How to Pay Independent Contractors in 5 Easy Steps

For employers, paying independent contractors is simpler and often cheaper than paying employees because they don’t have to withhold or pay taxes. Although year-end reports are required to show amounts paid, labor laws—like minimum wage—that cover employees don’t apply.

If you’re looking for an easy way to pay independent contractors, consider Gusto. You can pay them through direct deposit, and all payments will be reported at the end of the year on IRS Form 1099. In addition, you’re only charged during the months you actually pay your contractors, and even then, it’s only $6 per person monthly. Sign up for a free trial today.

Visit Gusto

Here are the five steps you should follow when paying independent contractors:

1. Determine How to Pay Contractors

Paying independent contractors isn’t difficult, but it is different from paying employees. Determining how to pay independent contractors (using payroll software in-house vs outsourcing to a payroll service) and how much to pay are some of the first decisions you’ll make to ensure the process goes smoothly.

Unlike with employees, you don’t typically pay contractors a salary. Instead, you should consider whether an hourly rate or per-project price would be more appropriate, their pay rates, and any payroll taxes to consider.

Before starting any work, you and your contractor should reach an agreement regarding pay. If you’ve hired contractors for similar work before, you may already have an idea as to the going rate; if not, you can call around and request an anonymous quote from your competitors. Contractors usually have their own rates, so you’ll need to ensure you’re on the same page.

Also, consider the type of work your contractor performs; if it’s work for which it’s difficult to estimate the required time to complete, a per-project rate sounds ideal. Being unable to estimate costs is bad for your business and could create conflict between you and the contractor if you’re charged more than expected.

As you determine how you’re paying, be sure to reflect on the length and size of the project.

Is it a month-long project? Or will the contractor finish it in a week?
How much time will your contractor need to devote to the project daily?
Are you expecting a big project to have a quick turnaround?

Depending on your answers and the contractor’s terms, you may need to pay a deposit or make payments at predetermined intervals. If you’re working with a contractor for the first time, be flexible; some contractors have had bad experiences with clients using their services without ever issuing payment.

Another point to keep in mind when negotiating a project or hourly rate is that independent contractors pay taxes on the money you pay them. You’re not required to withhold the taxes, but it is important to realize that the contractor won’t be able to pocket all of the money you pay.

They’ll pay federal and state income taxes in addition to local taxes—if they’re in an area like New York City that requires it. They’ll also pay self-employment tax of 15.3% (12.4% for Social Security and 2.9% for Medicare). In 2022, only the first $147,000 of earnings is subject to the Social Security portion.

These withholdings can quickly add up to 30% or more, which explains the need to pay contractors more than you would an employee. Employees pay half of the self-employment tax, although it’s termed Federal Insurance Contributions Act (FICA), and employers pay the other half.

Once you and your contractor agree on payment terms—including project due dates, required deposit, rates, and so forth—you’re ready to complete an official independent contractor agreement. This solidifies the deal and binds you both to deliver accordingly.

2. Collect W-9 Forms

Once you decide how much and how often to pay your contractors, you’ll have them complete a W-9 Form, which includes personal information, like name and Social Security number. It’s important to have all contractors complete this form before beginning work because you’ll use it to report their annual earnings on Form 1099 at year-end.

Require each independent contractor you work with to complete the W-9 Form before beginning any work.

There have been rare cases when independent contractors refused to provide their Social Security number or provided an incorrect Social Security number on their W-9; when that happens, the IRS will notify you to immediately begin withholding 24% of the contractor’s pay for backup withholding (taxes). In this case, you’d withhold, regardless of the contractor’s dismay, and remit to the tax agency as instructed.

If you opt to use payroll software or a service like Gusto, collecting the W-9 is simple. Once you add contractors to your account, Gusto will email them a link they can use to start their online accounts. It’ll also prompt them to provide all of the W-9 information before storing it within the application, saving you time and money. Sign up for a free 30-day trial today.

3. Set Up Contractors in Your Payroll System

Once you’ve collected the W-9 Form, you’re ready to set up contractors in your payroll system, which may consist of a notebook, Microsoft Excel, or payroll software. However you choose to do payroll, you need to start by ensuring you’ve recorded all of your contractors’ information; this will help prevent any hiccups on payday.

