How to Pay Independent Contractors in 5 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. Even better, some payroll services charge $5 a month per contractor.

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 can add historical payments made outside of the software to ensure your records are accurate. Sign up for a free trial today.

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How Paying Independent Contractors Works

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, such as by project or an hourly rate, are some of the first decisions you’ll make to ensure the process goes smoothly.

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. Then, you’ll use the information on the W-9 to set them up in your payroll system. If you use software like Gusto, the online system will retrieve your contractors’ W-9 information for you.

When you’re ready to pay your independent contractors, you can use check, cash, or an electronic method. At year’s end, you’ll report annual earnings on Form 1099-MISC to be mailed to contractors, the IRS, and possibly the state, if there are state income taxes.

Contractors will use the 1099 information to determine how much they owe in taxes. You don’t pay employer taxes for independent contractors and only have to withhold them (24%) if the contractor refuses to provide a Social Security number or provides an incorrect one.

Best Payroll Software for Paying Contractors

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

1. Determine How to Pay Contractors

Unlike with employees, you don’t typically pay contractors a salary. Instead, you should consider whether an hourly rate or per project amount would be more appropriate. 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 Rates

Prior to starting any work, you and your contractor should reach an agreement regarding pay. In addition to pay structure, it’s important to consider how much you’ll 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 both on the same page.

“The key is to analyze how much it would cost you to hire someone in-house to do the work. You have to take into account not only their salary or gross wages but also the cost of Social Security, Medicare, paid time off (PTO), retirement plan matching, and so on to get a true idea of the cost to hire someone in-house. After coming up with a number, I’m typically willing to pay an independent contractor 75% of that amount. Independent contractors are typically not as efficient as in-house employees, and It’s usually a little more difficult to communicate with someone who works outside of the office. As such, I think 25% is a fair discount.”
―Matthew Ross co-founder & chief operating officer, My Slumber Yard

When to Pay Independent Contractors

As you determine how you’re paying, be sure to reflect on the length and size of the project. Is it a monthlong project? Will the contractor finish 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 new contractor for the first time, be flexible; some contractors have had bad experiences with clients using their services without ever issuing payment.

Payroll Taxes to Consider When Paying Independent Contractors

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 if they’re in an area like New York City that requires it. They’ll also pay a self-employment tax that can be between 15.3% and 18.2% of earnings. This can add up quickly 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 reach an agreement on payment terms, including project due dates, required deposit, rates, and so forth, you’re both 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

A W-9 Form is used to collect basic information about contractors like name, birth date and, most importantly, Social Security number. It’s important to have all contractors complete this form prior to beginning work because you’ll use it to report their annual earnings on Form 1099 at year-end.

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 services 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 within the application, saving you time and money. Sign up for a free 30-day trial today.

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3. Set Up a Contractor in the Payroll System

Once you’ve collected the W-9 Form, you’re ready to set up your contractors within the payroll system. Your payroll system may consist of a notebook, Microsoft Excel, or payroll software like Gusto. However you 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 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 prior to beginning work, you’ll need to process immediately after setup. You can pay using cash, which is not recommended due to lack of paper trail, check, direct deposit, and even paycards, 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.

Payment Types for Contractors

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.

Paycards are typically offered by the larger payroll providers, like Paychex, so while the paycard program is free, the payroll services you’re required to purchase prior to 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.

After you enter and save the hours worked or payment information, Gusto will prompt you to print a payroll check, or it’ll 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-MISC

As the end of the year approaches, you should be ready to prepare 1099-MISC 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 January 31 deadline to report any payments made during the previous calendar year. You’ll use the W-9 Forms you collected from contractors prior to them beginning work; transfer information such as name, address, and Social Security number to the 1099-MISC to ensure the year-end reports you submit to the IRS are accurate.

The 1099-MISC Form helps independent contractors calculate how much they owe in taxes, so they can avoid overpaying or underpaying. It also helps the IRS track contractors from whom they should receive tax payments.

Laws About 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.

Joanne Peterson, CEO of Abator, describes a couple of instances that her company found itself under the microscope regarding independent contractor classification:

“Section 1706 of the Tax Reform Act of 1986 had a huge impact on our industry. As a result, we pay particular attention to the rules and regulations that define independent status. We often reference the IRS’ 20 questions test to make sure that whatever arrangement we make isn’t compromised by language or practices that would require us to treat any independent contractor as an employee.

“We had two challenges in regard to our initial findings on independent consultants. One was at the state level, after an independent contractor filed for unemployment compensation and named us as his most recent employer. Our documentation protected us from any obligations. In another instance, a disgruntled independent contractor filed a complaint with the IRS claiming employee status. After a thorough review of our practices and contracts, the IRS agreed that he was independent. The 20 questions test gives us the best guidance in protecting the company.”
―Joanne E. Peterson, CEO, Abator

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

• Send 1099-MISC: Send 1099-MISC before January 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.
• Start 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
• Disregard 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.
• Don’t withhold payroll taxes: Independent contractors don’t pay FICA taxes but self-employment taxes instead. Income taxes are also due, but contractors pay these when they submit their tax forms for the prior year.

State Independent 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 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.

Frequently Asked Questions (FAQs) About Paying Independent Contractors

Here are some common questions that employers ask about how to pay independent contractors. If you have additional questions on paying independent contractors or other small business topics, submit them on our forum.

Can you tell an independent contractor when to work?

Typically, independent contractors determine their own work schedules. Even if you’re paying by the hour, the time doesn’t have to be set. A business owner’s primary control lies in what the final product or service should be and look like, not when the contractor works. If you’re considering setting a required work schedule for your contractor, be careful. It could raise a red flag to the IRS.

What’s the difference between an independent contractor and an employee?

An independent contractor is self-employed and partners with the employer to work on a project while an employee is employed by the employer and performs consistent work that’s ultimately under the employer’s control. Another major difference is how taxes are handled. Contractors pay their own taxes, including a costly self-employment tax, while employers withhold and pay taxes for employees. In addition, employers have to pay their own taxes on employee earnings.

Can independent contractors collect unemployment?

Independent contractors aren’t able to collect unemployment. The state and federal unemployment funds are paid for by employers and are based on a percentage of their employees’ earnings. Employers don’t pay unemployment taxes on contractor earnings; therefore, there are no funds for contractors to claim.

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 free to $5 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-MISC 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.

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