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Kindra Cooper covers small business terms and topics for The Balance, ranging from business finance to entrepreneurship. With nearly a decade of experience as a freelance journalist in print, web, and multimedia, she has worked in-depth with the small business and financial industry, serving as a content manager for a financial services firm in NYC and heading digital marketing at the Lawrence N. Field Center for Entrepreneurship at Baruch College.
Updated on May 31, 2022 Reviewed byKhadija Khartit is a strategy, investment, and funding expert, and an educator of fintech and strategic finance in top universities. She has been an investor, entrepreneur, and advisor for more than 25 years. She is a FINRA Series 7, 63, and 66 license holder.
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Independent contractors help businesses meet short-term and seasonal staffing needs in a cost-effective way, helping to avoid cyclical hiring and firing. Independent contractors are also massively used in the present economy to access talent in niche areas or a temporary need for a certain expertise. As they are not considered full-time staff, they are often paid on an hourly or project basis and do not qualify for employee benefits.
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.
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.
| Independent Contractor | Employee |
| The company withholds no taxes from wages paid, leaving the contractor responsible for their own taxes | The company withholds income tax, Social Security, and Medicare from wages paid |
| The company does not pay unemployment tax on wages paid to a contractor | The company pays unemployment tax on wages paid to an employee |
| Contractors are not covered by employment and labor laws | Employees are covered by employment and labor laws and are entitled to overtime pay, sick leave, and worker’s compensation |
| Contractors are generally not entitled to any benefits | Employees receive benefits such as paid time off, insurance, and pension plans |
| The company generally cannot control where or when an independent contractor does the work tied with the job | The company has the right to control all business aspects of an employee’s job |
| Contractors are not paid until an invoice is received | Employees are paid on a regular schedule |
| Independent contractors are given a Statement of Work outlining their responsibilities, pay, and the length of the contract; they are not bound to maintain confidentiality unless a non-disclosure agreement is signed | Employees must sign an employment contract to complete the hiring process, which may also include a non-compete agreement, non-disclosure agreement, and so on |
There are penalties involved if you misclassify an independent contractor and a full-time employee. It can result in fines, legal fees, and retroactive payroll taxes.
The Internal Revenue Service (IRS) and the U.S. Department of Labor (DOL) use slightly different frameworks to distinguish employees from contractors.
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.
If you’re ever confused about classifying an independent contractor, complete and submit Form SS-8 to the IRS. The IRS will review and make an official classification determination.
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.
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.
Contractors and employees should not send Form W-9 to the IRS. This form is meant for internal purposes of collecting information needed to fill out Form 1099-MISC. Business owners should keep the contractor’s W-9 form on file for four years after hiring in case questions arise in the future.
A work agreement spells out the business relationship between a contractor and a client. This type of legally binding written contract typically includes:
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.
It’s important to add a section in the work agreement that states the contractor will not receive employee benefits such as health insurance, unemployment compensation, paid vacation, etc. This way, there will be no confusion about potential benefits down the line.
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.
Using cash as a payment method for independent contractors is not recommended because there will not be a traceable paper trail of payments.
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 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.
The deadline for sending form 1099-NEC to both the IRS and all hired independent contractors is Jan. 31 of the year following payment.
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.
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.
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.
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.
The top risk of hiring an independent contractor is misclassification. IRS penalties include paying back taxes (with interest), fines, and even class-action lawsuits. In some cases, suspected misclassification may lead to an IRS audit.
Hiring contractors allows businesses to meet short-term or seasonal staffing needs in a cost-effective way. Contractors are also easier to onboard in terms of paperwork, and companies are not obligated to provide them with benefits.
Independent contractors are often called “1099 employees,”—although this is a misnomer since 1099 forms do not apply to employees. You must decide whether to hire someone as an employee (with the associated responsibilities) or keep them as a contractor (and lose some degree of control).