4. Process Payments to Independent Contractors

After setup, you won’t have much to do until it’s time to make the first payment. If the agreement requires a deposit before beginning work, you’ll need to process it immediately after setup. Determine the Payment Method

There are many different ways to pay your team for their work. You can pay using cash (not recommended due to lack of paper trail), check, direct deposit, and even pay cards, which are reloadable prepaid debit cards employers use to deposit wages. Be mindful of processing times; direct deposit, for example, requires up to four days to process.

Direct deposits usually cost additional money if you’re not using a payroll service and go through your bank instead; however, if you only need to process a few payments, you can print checks online for free. Most of the best payroll software offers direct deposit at no additional charge, and some will guide you through printing your own checks using the system.

Pay cards are typically offered by the larger payroll providers, like Paychex, so while the pay card program is free, the payroll services you’re required to purchase before being approved for the program are usually more expensive.

5. Send 1099-NEC Forms

As the end of the year approaches, you should be ready to prepare 1099-NEC Forms for each contractor to whom you’ve paid more than $600 within the year. You’ll have to distribute a copy of the 1099 to each contractor along with the IRS and state tax agency (if there are state income taxes), and it must include the total amount you paid during the year.

Don’t forget to keep a copy for your records and be mindful of the Jan. 31 deadline to report any payments made during the previous calendar year. You’ll use the W-9 forms you collected from contractors before their beginning work; transfer information (such as name, address, and Social Security number) to the 1099-NEC to ensure the year-end reports you submit to the IRS are accurate.

The 1099-NEC Form helps independent contractors calculate how much they owe in taxes to avoid paying their taxes incorrectly. It also helps the IRS track contractors from whom they should receive tax payments.

Laws for Paying Independent Contractors

Learning how to pay independent contractors involves understanding the legalities surrounding it. One major error some companies make is misclassifying employees as independent contractors. Federal law is pretty strict in differentiating between the two; thus, misclassifying can result in thousands of dollars in fines and taxes owed.

Keep in mind that contractors control how they deliver the finished project and how often they work. The only factor you determine is how the final product should look.

Federal Contractor Laws

Per federal laws, your responsibilities when paying independent contractors are:

Sending 1099-NEC forms: Send 1099-NEC forms before Jan. 31 so contractors can report their income and file taxes. Also, submit a copy to the federal and state tax agency, if applicable. It’s also a good idea to keep a copy on hand.
Starting backup withholding if there’s no Social Security number: If the contractor fails to provide a Social Security number or tax identification number (TIN) or provides an incorrect one, employers must begin withholding 24% from each payment processed immediately.
Disregarding labor laws: This includes the minimum wage, overtime, unemployment compensation requirement, workers’ compensation, and so forth. These only apply to employees, so contractors are not covered.
Not withholding payroll taxes: Independent contractors don’t pay FICA taxes and instead pay self-employment taxes. Income taxes are also due, but contractors pay these when they submit their tax forms for the prior year.

State Contractor Laws

Many states regulate the classification of independent contractors, so in addition to receiving fines for misclassifying on the federal level, you can also receive penalties from your state. It’s a good idea to visit your state Department of Labor (DOL) site because some states have more restrictive classification rules for independent contractors.

For example, California revised its regulations in 2018 to the ABC test that requires three factors to be met before classifying a worker as a contractor.

A: The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.
B: The worker performs work that is outside the usual course of the hiring entity’s business.
C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

There are numerous factors to consider when classifying independent contractors. The DOL has an opinion, as does the IRS and many states. Although there are no hard and fast rules, If you’re ever confused, complete and submit Form SS-8 to the IRS; the IRS will review and make an official classification determination, but it could take up to six months.

We’ve researched payroll providers that will help you pay contractors easily. If you’re interested in payroll software but need help deciding which is best for your business, check out our guide to choosing contractor payroll services.

Bottom Line

Determining how to pay independent contractors isn’t too complex if you set up an effective system to help you track contractor and payment information. You can use a notebook, Excel, or payroll software to help, and costs range from $0 to $6 a month for one contractor.

If you’re looking for payroll software that supports contractor payments, consider Gusto. It collects all of the information needed to prepare 1099-NEC forms at year-end. It also makes it easy for contractors to review their payments and tax documents by prompting them to set up an online account. In addition to giving contractors control of their paperwork, you save money and time by not having to print and distribute tax documents. Sign up for a 30-day trial today.