If you plan to hire an independent contractor, you might be wondering about taxes.
Independent contractor taxes do exist — freelancers must report their income to the tax man to keep up with US tax regulations.
If you’ve typically hired traditional W-2 employees, you may have no idea what your responsibility is as an employer with independent contractor team members.
This helpful guide will teach you everything you need to know about hiring independent contractors, including who qualifies as this type of worker, how to determine which kind of employee you’re hiring, and different tax forms that independent contractors need to use.
Independent contractor defined
There’s been a significant rise in the number of people choosing to work independently in recent years. As of 2022, there were 31.9 million individuals working as independent contractors in the United States.
An independent contractor is an individual or company that provides services to another individual or business under a contractual agreement.
As such, they’re considered to be separate and distinct legal entities from the companies they work for and are not entitled to certain benefits and protections, including the following:
- Wage and hours laws
- The ability to unionize
- Worker’s compensation
- Disability insurance
- Unemployment insurance
- Most employer-provided benefits
People who engage in independent contractor work can also be referred to as the following:
- Contracted workers
- Gig workers
- 1099 workers
A company may choose to hire an independent contractor if they need an area specialist to complete a certain job.
For example, a marketing agency may hire an independent contractor to design a new website or shoot a video for an advertising campaign.
The benefits of hiring an independent contractor include the following:
- Increased flexibility: contractors can be hired on a project-by-project basis, allowing businesses to scale their workforce up or down as needed without committing to long-term employment contracts.
- Cost savings: independent contractors are responsible for paying their own taxes, insurance, and other business expenses.
- Reduced liability: since independent contractors aren’t employees, the hiring company may have reduced liability for any accidents or injuries that occur on the job.
- Access to a wider talent pool: hiring independent contractors gives companies the option to hire talent with specialized skills and experience from different geographical locations.
Independent contractor: self-employed worker or employee?
One challenge that businesses often face is determining whether an independent contractor should be classified as a self-employed individual or an employee.
However, this determination is actually a lot simpler than many think in the US. According to the IRS, if “…you’re an independent contractor, then you are self-employed.”
There are some important distinctions between self-employed contractors and employees, including the following:
- Control over work: self-employed contractors have more control over their work and schedule, while employees are assigned specific tasks and deadlines by their employers.
- Job security: self-employed contractors aren’t guaranteed a steady stream of work or a stable income, whereas employees have more job security and are typically protected by employment laws.
- Taxes: self-employment taxes require contractors to pay their own taxes, while employers are usually in charge of deducting taxes from an employee’s paycheck.
It’s important to understand the difference between self-employed contractors and employees, as misclassifying workers can lead to hefty fines.
Consequences of misclassifying workers include the following:
- Legal penalties
- Reputational damage
- Audit risk
- Employee claims of unpaid wages
A study in 2021 found that the construction industry had high levels of payroll fraud and misclassification of employees as independent contractors.
In Minnesota, 23% of the workforce is misclassified, meaning workers “…lose access to basic labor protections, including minimum wage, overtime pay, unemployment insurance, and worker’s compensation insurance.”
Define your workers
The first step in understanding how to correctly handle worker payments and taxes is to determine the nature of the business relationship between you and the worker.
The person performing the services may be an:
- Independent contractor
- Common-law employee
- Statutory employee
- Statutory non-employee
- Government worker
When determining whether the individual who’s providing your company with a service is an employee or an independent contractor, it’s important to consider the elements of your work agreement that influence the level of control and independence the worker has.
Define your (working) relationship
To determine what category to classify a worker in, you can also look at the nature of your working relationship.
The IRS recommends using three categories to decipher a worker’s status and how that status will impact the worker’s income taxes and payment implications.
The three categories are as follows:
1. Behavioral: do you have the right to dictate what the worker spends their time on, how they do their job, or what hours they work?
2. Financial: are the worker’s payment rates and business taxes controlled by your company, or is the worker responsible for them?
3. Type of relationship: are there written contracts between you and the worker or an agreement to offer the worker any type of employee benefits, like insurance or paid medical leave?
Deciding whether a worker is an employee or an independent contractor can be confusing, as some factors may indicate that they’re an employee, and others may suggest that they’re an independent contractor.
