Independent contractors have a lot to offer businesses, big and small. They can help companies meet long- and short-term goals while giving organizations a cost-effective solution for bringing in new talent. More and more businesses are turning to contractors to fulfill roles they may not need on a full-time employee basis. For example, contractors often work on specific projects or cover seasonal staffing issues.
With independent contractors around the world offering their skills, it's also a way to tap into a much broader pool of talented workers. As of 2022, nearly 40 million people in the United States worked as independent contractors to some degree. Outside the U.S., that number is even bigger. Bringing in contractors can lead to impressive growth that boosts your bottom line.
There's a lot to gain from hiring contractors. However, the logistics become more complex. The legal differences between a contractor and a staff employee are important, and failing to do things correctly can open your business up to many headaches. So what tax forms and documents do you need to hire contractor workers?
In this guide, we'll go over the paperwork you'll need to hire independent contractors.
What is an Independent Contractor?
First things first, what is an independent contractor? While you might have a general idea of contractor versus employee, this is a critical distinction you must understand.
It's up to your business to properly classify workers. Incorrect classifications can lead to serious tax complications and legal issues. The Internal Revenue Service (IRS) and the U.S. Department of Labor are cracking down on individuals and companies that abuse the tax system, and classification issues are in their crosshairs.
At its core, the difference between an employee and a contractor comes down to the extent of their work and who they work for. When you bring in new employees, you're hiring people permanently. Those individuals work for you, contributing to the bottom line. They're eligible for employee benefits, and you must take out relevant taxes for each paycheck. For example, your company withholds income tax, Social Security tax and Medicaid from each check. You also pay unemployment tax on their wages and pay employees regularly for their contributions. Labor laws also cover employees while making them entitled to overtime, workers' compensation, sick leave, etc.
That's not the case with an independent contractor. That's because independent contractors don't work for your company as an employee. They work for themselves as sole proprietors. They're separate business owners, and you are one of their clients.
Typically, contractors are freelancers you hire to work on a specific project during a set timeframe. Once they complete their work, they have the freedom to move on to another client. Of course, you can continue to hire contractors and even extend contracts to harness their skills for longer. But contractors are under no obligation to keep working for you. It's up to them to accept another project or move on. Generally, contractors focus on auxiliary tasks. They might not affect your company's daily operations but can lead to more success later. An employee's work is critical to business continuity, but a contractor's is not.
There are many details to consider. The IRS uses many guidelines and frameworks to distinguish independent contractors. One of the most powerful differentiators is whether you control how a contractor does their job. When you hire a contractor, you're paying them for their service. Therefore, you can only direct the finished deliverable. You have no say in how they get to the final product, and contractors have the right to control how they get to the result of the work. When an individual is an employee, you can control what they will do, how they do it, and the overall scope of work they must complete.
Classifying independent contractors can be confusing, but it's important to consider all possible factors. If you classify someone as a contractor when their work best suits that of an employee, you can be subject to legal troubles, fines, and back payroll taxes. If you're unsure about classification statuses, asking attorneys for guidance is always a good idea.
Form W-9
One of the first tax forms you'll need to provide independent contractors is IRS Form W-9. It's also called "Request for Taxpayer Identification Number and Certification." A Taxpayer Identification Number (TIN) is how the IRS identifies the person or entity you're paying. In most cases, it's a Social Security number (SSN). However, it can also be an Employer Identification Number (EIN) if they work under a business name.
Form W-9 aims to collect tax-related information that your company will use to report to the IRS later. Companies that hire contract workers must report compensation if they pay contractors more than $600 in any given tax year.
When you send a W-9 to a contractor, make sure they check the box that exempts them from income tax withholding. The IRS views contracts as separate business entities. They're not your company's employees, so you're not obliged to tax withholding. The contractor will handle relevant tax duties like Social Security and Medicare taxes through their own taxes.
As a general rule, it's best to keep every W-9 form for at least four years after working with a contractor or freelancer. The form is strictly for internal purposes, and your team will use the tax information in it to fill out 1099-MISC or 1099-NEC forms.
If hiring foreign contractors living outside the United States, you should also collect Form W-8BEN. It's also called "Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting." The purpose of W-8BEN is to confirm that foreign independent contractors don't have U.S. income tax obligations.
Form 1099-MISC
IRS Form 1099-MISC is for reporting miscellaneous income. In the past, it was what businesses used to report compensation over $600 in the given tax year. However, most companies moved away from the 1099-MISC when the IRS introduced 1099-NEC in 2020. More on that soon.
Contrary to popular belief, the form still exists. Depending on your business and what types of payouts you send, you may need a 1099-MISC. It can include various forms of income, such as rent, prize winnings, royalties for intellectual property, and more. As a business, you must file one 1099-MISC to the IRS and prepare one for each contractor worker you pay. The filing deadline to generate and send this form to contractors is January 31st for the prior calendar year.
Form 1099-NEC
Here's one of the most important tax documents you must provide when hiring independent contractors. IRS Form 1099-NEC is what you'll use to report non-employee compensation. Its purpose is in the name. Contractors are not employees, but you still pay them for their services. This form is how you report that compensation to the IRS.
