Managing a payroll can be a demanding task if you own a business with multiple employees and independent contractors. That’s why we have the best tips and tricks in one place that will help you understand worker classification and streamline your payroll process.
It’s especially useful terminology to learn if you own a construction business and hire your workers seasonally. This way, and with the right time tracking system you will easily manage your hourly workers and payroll.
So, keep on reading to find out how to pay independent contractors.
Correctly Classifying Workers As Independent Contractors
One of the most important aspects of independent contractors is the classification and differentiation from the employees in the company. Independent contractors and employees are managed and paid differently, so it’s crucial to be completely sure what type of workforce you have and follow the IRS tax regulations, and federal and state rules.
While it might sound simple enough to make a clear difference between independent contractors and employees, the marginal and complex cases, large companies and various industries prove otherwise. But, the classification is not just vital for tax purposes but can lead to severe penalties and lawsuits if not followed properly.
That’s why the first thing you need to know is the definition of:
- An employee
This type of worker is paid to work in a company for a long term and the process, tools, and other work-related matters are managed and supervised by the employer. The employee and the employer have a specific contract that guarantees certain benefits for the employee and requires them to work under the employer.
It’s also important to notice that for the employee you need to withhold and pay income taxes, Medicare, and social security taxes.
- An independent contractor
Unlike an employee, the independent contractor is usually hired to work on a task or a project in the company, and they are not part of the permanent workforce. The independent contractor is self-employed and doesn’t have the employee benefits such as vacation, health insurance, or sick leave.
Unlike employees, you generally are not obliged to withhold taxes as the independent contractor pays for self-employment taxes and other local taxes.
To fully understand and classify your workers better, the IRS has a guide. In this guide, you are provided with the three basic categories to consider when deciding on the status of your workers, and it can be quite helpful in situations where the classification is not so easy.
The control and independence rules fall into these three categories:
- Behavioral control
Behavioral control determines what work will be done and how it’s going to be done by the worker. Independent contractors have more freedom here and manage their time freely, as long as the tasks are completed. On the other hand, if the employer needs to tell the worker what tools to use, when to take a break, or even provide training for them the IRS considers them to be an employee in the company.
Even though this rule can be helpful in many situations, especially in an office setting, there are some cases where behavioral control is not enough for classification. So, the IRS focuses on two more categories.
- Financial control
Financial control determines the financial risk that is shielded from the worker. So, independent contractors control and direct the financial aspects of their job while the employees depend on the employer for compensation for tools, expenses, profit, and even losses.
- Type of relationship
The type of relationship between the worker and the employer can be very helpful when defining the status. If the relationship is based on long-term cooperation that continues indefinitely, and the worker has employee-type benefits such as paid time off, 401ks, or vacation days he or she is more likely to be seen as an employee by the IRS.
But, keep in mind that the IRS rules are not the only ones you need to follow as the Department of Labor and different states might have even more stringent classification rules and regulations. For example, California-based companies and workers need to follow the new Assembly Bill 5 (AB 5) especially significant for the construction workforce.
In 2018, California amended its standards to the ABC test, which requires three conditions to be satisfied before a worker is classified as a contractor:
A: The worker is free from the hiring entity’s control and direction in connection with the performance of the task, both under the contract and in actuality.
B: The worker does work that is not normally associated with the hiring entity’s business.
C: The worker is normally involved in an independently established trade, activity, or business related to the labor done.
If you as a business owner still have doubts about the classification of the workers, you can file form SS-8 which is the official determination of worker status for purposes of federal employment taxes and income tax withholding form. This way the IRS officials will determine the status of the worker and inform the employer about the final decision and tax regulations that need to be followed. Keep in mind that this process can take up to six months.
Businesses that misclassify the employee as an independent contractor, even if it’s not done on purpose, can have severe repercussions. This can include penalties, fines, overtime pay, and even lawsuits, so you need to be very careful with the classification and rely on good construction time tracking software to make the payroll an easier process.
Agreeing On Payment Terms Upfront
While the agreements between the employer and the independent contractors should be backed up with written contracts, it’s up to both parties to decide on the terms that suit them the best.
This includes the pay rate and the pay frequency in which the independent contractor will be compensated.
Agreeing on a pay rate
The pay rate for independent contractors is usually set and agreed upon before the work begins.
This allows both parties to choose the best and most appropriate pay rate that can be based on a fixed price, hourly rate, or even per project. Typical overtime and employee regulations don’t apply to independent contractors so each written contract can be defined differently.
Most of the time it’s easier and safer to use an hourly rate if the independent contractor agrees. This is by far the easiest method to track and include in the payroll with the help of time-tracking apps. You will have a better overview of the payments made and your budget, while the independent contractor will have the freedom to schedule their hours accordingly.
Pay frequency
When it comes to contractor payments and frequency it’s also a mutable term that depends on the agreement between the independent contractor and the employer. While there are some workers who can be paid monthly or even quarterly, most like to have a steady income.
