If independent contractors work for your small business, it’s important to understand the legal differentiation between them and full-time staff members. Below, find a breakdown of the paperwork involved and guidelines to follow when it comes to independent contractors that work for your small business.
Independent Contractor or Employee?
There are many important practical and legal differences between an employee and an independent contractor. The responsibility of correctly classifying a worker falls squarely on businesses, so it’s imperative to get this right during the hiring process. Below, find a summary of the key differences between contractors and employees. Generally, contractors tend to work on a project or freelance basis, or for a fixed period of time, with the possibility of contract extensions, whereas an employee is a permanent hire. The Department of Labor (DOL) also considers the extent to which the business controls the worker’s job-related activities. For example, employees qualify for expense reimbursements related to business activities such as travel. Contractors, on the other hand, use their own tools and supplies and cannot claim any expenses. This is how the IRS defines the difference: “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, and not what will be done and how it will be done.” Finally, employees need to consider whether the worker’s role is integral to core business processes. Contractors typically focus on specific projects or auxiliary tasks that don’t directly impact business continuity, whereas employees are a key part of business operations. Examples of common independent contractor roles include writers, IT professionals, accountants, musicians, designers, digital marketing specialists, SEO specialists, and social media content creators.
Essential Forms for Hiring Independent Contractors
In terms of paperwork, hiring an independent contractor is less complicated than hiring a full-time employee. There are three key documents you need from an independent contractor: a W-9 form, a written contract, and documentation of payment information. In the case of an IRS audit, it’s important to keep thorough documentation on your independent contractors. Learn more about each form you need, below.
W-9 Form
Businesses that pay independent contractors $600 or more in a given tax year must report this compensation to the IRS. The first step after hiring an independent contractor is to send them a copy of the W-9 Form. This form is used to obtain a contractor’s tax and financial information. Once filled out, the contractor should send the form back to you and your business.
Work Agreement or Contract
A work agreement spells out the business relationship between a contractor and a client. This type of legally binding written contract typically includes:
Scope of work, deadlines, and deliverablesTerms and length of the project or servicePayment details (including deposits or other billing details)Confidentiality, non-solicitation, and dispute resolution clauses
The agreement protects both parties, ensuring the client gets the service they asked for and the worker is paid according to the agreement. Having a written contract is key for bookkeeping and tax purposes.
Payment Information and Documentation
For convenience, you may wish to pay contractors through payroll using direct deposit, just like you pay your W-2 (full-time) employees. To set up a contractor in your payroll software, you’ll need information from their W-9, such as their SSN or TIN, as well as their banking info (a routing number and account number will typically suffice). You can also pay contractors using cash, checks, pay cards, and prepaid debit cards. No matter how you choose to pay an independent contractor, payment terms—including pay rate, payment method, and payment schedule—should be established upfront. This information can be detailed in the work agreement or separately. Determining how you pay these individuals depends on how many you hire, how frequently you pay them, and where they are located for tax purposes. Wire transfers are generally considered best for project-based, one-time payments, whereas checks or direct deposits may work best for contractors who are paid weekly or biweekly to avoid costly transfer fees.
Form 1099-NEC
Form 1099-NEC is used to report nonemployee compensation. While it is not directly filed by the contractor themself, it is important to be aware. Each form comes with Copy A and Copy B. As the business owner, you must file Copy A with the IRS and send Copy B to the contractor for their own records. To fill out the form, transfer the information contained in the W-9 Form your contractors filled out when they were hired. The 1099-NEC helps contractors calculate how much they owe in taxes while enabling the IRS to keep tabs on contractors for their records. As of 2021, independent workers pay self-employment tax (at a rate of 15.3%) plus income tax.
Other Documents You May Want
Confidentiality Agreements
Consultants routinely work for competitors and are engaged in their own business efforts, so they’re not bound by the same confidentiality clauses as employees. Because of this, you may want to write your own. If a valid agreement is breached, you can sue for monetary compensation.
Non-Compete Agreements
A non-compete clause prevents a contractor from working with another employer during the contract and for a set period of time after the contract expires. The agreement usually means the contractor cannot work for a competitor or work independently in the exact same field. In most cases, it is uncommon for businesses to request a non-compete clause from an independent contractor.
Proof of Worker’s Compensation
General contractors or subcontractors may be contractually obligated to provide proof of worker’s compensation, which covers medical expenses associated with a work-related injury. Some states require businesses to provide worker’s compensation coverage to contractors, as well as employees, too.
