How Do I Pay an Independent Contractor?

Payment Options and Withholding Requirements

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Paying an independent contractor is different from paying an employee. This article looks at issues of payments, contracts, and taxes for contract workers.

What is an Independent Contractor? 

An independent contractor is an independent business owner who does work for a company on a contract basis. Independent contractors include people who offer services to the general public.

The general rule is that someone is an independent contractor if the payer of this person has the right to control and direct only the result of the work done and not how it will be done. For example, if your business hires an independent contractor to install a new wireless network at your location, you can't tell them how to do the installation. 

Independent contractors are considered self-employed, and they must pay self-employment tax (Social Security/Medicare tax) on their self-employment earnings.

The IRS has several ways to distinguish a worker as an independent contractor or employee, based on the amount of control over the work and the time of the worker. The type of work being done also has an effect on whether the worker is an employee or an independent contractor; for example, a salesperson might be either. The IRS looks at the general categories of behavioral control, financial control, and the nature of the relationship. 

Some states have additional, more detailed, tests for determining independent contractor status. For example, California has an ABC test stating that the worker is an independent contractor only if all three of these conditions are met:

  1. 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.
  2. The worker performs work that is outside the usual course of the hiring entity's business.
  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

Federal and state regulations assume that a worker is an employee unless it's proven otherwise. Regulators review cases and make determinations on a case-by-case basis.

Before You Hire Your First Independent Contractor

Before you begin paying an independent contractor, you will need several documents:

An Employer ID Number (EIN), which is similar to a Social Security Number for a business, is required for most businesses even if you have no employees. You can apply for and get an EIN number online through the IRS.

A W-9 Form (Request for Taxpayer Identification Number and Certificationsigned by the worker. This form identifies the contractor (with a taxpayer identification number) and provides other information necessary for completing the payments and submitting them to the IRS.

An application or resume/CV from the prospective contractor and

A written contract that includes terms of payment.

For projects, you might want a written proposal outlining the work to be done.

Options for Paying an Independent Contractor

An independent contractor receives compensation in one of several methods, depending on the agreement set up between your company and the contractor:

  • Hourly. Some contractors get paid on an hourly basis; for example, a computer programmer might get paid for hours worked on programming tasks.
  • By the Job. The other payment alternative is to pay for the work done or by the job. For example, a cleaning service might get paid a set amount for cleaning your office.

A verbal contract is just as valid as a written contract, but it's always better to get the details of the pay in writing, to avoid miscommunication and difficulty proving a case in a lawsuit.

State laws determine when a contract must be in writing. One requirement that might apply to you is that a contract that extends over a year must be written not verbal.

Including Additional Terms in a Payment Agreement

In addition to describing the pay type and amount, some other important terms should be included in a payment agreement or written contract for an independent contractor.

  • What form of payment (fee or hourly)?
  • How often is payment due? 
  • What's the amount?
  • Is there a minimum amount? Are there times when additional payments need to be made?
  • What are the "measureables" or milestones for payment? For example, a "by the job" pay agreement often includes specific deadlines for parts of the project. When the deadline is met, a specific amount of pay is released. 
  • What reports are due and when?
  • Are subcontractors allowed (people who work for the contractor)?
  • What if the work isn't done on time? 
  • What if payments are not made on time? 
  • What if the work isn't acceptable?

These payment terms are just as important as the payment amount, and they should be decided before the person begins work. 

Withholding and Deductions from Contractor Pay

In most cases, you don't need to withhold Social Security/Medicare tax (called SECA tax) or federal or state income tax from payments to an independent contractor. The contractor is responsible for paying his or her own income taxes and self-employment taxes.

Withholding under Backup Withholding Regulations

As mentioned above, you need a W-9 form for the independent contractor before work begins. In some cases, the taxpayer ID on that form may be incorrect or missing. In those cases, you may be directed by the IRS to withhold federal income tax from that person's payments. This is called backup withholding.

You must withhold federal taxes at the backup withholding rate of 24%. Just as with an employee, take the gross payment to the person and multiply it by .24 to get the tax. 

You will receive a backup withholding notice from the IRS when backup withholding is due. Follow the requirements exactly as directed.

If you must withhold taxes from an independent contractor under a backup holding order, you must also pay these taxes to the IRS at regular intervals. Backup withholding must be reported to the IRS on Form 945, Annual Return of Withheld Federal Income Tax. Form 945 is due January 31, for the previous tax year.

Reporting Payments to Independent Contractors

Each year you must report payments to any contract worker if you paid that person $600 or more during the year. Beginning in 2020, you must use a 1099-NEC form for this report. It's due at the end of January of the year after the tax year. A10099-NEC for 2020 is due January 31, 2021. 

If you are confused about reporting payments for independent contractors, see this article about Who Must Receive a 1099-NEC.