May 24, 2021Payroll

How to pay independent contractors: A step-by-step guide

Paying 1099 contractors can be complex. There are several forms to complete, rules to follow, and different ways to pay. We’ve put together this guide that covers all the information you need for how to pay independent contractors: from the W-9 IRS form and 1099 tax documents, to what kind of payment options you have. It’s all to help you understand your obligations as an employer, so you can avoid costly mistakes down the road.

1. Classify workers correctly

Before making payments to a 1099 contractor, it’s important to know how to classify this type of worker in the first place. Gig worker classification has become a highly contested topic as states like California rollout expansive legislation about how to classify independent contractors. If you’re a California-based company or if you work with or plan to hire California-based workers, check out our resources on the state’s AB5 law.

So, what’s the difference between 1099 contractors vs. W-2 employees?

An independent contractor is a self-employed worker who is typically hired to complete a short-term project without any obligations to work for the company on an ongoing basis. He or she usually isn’t part of the organization’s permanent workforce, and doesn’t receive benefits offered by the employer such as health insurance coverage, paid sick leave or vacation time.

A W-2 employee, on the other hand, is a worker who is hired by an organization and has the same responsibilities as someone in salary employment.

IRS definition of an independent contractor

The IRS has parameters to help determine whether a person qualifies for independent contractor status. They look at three types of control when determining status, including financial, behavioral and relationship.

For instance, if the business controls how, when and where a worker does his or her work, they’re most likely an employee. In contrast, if the independent contractor has control over these three factors – for example they have to provide their own tools and can work when they want – then the individual is more likely classified as self-employed.

2. Set a rate and payment frequency

If you’ve determined that your worker is correctly classified, it’s time to set the best way to pay your independent contractor. Typically a business sets a rate with a contractor upfront, either hourly or per-project. There are also instances when a contractor may be on retainer, which means they’re paid a flat fee for ongoing work.

How often should you pay independent contractors?

While oftentimes contractors will invoice once a month or even quarterly, it’s becoming more and more common to offer flexible pay to contractors like weekly or even daily payments.

For contractors, getting paid more often helps them manage their cash flow and see the value of their work faster. If they’re doing contract work for multiple companies, they’re likely to give more hours to a business that pays them faster, so it’s a win for you, too.

It’s also easier for a business to reconcile invoices with time daily or weekly if you’re paying a contractor by the hour, as opposed to once a month. You can also keep your cash flow in check when payouts happen more frequently. You’ll know how much cash will roll out of your business before the month ends, and you can reduce a contractor’s hours later in the month if funds are tight.

If cash flow is a concern, there are some payroll companies that will front faster payments for you, and you settle up after you invoice accounts or at the end of your normal pay cycle.

3. Collect a completed W-9 form

Before work begins, you need to have your independent contractor complete a W-9 form. A W-9 form is a federal tax form that requests the contractor’s name, their social security number and other information. It’s an agreement between the company and the contractor that the contractor is a non-employee and not subject to withholding taxes.

Keep W-9s in your records for at least three years, and take note of how they classify themselves in the #3 section at the top of the form (i.e. sole proprietorship, S corp, etc.). How they’re classified will tell you whether or not you need to file a 1099-NEC in January (more on that below). It’s important to note whether the 1099 contractor is subject to backup withholding or not (line 2 under Part II), as you will be required to deduct backup withholding from their earnings if they do not provide you with a valid taxpayer identification number in Part 1.

4. Calculate payment

Calculating payment depends on the payment terms you set with your independent contractor upfront. Once that’s set, calculating pay for independent contractors is easy, because you don’t have to withhold any taxes from their payments.

If a contractor bills hourly, they should report the number of hours worked on a project, down to even half or quarter of hours worked, in the agreed upon time frame for payment. They should also list at least high-level information on the services performed during those hours. It’s then as simple as multiplying the hours by their hourly rate (i.e. 4.5 hours worked at $50 per hour is 4.5X50).

If they’re paid per-project, the fee would already be determined upfront regardless of the amount of time the work takes. In this instance, it’s not uncommon to pay a portion, say 25%, of the fee upfront to guarantee the work, and then pay the rest at project completion.

For contractors who are on retainers, there are two typical arrangements. You either pay them a flat fee to have them “on call” and then pay additional fees by the hour or by the project. Or you pay a flat fee each month or quarter, regardless of hours or work performed.

