the result of the work.
Read more about what is an independent contractor.
What are the benefits of hiring independent contractors?
There are many benefits of hiring independent contractors. If you are a small business owner, an independent contractor can help with some of the short-term workloads, allowing you to focus on the core of your business.
The main benefits of hiring an independent contractor are:
- Minimal training required - Independent contractors are usually very skilled workers, who are hired based on their specific knowledge and don't require any training.
- Cost-efficiency - Even though sometimes, at first, independent contractor fees are higher than full-time employees' hourly rates, the total business expenses of one employee is much higher, given that the businesses who work with contractors do not cover traditional employee benefits, and there is no backup withholding, which makes hiring them very cost-effective.
- Staffing flexibility - Since independent contractors are usually hired short-term or on a need-basis, you will have better management of the business expenses. The flexibility enables you to hire the contractors when and for as long you need them.
Read more about the benefits of hiring independent contractors.
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Make sure you're not at risk of the employee misclassification
Misclassification is one of the most common issues when hiring independent contractors. There is certain criteria that needs to be met in order for someone to be a contractor. Independent contractors usually perform the work on their own terms, allowing the employer to control only the result of the work.
This is because tax implications are different for employees and contractors. Employers are required to do backup withholding from their employees' salaries, causing them to spend a significantly higher amount of money on them. If the IRS decides that your independent contractor should in fact be your employee, you will be required to pay all of the Social Security and Medicare taxes (FICA taxes), along with unemployment taxes.
Make sure that you have aligned any written contract and your business relationship accordingly. For a more detailed overlook, check our employee misclassification guide.
Before hiring and paying independent contractors
Collect the necessary paperwork
Let's tackle the legalities. Before you start working with an independent contractor, there are a couple of things that you need to do.
- Collect Form W-9: This form contains the name, address, and Social Security Number or Taxpayer Identification Number (TIN) of an independent contractor. This form is not filed to the IRS but is necessary to be kept on record before the first payment is made.
Read more about Form W-9
- Sign a written contract: Sign a contract with your independent contractor regardless of the size or length of the engagement. In the written contract, outline the scope of work and the payment terms, as well as any other clauses that can protect you or the contractor.
Read more about how to draft an independent contractor agreement.
How are independent contractors paid?
Since independent contractors are considered to be non-employees, they receive compensation based on the work that they perform. They can be paid in two ways:
- By the hour: If the independent contractor is a freelancer or a consultant, they will most likely have an hourly rate for their services.
- By the job: If the independent contractor is hired for a specific project, they will most likely have a defined compensation based on the work they perform.
Withholding and deductions for independent contractors
In general, you don't need to withhold any taxes when you make a contractor payment, as long as you have Form W-9. However, in case you are missing the W-9 or any of the information such as the contractor's TIN is incorrect or missing, you are obligated to withhold federal income tax (called backup withholding). The IRS will instruct you to perform the backup withholding in a notice.
How do independent contractors pay taxes?
Independent contractors are usually sole proprietors or business owners themselves, which means that they are responsible to pay their own tax payments and other benefits such as health insurance, pension plan, etc.
If they operate under a sole proprietorship, they are paying their own taxes such as self-employment tax and federal income tax.
Read more about independent contractor taxes.
The best way to pay independent contractors
Once you have all the paperwork and the work is completed, it's time to consider the best way to pay an independent contractor. There is no one payment system that works for everyone, so you should consider what makes the most sense for your business. Let's take a look at the different payment methods.
One of the fastest ways to pay a contractor through a wire transfer. It usually takes about 24h to clear the payment. However, this payment method can be costly, as the fees are often paid by both the sender and the receiver. That means that if you're paying the contractor more frequently or in smaller amounts, it might be good to consider other methods.
ACH direct deposit
ACH transfers are paperless and quite secure. They are often used by employers to pay their employees but work just fine for contractors as well. All you need is the contractor's bank account information and you're good to make the direct deposit. They are convenient for recurring payments, especially if you're using online software to make contractor payments.
Using credit cards to pay your contractors is another quick and easy payment method. Credit cards offer a layer of security, so for any potential disputes, the resolution time or refunds are quite fast.
Paying contractors through digital wallets are being used more and more. Instead of long queues and paperwork hassle, you can easily transfer money in just a few clicks.
PayPal is the most frequent method of transferring money. Fees are also quite low, 2.9% + $0.30 in the US. If you have more than one contractor you can use an advanced business solution called PayPal MassPay. It helps decrease the time needed to pay all of your contractors, since you can make multiple payments at once, just by uploading the necessary information. In addition, it has significantly lower fees than the regular bank account. It is important to mention that PayPal has a certain restriction - you aren't allowed to use friends and family option for business purposes.
Another great option for paying an independent contractor is Payoneer. It also has a global presence, and it offers multiple options for money withdrawal, one of them being a Mastercard issued by them. This is much faster than waiting for the funds to be deposited on regular bank accounts, although Payoneer offers that option as well.
On the downside, Payoneer fees are also substantially higher for contractors. it costs $2 to $4 to load the debit card and up to 3.5% for currency conversion. There is also a % fee for transferring money to your local bank account.
Another digital payment option, currently used by 12 million customers, Revolut offers not only money transfer but also deals in gold and crypto payments. This app offers transactions internationally, to both private customers and business, with no hidden fees. They also offer their customers a card that currently supports up to 130 currencies. There are various subscription options you can choose from, offering different fees and products.
The biggest upside of using Wise (formerly transferWise) as a payment method is the fact that they have the fairest exchange rate, allowing for local bank payouts in multiple currencies. Every other payment service adds a premium to the wholesale exchange rate, making the transaction more expensive. They also list the benefit of offering rates and fees before the money is sent.
Although still considered a novelty, many businesses are opting for paying their contractors in cryptocurrency. Some still consider cryptocurrency payouts to be sketchy, mostly because the market for cryptocurrency business payment is still very new and untested. However, this prejudice is proving to be untrue, and cryptocurrencies have many benefits. Cryptocurrencies can help you avoid exchange rates and hefty fees, and allow your contractors to choose their own method of payment and the currency they want to use. This is why Deel contractors have the option of using cryptocurrencies as a means of payment.
Reporting payments to independent contractors
Just because you aren't required to pay any payroll taxes for contractors, doesn't mean that you aren't obligated to report the contractor payments. You need to report the payments made to contractors higher than $600 within a tax year. For that, you should use Form 1099. Until 2020, the form used to report the non-employee compensation was Form 1099-MISC. In 2020, the IRS reintroduced Form 1099-NEC, separating it from Box 7 of the 1099-MISC. The deadline to file 1099-NEC forms is January 31, following the applicable tax year.
Don't forget to collect the Form W-9 before the end of the year so you're ready for submitting your 1099-NEC.