Who Is An Independent Contractor?
It is important for both companies and their workers to understand if the worker is considered an employee or a contractor. This has several implications:
- In the US, if the worker is a contractor, payers must submit Form 1099-MISC to report income paid in the previous year. Otherwise, they submit a W-2 form for an employee.
- If the worker is a contractor, the employee does not pay benefits, such as vacation time, sick leave, pension, and health insurance. Otherwise, the employer needs to pay benefits according to local laws.
In the US, the IRS has the authority to decide if a worker is an independent contractor or not. In general, the test of an independent contractor is whether the person or company paying the worker tells them what to do and how. In some cases, it can be complex to determine whether a worker is an independent contractor or not.
Examples of occupations in which workers are almost always considered as independent contractors include medical practitioners, lawyers, accountants, electricians, and building contractors.
How Is Independent Contractor Income Paid and Reported?
Employees are usually paid on a consistent schedule, such as weekly, biweekly, or monthly; contractor payments are different. The worker and the payer agree on a payment schedule. Payments could occur on a regular basis (a retainer agreement) or according to specific deliverables, and can be delayed (e.g. a contractor could receive payment Net+30 or Net+60).
Payments to independent contractors are not considered “wages” by the IRS, and the payer does not deduct any taxes. In other words, no Federal income tax, social security or Medicare taxes are deducted from the amount paid to the contractor.
During the income tax season, payers must file Form 1099-MISC to report all income paid to the contractor in the previous year, as long as the contractor’s income is higher than $600. The form must be completed and postmarked by the last day of January each year.
Considerations Before Choosing How to Pay your Contractor
Contractor Classification
There are several types of contractors, each requiring a unique payment process. Self-employed professionals providing short-term services are typically classified as independent contractors, 1099 contractors, or freelancers. These are often external workers who can choose their clients and are responsible for their insurance, taxes, and benefits.
Skilled professionals hired through an outsourcing company or an agency to engage in long-term projects are typically classified as W-2 contractors. They are responsible for their taxes, but the outsourcing company or agency may offer perks and insurance benefits. Some contractors own a limited company, which increases their similarities with freelancers. In these cases, it may prove difficult to classify the contractor adequately.
Taxes
Each contractor classification—W-9 or independent contractors—requires filling out different tax forms and documents. The information should include the relevant and correct details on record because inaccuracies may result in fines for you or the contractors.
Number of Contractors
You can use two main methods to pay contractors—manually or automatically. Manual payment can work if you pay a small number of contractors. However, the more contractors you engage with, the more complicated the payment process.
When paying contractors, you need to verify timesheets, cross-check charges, maintain accurate records for audits, and ensure payments are made according to each contractor’s terms. Automated payments can help make this process more efficient, accurate, and faster.
Contractor Geographies
The geographical location of the contractor can add a layer of complexity to the payment process. Local payments can be easy to handle, but international payments typically involve additional bank authorizations, conversion charges, and processing fees. These factors can significantly impact your project’s budget and timeline.
Ways to Pay Independent Contractors
Direct Deposit for Contractors
With the COVID-19 pandemic (a global pandemic) and more people working in remote areas, direct deposits to contractors are becoming more common. Direct deposit means depositing money electronically into your bank account without using a paper check. “Electronic” means a transfer from a Company’s bank account to the independent contractor’s account.
Paying Independent Contractors by Check
Checks paid to independent contractors are increasingly unpopular for employers because they are inefficient and due to the complex logistics involved.
When paper checks are used to pay contractors, payroll managers have to process payroll and receive authorization for the check, and then physically mail it to the contractor or distribute it in person. In some cases, if it is not possible to deliver the check, it must be held in the office, which raises security concerns.
Another complexity is tracking checks before they are deposited—in some cases, contractors may lose their checks before they are deposited. A new check must then be issued, which is time consuming and frustrating for both payer and contractor.
Paying Independent Contractors via Wire Transfer
Wire transfer is often used for large transactions. Although less common, it can also be used to pay independent contractors. Wire transfer works by receiving funds from one person’s bank account and depositing it into another person’s bank account, usually through a wire transfer service such as Western Union. Some companies allow same-day wire transfers, but transfers can take up to three days and usually incur a transfer fee.
Freelance Management Systems (FMS)
A Freelancer Management System (FMS) provides multiple payment methods to ensure that contractors get paid any way they want. Most FMS platforms are 1099-K compliant, meaning they can handle all tax compliance requirements such as issuing 1099 forms and collecting W8/9s from contractors.
Another option is to work with marketplaces for freelance services. These marketplaces handle payments and tax compliance, but also charge significant marketplace fees.
Conclusion
In this article, I explained the basics of contractor payments and showed four ways to pay your contractors:
- Direct deposit – depositing funds directly to the contractor’s bank account.
- Paying by check – a traditional method that is going out of favor because it creates complexity, frustration, and security issues.
- Paying via wire transfer – a faster method, but which still requires some logistics.
- Freelance Management Systems (FMS) – an automated system that helps manage contractor payments.
I hope this will be useful as you find more efficient methods to manage and pay your independent contractors.