When generating Form 1099-NEC, you'll use the information collected on the W-9. At the start of a new tax year, you must generate two copies of the form for every contractor you hire. One copy goes to the IRS. The other goes to the contractor. Like the older 1099-MISC forms, the filing deadline for the 1099-NEC is January 31st. You must get the form to your contractors early in the year because it plays a big part in helping self-employed individuals calculate how much they owe in self-employment taxes before the filing due date.
Invoicing Documents
Invoicing documents are another must-have. Contractors and gig workers should not get paid until they complete their work and submit an invoice. Paying a contractor before that puts you at risk of misclassification because employees get paid regularly.
Work with your contractors to establish a protocol for invoices. Your business can suggest specific procedures and forms for invoicing. However, it's up to the contractor to send those invoices your way. Agree on a process together and only send payments when invoices are submitted.
Review each invoice and ensure it has the appropriate statement of work and pay rate. You should never accept expense reports. Equipment, mileage and other business expenses are not your company's concern. Remember: They're not employees. Therefore, contracts are responsible for covering their business expenses. They are separate entities, and you only pay for their service.
Confidentiality Agreement
While not always necessary, many organizations consider it best practice to provide confidentiality or non-disclosure agreements. Your full-time staff employees might have to sign these documents, too. However, independent contractors aren't bound to the same clauses as employees. Therefore, it's wise to create separate agreements that protect your company.
Contractors might have access to potentially sensitive information. They may learn more about your company and gain insight into things the general public doesn't. The last thing you want is for a contractor to go to a competitor and give away your secrets. Confidentiality agreements prevent that. If the deal is valid and the contractor breaks it, you may have the means to take legal action.
A Signed Contract
Written independent contracts are beneficial for all parties. It details what you expect from the contractor, ensuring you get the service you're paying for. Meanwhile, it reassures contractors that they get paid for their services. It's mutually beneficial and protects both you and your contractors.
Ideally, a lawyer should write contracts. The purpose of this document is to spell out the working relationship between your company and the contractor in black and white. It should eliminate all doubts and confusion about their work classification while detailing all aspects of the job.
Take time to craft the perfect written contract. There are many elements to include.
The most important is the scope of your contractor's work and how long the contract will last. It should also include relevant deadlines and information about key deliverables. Contracts also need payment details to avoid disputes. That includes invoicing processes, billing details, pay rates, etc.
If you have any additional clauses, such as confidentiality agreements and non-compete clauses, you can add those, too.
Contracts need to specify that you're the client paying for a service from the contractor. That means including language that avoids confusion should the IRS get involved. Consider adding points that state you will not withhold taxes as a client and that the contractor will use their skills and equipment to complete tasks. It's also a good idea to include clear conditions regarding contract termination and violations of the terms.
Well-written contracts are an investment, but they can come in handy and protect your business. Sometimes, red flags arise at the IRS if you hire contractors more than once. A contract covering your bases will protect your company from legal troubles. Allow your contractors to review these documents before signing so that they know every term they agree to.
Non-Compete Clause
A non-compete clause is another optional document or addition to the contractor agreement. Most businesses don't have non-compete clauses for independent contractors. It tiptoes the classification line and can be risky. But it's worth considering if you're hiring a contractor to do sensitive work.
With a non-compete agreement, you're requesting that the contractor doesn't work for a competitor or within the same field during your contract with them. It may also cover a period after their contract ends. If so, you must provide a timeline stating when the non-compete clause will expire.
A non-compete clause in your independent contractor agreements can be risky, so it's wise to consult a lawyer or your company's legal team. You may find that many contractors will not sign these contracts, especially if you're only hiring them for a one-off project. They can severely limit how a contractor works after your contract ends, so put great thought into deciding if a non-compete agreement is necessary. Alternatively, you may consider having a non-solicitation agreement to ensure that contractors don't pull your customers away from you.
Proof of Worker’s Comp
Finally, we have proof of worker's compensation. Worker's comp is a type of insurance that covers workers who get hurt or become ill as a direct result of their work. You won't have to worry about this document if you're hiring contractors for creative work, consulting or other office-based work.
However, it's a must if you hire physical laborers, such as contractors, and subcontractors. Liability is important and proof of worker's compensation can provide more peace of mind. Most businesses hiring contractors for physical jobs make this detail a contractual obligation. Laws can vary based on where your company operates, but some states require organizations to provide worker's compensation for both employees and contractors. Familiarize yourself with laws in your state before hiring independent contractors.
Easily Pay Your Contractors With the Dots Payouts API
There's a lot to gain from hiring independent contractors. They provide a cost-effective solution to get the talent you need. Think of hiring contractors as paying small businesses for their services. Because they're not employees of your company, you must do your due diligence the first time to ensure you stay compliant with all tax and employment laws. These documents can help you forge a solid business relationship and take advantage of everything independent contractors and freelancers offer.
If you need a way to pay your contractors efficiently, check out Dots. The Dots API is a unified platform that allows you to send and receive money worldwide. Give your contractors a choice in how they get paid, take care of tax reporting, and more. Schedule a demo with Dots today to learn more.