The independent contractors can be paid per project, per milestone, or hourly, and depending on that agreement you can create daily, weekly, and monthly schedules. It’s easier to pay per hour since the calculations don’t include any tax reductions, but some workers also appreciate milestones where there is a custom of 25% upfront payment before the project begins.
Considering that independent contractors usually have multiple employers it’s easy to see how accommodating their payment needs can set you up for a successful collaboration. This is especially noticeable with construction workers who need a regular source of income and gladly set apart more hours for the employers who pay them on a weekly basis.
Collect W9 Forms Before Work Begins
Before you begin any work, you must have a fully completed and correct W-9 form from the independent contractor. This form will include the type of business (Sole Proprietor, Corporation, Partnership, etc.), the worker’s name, address, taxpayer identification number, and other information that will assist you as the employer in reporting the wages made to the worker.
If the independent contractor does not have a business entity, they must supply their social security number, and those who do must provide their federal employer identification number or a valid taxpayer identification number (TIN).
Employers must immediately begin withholding 24% of each payment processed if the contractor fails to give a Social Security number or tax identification number (TIN) or supplies an invalid one.
This is why it is critical to double-check the W-9 documents and confirm that you are paying the 1099 independent contractor based on them in order to prevent any IRS difficulties.
Furthermore, you should go through all of the present employees’ W-9 forms and request updated forms for each year to check that all of the data is still the same. In addition, the W-9 forms should be kept for three years for future reference and for any issues with the IRS.
Use Software To Pay Independent Contractors & Reduce Your Admin Burden
Once the previous steps are completed and you classified the worker as an independent contractor and obtained the W-9 form you can move on to the actual work and find the best way to process the future payments.
If you have a company with many different teams and workers, it’s always a good idea to rely on a construction time tracking app to easily manage the hours and payroll. A time tracking app will make it easy for independent contractors to log their hours electronically and allow you to also automate the process of paying them on a regular basis.
There are many payroll solutions in the market that in addition to running payroll for your permanent employees also support paying 1099 contractors as part of the payroll process. Examples such as ADP payroll and Gusto will process 1099 payments for you. They will also even take care of electronically filling 1099 documents to the government.
Paying 1099 Contractors With Cash, Direct Deposit, or Cheques
There are many different ways you can pay the independent contractors that don’t involve the automatic payroll but they usually require more manual work and time. The employer can choose a payment method and compensate the independent contractor with:
Cash
While many contractors insist on cash payments and they are a doable option in some cases, the lack of a paper trail should be a cause for concern. It’s not the best method to use long-term and for many different contractors as it can cause miscalculations and often lead to unnecessary tensions due to a lack of paper evidence for payments made.
On the other hand, this form of payment can be a good solution for occasional or trustworthy workers who need the payment as soon as possible and don’t want to wait for ACH direct deposits or cheques.
Pros:
- Fast
- Easy
- Preferred by some contractors
Cons:
- Lack of paper trail
- Leads to tax issues
Direct deposit
Direct deposits are one more option for paying independent contractors, but they require a few days to be processed and there are usually additional fees involved. If you want to make a direct deposit to the worker’s account through the ACH networks you will need their account number, routing number, and the type of the account (checking or savings).
Direct deposits can be a viable solution for occasional payments if the independent contractor agrees to share all the needed information and is willing to wait for the processing time it takes.
Pros:
- Good for occasional payments
- Secure and reliable
Cons:
- Takes a few days to process
- Additional fees apply
Cheque
While employers can pay contractors with cheques this method is becoming a less popular means of payment in the last few years. It’s not as fast as payroll and requires immaculate logins of the worker and the payment information such as the name and address, date, pay rate, hours, and so on.
Keep in mind that cheques as physical things can easily be lost or stolen, and as such, they are not the most reliable method you can use to compensate the workers.
Pros:
- Some independent contractors and companies prefer this type of payment
- It’s easy to transfer money
Cons:
- Slower payment process
- Less secure (theft and losing)
Reporting 1099 Payments to the IRS
When the employer pays over $600 in one year to an independent contractor (and the business is not an S corp or C corp) they need to report the payment to the IRS via the 1099-NEC form at a year-end. This form is easy to fill out, but be mindful of the time frames and the exact recipients that need a copy of the form.
1099-NEC needs to include the business name and all the required information about the employer (payer) and the independent contractor (recipient). You must disclose the backup withholding amount in Box 4 of the 1099-NEC if you withheld any federal income tax.
However, keep in mind that you need to provide copy A of the 1099-NEC form to the IRS, and copy B of the same form to the independent contractor by January 31 (or the next Monday, if the date falls on the weekend).
In addition, depending on the state of the business headquarters and the federal regulations, you might have to send the 1099-NEC to your state, the state of the contractor’s residence, and even the state where the work is performed if applicable.
Any mistake made during this process that can include poorly filled out forms, missing the deadline, or failing to deliver to specific addresses can lead to severe penalties.