5. Process payment

When work is completed, it’s time to process payment and pay your contractors—usually through a payroll system via direct deposit or check.

How to pay contractors through payroll

If you have a lot of contractors to pay and need to pay them often, you’ll want to consider a payments or payroll platform. Once you select a platform, you’ll need to link it to your bank account that will fund the payments and create accounts for your contractors. This can be done either by having contractors add their personal information or you may be able to upload this information from a spreadsheet.

To that end, a payroll solution that’s built to handle a lot of contractor direct deposits should let you upload a spreadsheet with payment data to make bulk payments, which is a huge timesaver. The spreadsheet will usually need to include the following information:

Worker ID (a unique number associated used to identify them in your systems and the payroll system)
First name
Last name
Full name
Payment amount
Note (to give the worker context on the payment, i.e. Tuesday’s deliveries)

Payroll platforms may have an API where your business systems can feed payment data directly to their app. This will require some integration work between your technology teams and theirs, and you should be able to request API documentation upfront to understand how big of a lift it will be for your business.

Bulk uploading or an API integration make contractor payments quick and seamless, so you can pay contractors as often as daily.

How to pay contractors via direct deposit

Direct deposit is a process by which money is deposited into a contractor’s bank account electronically through ACH networks. To set up direct deposit for a 1099 worker, you’ll need authorization to pay them this way. You’ll have to collect their bank account number, routing number and checking or savings account type, as well as transaction type (one-time, recurring). The best way to collect this information is either through the tool you’ll use to pay them (if available) or by sending an ACH authorization form using a tool like Docusign.

You can make a direct deposit using an online accounts payable solution, like Bill.com, which takes several days to process payments and requires a monthly subscription fee. These tools can work well if you only work with a few contractors and pay them infrequently.

How to pay an independent contractor via check

Today’s contractors are more likely than ever to work with multiple businesses, so they want their pay as fast and easy as possible. That’s why paying via checks is less popular today, but some businesses still operate this way.

If you’re paying with checks, you’ll need a system for keeping track of worker and payment information. You could create a payment log with the following columns:

Name and address of contractor
Date of payment
Pay rate
Hours worked
Taxes withheld (if applicable)
Total owed to worker

On the agreed upon repayment time frame, you can cut a check for the contractor and mark the date of payment as complete. You would then write a check for the total payment and either mail the check directly to the contractor or keep it in a secure location for the contractor to pick up in person.

It’s worth noting that physical checks come with some headaches and security risks that direct deposits do not. It’s not wise to hold onto physical checks for an extended period of time because of potential for loss or theft. It’s also a pain if a contractor misplaces a check and then you have to reissue it.

6. Create a general ledger sheet

When you’re paying a lot of contractors, if your payment tool doesn’t provide detailed reporting, you may want to create a general ledger sheet.

A general ledger sheet organizes information about all contractors who have received money from your business in one place, so you can quickly find data when needed. This could be an additional tab on your payment log that tracks contractors’ gross earnings for the year, so you’ll be able to easily identify which workers you’ll need to process 1099s for at year end. This spreadsheet is also where you can track things like commission percentages, variable pay rates and other information that’s specific to each contractor.

7. Prepare your 1099 tax documents

You must report payments made to contractors to the IRS. The IRS needs to know what wages are being paid out, so they can assess the appropriate taxes, which the contractor is responsible for submitting.

A Form 1099-NEC needs to be completed for any non-employee payment over $600, if their business entity is not an S corp or a C corp. You need to submit the form by mail or electronically to the IRS by January 31 and also need to provide the contractor with a copy by that same date.

If you’re considering a payroll platform to handle your contractor payments, look for ones that will submit your 1099s to the IRS for you and distribute 1099s electronically to your workers. This will save you a ton of time from rather than manually mailing copies of the forms.

Avoiding mistakes when paying independent contractors

The compliance and payment process for independent contractors isn’t always clear. Classification rules, IRS forms and tracking hours make paying contractors unnecessarily complex for many businesses. Understanding your options and following some basic processes can improve efficiencies and help you scale your contractor workforce without worry.

Using the right payments platform for your business can help you pay contractors quickly while remaining compliant and up to date with the latest classification and tax guidance. We’ve put together a guide to help you choose the right payroll solution based on your needs. Plus, the signs you need to switch payroll platforms and a step-by-step guide for switching payroll. If you’re looking for a solution to pay contractors daily with less work, check out Everee’s simple, same-day payments for 1099 workers.