The best way to overcome this issue is to assess how much control you have over the individual’s work.
For example, if you’re able to direct how the person conducts their work, when they come into the office, or how long they spend on an assignment each day, this is a good indication that you have hired an employee rather than an independent contractor.
You can also use Remote’s employee misclassification risk tool. This easy online tool will show you what your risk level is when hiring contractors anywhere in the world — and what you can do to reduce the risk of misclassification.
Understanding the “final rule”
The US Department of Labor announced its “final rule” to clarify independent contractor status under the Fair Labor Standards Act (FLSA) in 2021.
Under this rule, the Department has adopted an “economic reality” to determine whether a worker is an independent contractor or an employee.
US Secretary of Labor Eugene Scalia states, “…this rule brings long-needed clarity for American workers and employers.”
The test considers the following:
- Whether the worker is in business for themselves
- The nature and degree of the worker’s control over the work
- The opportunity for profit or loss based on initiative and/or investment
It also requires consideration of the following three other points:
- The skill required to complete the work
- The strength of the working relationship between the worker and the company
- Whether the worker’s tasks are essential to the organization
The “final rule” is intended to provide clarity and consistency in determining whether a worker is an independent worker or an employee. It also helps to reduce litigation and provides regulatory relief for employees who use independent contractors.
However, it’s important to note that this rule only applies to the FLSA and doesn’t affect other laws or regulations that may have different definitions of “independent contractor.”
Tax forms that are applicable to independent contractors
It’s important to be aware of the business tax forms you’re required to submit when working with independent contractors.
As independent contractors are responsible for their own income tax filing, they’re not subject to the same tax-withholding requirements as full-time employees.
It’s important to know what the right tax forms for independent contractors are and ensure these are lodged in a timely fashion. This will help ensure compliance and avoid potential legal issues
Applicable forms may include the following:
Independent contractors, vendors, and other payees must complete Form W-9 in the same way that employees have to fill out a W-4 form before starting work with a new company.
The W-9 is used to ask for the worker’s name, address, and taxpayer identification number (TIN) for tax reporting purposes.
Any independent contractor who earns $600 or more from your organization within one year is required to fill out a W-9 form.
It’s best practice to get the contractor to complete this form and hand it back to you before you begin working together. This will ensure that you stay compliant and avoid payment issues from the beginning of your work relationship.
Businesses are required to keep each completed Form W-9 in their files for at least four years in case there are any questions or disputes with the IRS regarding the payee’s classification.
It’s also vital to know that the form itself isn’t sent to the IRS, but the information the independent contractor adds is used to complete Form 1099 — which is submitted later.
At tax time, independent contractors use Form 1099-NEC to report payments of $600 or more made to them during the tax year.
The 1099-NEC is similar to the 1099-MISC (miscellaneous taxable income), which was previously used to report non-employee compensation. However, in 2022, Form 1099-MISC was re-introduced to specifically report non-employee compensation.
Businesses use Form 1099-NEC to report the total amount of compensation paid to an independent contractor during the tax year, including the following:
- Hourly rates
Once you have completed the 1099-NEC form, you must provide a copy to the independent contractor and file a copy with the IRS.
It’s important to understand that the 1099-NEC has special requirements compared to Form W-2 used for employees. These include the following:
- Who fills out the form: employers fill out form W-2, whereas businesses fill out the 1099-NEC for independent contractors.
- Penalties for noncompliance: employers who fail to file a form W-2 correctly could face penalties from the IRS, whereas if a business is found to have incorrectly lodged a Form 1099-NEC, they’re fully responsible for it.
Companies may also use Form 1099-K to report any payments made to an independent contractor through a payment card or third-party network. This can include payments made through services like PayPal and Venmo.
An issue of Form 1099-K must also be given to the independent contractor if they meet certain thresholds.
Understanding independent contractor taxes can save you time and money
It’s crucial for every business that hires independent contractors to understand their tax obligations.
Properly classifying your workers and meeting your tax obligations can save you time and money on legal issues down the line. It’s also important for maintaining positive relationships with your workers.
When deciding whether a worker is an independent contractor or employee, remember to consider the behavioral, financial, and type of employment relationship factors outlined by the IRS.