What to know about managing payroll for contractors
What’s a contractor?
When it comes to getting work done at your business, there are two types of workers – employees (both part-time and full-time employees) and contractors. Each can have a place and an important impact on your business, but knowing how to classify each is important. There are two main determinants of how to classify workers. The first is the amount of control your business has over the person and their work, including controlling exactly what will be done, when it will be done, and how it will be done. If this is the case, then the person is an employee. However, if your business has the right to direct the result of the work but not what, how, or when it’ll be performed, the individual is an independent contractor.
When it comes to contractors, another important difference is that the Fair Labor Standards Act (FLSA) doesn’t apply to contractors. If you’re not familiar with the FLSA, it is the federal labor law that mandates minimum wage and overtime pay. Because contractors work independently of the business, they pay their taxes as a separate entity. Therefore, as a business owner, you’re not responsible for any of the employment taxes that you’re responsible for when it comes to employees. These taxes include local, state, or federal income taxes, in addition to FICA taxes, which include Social Security and Medicare taxes.
Because independent contractors are seen as self-employed, they are responsible for all of their tax liability, paying self-employment taxes on the income they earn. This difference in the categorization of contractors also affects how you pay them. To better illustrate this, let's take a look at how you typically pay employees.
As you know, you pay employees via payroll. The process starts with hiring a new employee. During the onboarding process, a new employee fills out the appropriate forms, including Form W-4, which tells you how much your business should withhold for that employee. Then, whether your business uses payroll software or a third-party payroll service, you’ll calculate payroll taxes and employee income tax withholding, taking out the appropriate amount for each. At year’s end, your business fills out and sends a Form W-2 to each employee which shows yearly wages and taxes withheld for the employees’ tax filings.
Misclassifying employees as contractors is a common mistake when it comes to employee classification. The IRS is strict about employee classification, and while you may think it’s a simple mistake, misclassification can be costly for your business. If you misclassify an employee, your business could face additional taxes and penalties, including reimbursing misclassified employees any overtime pay that they are due. If you find your business in a situation where you can't determine a worker's status, you can submit it to the IRS for a determination.
Next, let’s take a look at the process of paying contractors.
How to pay contractors
When working with contractors, paying them is different than paying employees. The first thing to discuss with a contractor is how they’ll bill you for the work they're doing. Contract workers typically bill either hourly or on a project basis. You’ll also need to determine the payment structure. Do they require a deposit before starting the work? Will they send you monthly invoices? In addition, it’s best practice to have a signed agreement in place ahead of time that discusses the terms of payment, timelines, and expectations.
Once these details have been worked out between your business and the contract worker, the next step is to set up payments. Here’s the general process for paying contractors:
- Get the independent contractor’s Form W-9, Taxpayer Identification Number, and Certification: IRS Form W-9, Request for Taxpayer Identification Number (TIN) and Certification is a one-page IRS tax document. The TIN helps your business confirm that the contractor is legally able to work. You’ll use the information on this form, like the contractor's social security number, to report payments your business makes to the contractor. Make sure that all the necessary information is on the form so that you’ll have what you need to pay them.
- Provide compensation for work performed: Pay the freelancer according to your agreement. Make sure you’re making accurate and on-time payments using the payment method you discussed. Your business can pay contractors in a variety of ways – ACH direct deposit, check, wire transfer, etc. Note that it’s important to agree upon the payment agreement beforehand.
- Remit backup withholding payments to the IRS, if necessary: Sometimes, your business may receive a backup withholding notice from the IRS. In this case, your business must deduct a 24% tax from any future payments to the independent contractor mentioned by the notice.
- Complete Form 1099-NEC, Nonemployee Compensation: This last step is necessary for businesses that pay more than $600 per year to a contractor. This form details the compensation your business paid to a contractor and should be submitted to both the IRS and the freelancer by the annual deadline. The freelancer will then use this form to complete their tax return. It's important to note that this form is different from a Form 1099-MISC. Talk to your tax advisor to confirm the appropriate forms needed for your business.
Now that you know how to pay contractors, let’s take a look at some of the biggest benefits of working with contractors for your small business.
Benefits of contract workers
For small businesses that need help, contractors can provide a few distinct advantages over employees. Here are some of the benefits of contract workers:
- A lower commitment: Because contractors can be hired for specific projects and for determined time limits, they require a lower commitment from small business owners.
- Lower costs: Contractors typically cost a company less money than internal employees. While contractors may earn a higher rate per hour, they don’t receive the same amount of training and don’t receive company employee benefits. That means that the overhead for contractors is often lower than that of comparable employees.
- Specific skill sets: Contractors have very specific skills that can be utilized for specific projects. That allows small businesses to tap into their expertise for the amount of time they need it.
- Fewer resources: Because many contractors work from their homes instead of coming to your business, they don’t use office resources like computers, printers, internet, etc.
Employee vs contractor: A summary
As you’ve seen, there are some key differences between employees and contractors. Let’s look at the differences.
- Taxes: Employees receive a W-2 tax form and businesses deduct taxes automatically from paychecks.
- Work duties: The company dictates a set of duties to employees.
- Training: Employees receive training about their roles and responsibilities, company culture, and policies.
- Work hours: Your company dictates a set schedule of days and hours.
- Pay: Employees receive pay on a set schedule.
- Travel: The company pays employee expenses for required work travel.
- Benefits: The company usually provides health insurance and life insurance to employees.
- Time off: Employees receive paid time off based on company policy.
- Taxes: Contractors receive a 1099 tax form from the business and pay their own taxes.
- Work duties: Contractors perform a specific task or role on, usually, a short-term project.
- Training: Contract workers receive training and instruction exclusively related to their project(s)
- Work hours: Contractors can typically choose the days and hours they work.
- Pay: Contracted employees usually receive compensation at the completion of the project rather than on a set schedule.
- Travel: Contractors are usually responsible for their own travel expenses.
- Benefits: The company doesn’t provide benefits like health insurance or life insurance.
- Time off: The company doesn’t give contractors paid time off.
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