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.
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. And when setting their pay rate, consider that the contractor will have to pay taxes on any money you pay them, which lowers their net pay; you may need to increase your typical base rate to make it attractive if it’s below industry standards.
Contractor Pay Rates
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, contemplate 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. Not being able to estimate costs isn’t good for your business and could create conflict between you and the contractor if you’re charged more than expected.
Contractor Pay Frequency
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 on a daily basis?
- 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.
Contractor Taxes
Another point to consider 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 keep in mind 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 2021, only the first $142,800 of earnings is subject to the Social Security portion.
These withholdings can add up to 30% or more quickly, 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 reach an agreement on payment terms—including project due dates, required deposit, rates, and so forth—you’re ready to finalize by completing an official independent contractor agreement. This solidifies the deal and binds you both to deliver accordingly.
2. Collect W-9 Form
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.
Make sure that you require that each independent contractor you work with 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 Contractor in Your Payroll System
Once you’ve collected the W-9 Form, you’re ready to set up contractors within 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.
These are the details you would enter in Gusto, and as long as you enter your contractor’s email address before saving the data, Gusto will send an invite so that they can view payment and tax forms online.
4. Process Payment to Independent Contractor
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. You can pay using cash, which is not recommended due to lack of paper trail, check, direct deposit, and even pay cards, reloadable prepaid debit cards employers use to deposit wages. Be mindful of processing times; some payment methods (direct deposit) require up to four days to process.
Determine the Payment Method
Direct deposits usually cost additional money if you’re not using a payroll service and opt for going 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.
Enter Hours or Amount Due in Payroll System
Payroll software like Gusto will calculate contractor payments based on an hourly rate, as shown below, but it’ll also allow you to enter a flat rate, if appropriate.
If you’re paying independent contractors by the hour, you can enter the hours worked within Gusto, and the payment amount will automatically calculate. You can also enter a memo to identify the reason for the payment.
After you enter and save the hours worked or payment information, Gusto will either prompt you to print a payroll check or automatically submit a direct deposit, depending on the payment method you selected for the contractor during the setup process. You can repeat this process as often as you need to pay contractors since Gusto allows you to run unlimited payroll runs at no extra charge.
5. Send Form 1099-NEC
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 1099s to each contractor along with the IRS and state tax agency (if there are state income taxes), and they must include the total amount you paid out 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 they begin 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 so that they can avoid overpaying or underpaying. It also helps the IRS track contractors from whom they should receive tax payments.
Laws Around 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 what the final product should look like.
Per federal laws, your responsibilities when paying independent contractors are:
- Sending 1099-NEC: Send 1099-NEC before Jan. 31 so that 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.
Independent 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 SS8 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. Our top recommendation is Gusto, but if you’re interested in seeing other options, check out our other top picks in 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.
