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. 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:
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 Certification) signed 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.
Additional Terms to Add to 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. 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.
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.
Contractor Pay Withholding and Deductions
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 their 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 0.24 to get the tax. 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 to the IRS 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. For example, 1099-NEC for 2022 is due January 31, 2023. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