Because it’s important to fill in the forms correctly and mail them to the appropriate addresses to avoid potential penalties, it’s a good idea to pick a payroll system that will do everything for you. With the right payroll software, you can be sure the forms are filled out and sent to all the government addresses and communicated to your 1099s electronically. This is just one of many reasons to choose the payroll system carefully and pick the one that will reduce manual labor and additional costs.
Avoiding Mistakes When Paying Independent Contractors
Paying independent contractors is not an easy task if you have a big company and lots of contractor payments to process. But, considering that the misclassified workers, inadequate forms and even missing the deadlines for form filing and mailing can lead to serious penalties, it’s a good idea to consider the best payroll services.
Implement an easy and reliable time tracking system such as the Workyard that will help you and your independent contractors keep up with hours worked. With an accurate time clock, you can easily find a reputable payroll system that will enable you to process payments with ease.
Just keep in mind that the payroll software should include the solution for 1099-NEC forms and automatically send all the copies to the right recipients, government agencies, and your contractors.
FAQs
What is the safest way to pay a contractor?
While the payment system and method will depend on the agreement between the employer and the independent contractor, the safest way to do so is to use a reputable payroll service. The automated and optimized platforms will keep records and allow you to easily connect your bank account with the payroll service for timely and safe transactions.
In addition, you will have a dedicated paper trail that proves the paid wages and avoid potential tax problems with the IRS.
It’s also important to find payroll software that will integrate your time tracking system and automatically fill out and send 1099-NEC forms and deliver them to the right addresses and in time.
With the right time tracking system and payroll, you will safely and efficiently manage the wages and all the workers you have in the company, and save money and time in the long run.
How much can I pay someone without putting them on the payroll?
Officially every dollar earned is subjected to tax, thus there is no amount that can be paid without causing issues with the IRS. But, with independent contractors, the employer is not required to issue a 1099-NEC form if the annual payment is under $600.
Independent contractors are self-employed and as such obliged to pay all the relevant taxes and file reports on their own. Independent contractors use the 1040-ES form to report their earnings to the IRS and cover federal income taxes and self-employment tax liabilities.
Does a 1099 employee get pay stubs?
Depending on the state of residence and the agreement between the employer and the 1099 employee the pay stubs can be issued but they are not mandatory.
Pay stubs are an excellent documented addition to the paycheck that further describes the wages. The stub can be physical or electronic, and it can carry a lot of useful information such as the hours worked, accumulated earnings, and tax deductions.
However, pay stubs or payslips are not mandatory in the US, especially for 1099 employees, so the choice is usually up to the employer. But, make sure to check the local laws as some states require the pay stubs to be issued with every payment.
Can I just 1099 my employees?
No, 1099 independent contractors and employees are two completely different types of workers and they are compensated differently. While it might be an interesting and lucrative idea to treat employees as 1099s because there is no tax withholding, and no additional payments for social security, unemployment, or Medicare, this is not legal.
Worker classification mentioned earlier is crucial for proper company management and following federal and state tax laws. So, even if it might sound like a good idea to treat and pay the employees as independent contractors or 1099 workers, it’s completely illegal.
If the worker fulfills all the conditions to be considered an independent contractor (ag. behavioral, financial, and relationship factors) it’s only then they are not considered an employee and a different set of tax rules can be applied. For the workers that don’t fulfill the requirements or for the IRS officials to consider that they are to be considered an employee additional taxes and deductions need to be paid.
Bottom Line
Paying independent contractors is not hard once you are familiar with all the vital information that will help you determine the type of worker and allow you to choose the best payment method.
To recap, you need to:
- Classify your workers properly:
Independent contractors need to fulfill certain criteria to be considered and treated differently than employees. Use the mentioned criteria from the IRS guide or file the SS-8 form if you are not able to define the worker. This way the IRS officials will help you and deliver the decision you need to follow from then on.
- Obtain the accurately filled out W-9 form
Once you are sure your classification is appropriate you should obtain a fully and accurately filled out W-9 form from the independent contractor before the work begins. Make sure that the W-9 form has either the right social security number or the taxpayer identification number.
- Agree on payment terms
Discuss and come to an agreement with the independent contractor about the pay rate and pay frequency. It’s recommended to use the hourly rate as much as possible, as it’s the easiest to follow and manage with time-tracking apps.
- Choose the best payment method
Go through our guide and choose if you want to pay your independent contractors via payroll, with cash, cheques, direct deposit, or even some other means of payment. Keep in mind that platforms that offer payroll services are usually the safest and the most efficient way to manage wages and all the documentation that needs to be filed for taxes.
- Report 1099 payments to the IRS
Following the state rules and regulations, you need to file the 1099-NEC form for any independent contractors you paid over $600 in one year. Make sure all the information is filled in correctly and copies of the form are sent to the mandatory recipients. Consider using a payroll service that automatically does all of the tasks for you and avoid potential issues with the IRS.
To make the entire process easier you should use time tracking apps for all the workers in your company, and send the data to the best payroll services for further processing. This way you can be sure all the hours are logged in, the appropriate wages are compensated and all tax-related matters are resolved.
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