Hiring and Paying an Independent Contractor
Taxes, Contractor Agreements, Backup Withholding
Many small business owners prefer to work with independent contractors rather than hiring employees. Benefits of hiring independent contractors include:
- Flexibility in being able to vary hours worked, or paying by project, and not having to pay when work isn't available
- Outsourcing non-essential tasks, like IT and maintenance, so you don't have to set up a new department within your company
- Being able to end the relationship easily without the paperwork and potential problems that go with firing an employee
- Not having to pay FICA taxes (Social Security and Medicare) on contractor income.
- Less hiring paperwork, fewer reports, and fewer payments to the IRS
As the hiring employer, there are still some things you must do to hire and start paying that independent contractor.
Before you hire and start paying an independent contractor, make sure that this worker is truly an independent contractor and not an employee. Misclassifying an employee as an IC can result in state and federal fines and penalties. Read this article to get more information: How Worker Status is Determined by the IRS, Dept. of Labor, and States. Also, check out this fact sheet from the Dept. of Labor on Misclassification of Workers.
New Dept. of Labor Standards for Independent Contractor Status
The Department of Labor has developed new standards for determining independent contractor vs. employee status. The ruling, effective March 8, 2021, clarifies the standard to bring more clarity to the new gig economy by establishing several tests:
An economic reality test to determine whether an individual is in an independent business or is economically dependent on an employer
Two core factors - the nature and degree of control over their own work and the worker's opportunity for profit or loss - to help decide the economic reality test
Other factors in the analysis to use when the two core factors differ:
- The amount of skill required for the work
- The permanence of the relationship between worker and employer
- Whether the work is an integrated part of the product
The DOL says that the actual practice of the relationship is most relevant, not a contract or theoretical possibilities.
The Department of Labor standards for determining worker status described above are different from the IRS standards and state standards below. Because these standards are all different, a worker may be classified as an independent contractor under one standard and as an employee under another. Get help from your employment attorney to help you with this issue.
For various reasons (mostly to do with payroll taxes), the IRS is concerned that workers are appropriately classified as either independent contractors or employees. The IRS considers that worker to be an employee unless you can prove otherwise.
The IRS determines the status of workers on a case-by-case basis, and it looks at several factors – including behavioral, financial, and control – to determine status. If you are unclear about the status of people who work for your business, you can request a determination from the IRS.
Be sure that the worker you are hiring is really supposed to be an independent contractor, not an employee. If you hire a new worker as an independent contractor and that person should be an employee, your business might have to pay fines and penalties.
An independent contractor is someone who does work for another person or company. Independent contractors are business owners who are in a trade, business, or profession and who offer their services to the general public. Someone is an independent contractor if the person paying them can only control or direct the result of the work.
An example of an independent contractor is a cleaning service. The service comes into your office to do work, but the cleaning service workers are not employees of your company. You can tell them which offices to clean and when you want them to clean, but you can't tell them what cleaning supplies to use or how to run the vacuum cleaner.
The most important document you must get from an independent contractor is Form W-9. Anyone you hire as an independent contractor must complete and sign this form before they begin work for your business. The person must put a tax ID number (social security number, employer ID (EIN) on the form.
The W-9 form serves the same purpose as a W-4 form for newly-hired employees.
If an independent contractor doesn't have a tax ID number on file or if the number is incorrect, they may be subject to withholding from their payments (called backup withholding – see below).
In addition to the W-9 form you'll need specific new hire paperwork for each independent contractor you hire:
- The person's resume or professional qualifications, for your own protection and to verify in case of an audit
- A contract, for even the most simple independent contractor relationship.
In the same manner, as you check references for an employee, be sure you check the credentials of a contractor before hire.
You might also want to do a background check on all prospective contractors. For example, if you are considering hiring a bookkeeping service, make sure this person has no felony convictions.
Some jobs require background checks. For example, state laws require background checks for anyone working with children, the elderly, or disabled people.
If the independent contractor is organized as a business, you should do a check with the Better Business Bureau to make sure no complaints have been filed against this business.
Don't forget the tried-and-true web search, including reviews of the business.
Paying an independent contractor is pretty simple. You can pay by the hour or by the job. In most situations, you don't have to withhold income taxes or Social Security/Medicare taxes from independent contractor income. You don't have to pay unemployment taxes on independent contractors.
Independent contractors are responsible for paying their own income taxes and self-employment taxes (for Social Security/Medicare).
You must keep track of payments you make to independent contractors each year and report the total payments to the IRS.
For each independent contractor you paid $600 or more during the year, you must report the total amount paid on Form 1099-NEC, beginning with the 2020 tax year.
You must send the 1099-NEC form:
- To each independent contractor no later than January 31 of the following year, and
- To the IRS no later than January 31, using either mail or electronic filing.
The exact date changes each year, depending on holidays and weekends. See this article with a business tax calendar for the due date for the current year.
In most circumstances, you do not need to withhold income taxes from the payments you make to independent contractors. But there are some exceptions:
You as a business owner and payer must withhold taxes on payments to an independent contractor if you receive a backup withholding notice from the IRS. Usually the IRS will send this notice if the taxpayer identification number (Social Security Number, Employer ID Number, or Individual Taxpayer ID Number) of the independent contractor is incorrect or missing.
You don't have to do anything until you receive the backup withholding notice from the IRS. Then follow the specific instructions on the notice and begin withholding income taxes from the independent contractor immediately at the backup withholding rate of 24%.
Each year you'll need to send the IRS a report on the amounts you have withheld from each independent contractor, using IRS Form 945.
In every case, before you hire an independent contractor, create an agreement and get it signed by the contractor. The agreement should include details about the requirements of the contractor, pay rates, and sections about non-disclosure and confidentiality.