Independent contractors are self-employed people or entities that provide services to other business entities as non-employees. They are often also referred to as freelancers and consultants.
Hiring independent contractors to perform different operational tasks for your business can be highly beneficial. Since contractors are not employees, you won’t have to pay any payroll taxes when compensating them for services. You also won’t provide any employee benefits, like retirement plans, health insurance, and other perks associated with full-time employment.
Any business that wants cost-effective, flexible, and skilled workers can benefit from working with independent contractors.
But there are different labor laws and tax rules you must follow to ensure compliance. Many businesses make mistakes with independent contractor management, which can lead to fines, back taxes, penalties, and potential lawsuits.
This guide will explain everything you need to know about hiring independent contractors, working with them, and remaining compliant.
Why Do Independent Contractors Matter?
Independent contractors can be a cost-effective alternative to hiring full-time employees. There are tons of benefits for employers and contractors alike, including flexibility and compensation. Bringing independent contractors onto your team is an excellent way to get skilled labor for part-time work while saving money.
What Does Success Look Like?
Labor is often one of the most significant expenses for any business. Recruitment, onboarding, training, payroll, taxes, benefits administration—the list goes on and on, and these costs add up quickly.
But the vast majority of these costs are eliminated when using independent contractors instead of direct employees. You’re only paying them for the cost of services exchanged, as defined by the contract terms.
Independent contractors typically have specialized skill sets. So if you’re seeking unique services, it could be easier to work with a contractor instead of hiring a full-time employee.
There’s also less of a learning curve when you’re dealing with contractor labor. Employees can take months to train, which is extremely expensive.
But contractors already know what they’re doing (otherwise, you wouldn’t be hiring them), and they’re used to working with different businesses. Many contractors start providing immediate value from day one.
The flexibility of working with an independent contractor is ideal for both ongoing and short-term work. There aren’t any long-term commitments, and you can terminate the relationship at any time without incurring costs beyond the contract agreement.
Independent contractors also make it easy for businesses to scale without hiring employees.
However, compliance needs to be a top priority when you’re considering using one or more independent contractors. Some business owners miscategorize employees as contractors to try and save money, but this can land you in lots of trouble. You must follow state, federal, and local labor laws and tax laws at all times.
Generally speaking, the following principles and considerations identify an independent contractor:
- They supply their own tools, materials, and equipment
- They control their own hours
- They choose whether or not to work without fear of losing the job
- They pay their own taxes
- They provide similar services to other businesses
- They have “freedom of action”
The nature of the work also helps define the relationship. When the tasks are considered integral to the business, the person will usually be defined as an employee.
For example, you can’t run a restaurant and classify your wait staff, bartenders, and cooks as independent contractors. Those are all employees.
But let’s say you wanted to start a blog for your restaurant. Rather than hiring a full-time employee for something like this, you could use an independent contractor to write and post blogs on your website.
The blogger would have the freedom to write each article on their own time using their own tools. As a contractor, this person sets their rates, and you only pay them based on the work completed by the terms of your agreement.
Case Study
One famous case study of independent contractors is ride-sharing. Companies like Uber and Lyft run and operate ride-sharing mobile applications without employing any drivers.
All of the drivers are classified as independent contractors because they use their own vehicles and make their own hours. Essentially, the drivers are their own bosses. When they do work, they get paid for the work they do.
This contractor relationship has allowed these companies to scale operations worldwide. For example, Uber has 19,000 employees but has over three million drivers. If they hired three million employees, the costs would be astronomical, and the business model would fail.
One Secret Weapon For Managing Independent Contractors
Gusto is our secret weapon for businesses that want to hire independent contractors and remain compliant. With Gusto, you can add contractors to your payroll for just $6 per contractor per month. This includes direct deposit and unlimited payments.
Using a self-service portal, contractors can onboard themselves to the platform, add their personal information, and set up their bank accounts for payments.
In terms of tax compliance, Gusto will automatically file 1099s with the IRS and send a copy to your contractors as well.
4 Essential Strategies For Working With Independent Contractors
Managing your relationship with independent contractors isn’t always easy. Ensure you apply the following tips and best practices to stay compliant and ensure you achieve the kind of success we described earlier.
Strategy #1: Create a Contractor Agreement
A contractor agreement (contract) is a formal document that defines the terms of the relationship between contractors and clients. The contract should include a description of the services being rendered and the length of the project or service.
Payment details are another critical aspect of a contractor agreement. It should include information for deposits, retainers, how payments are made, and billing frequency.
The main idea behind a contractor agreement is to get everyone on the same page and avoid surprises by both parties.
For example, let’s say your business hires an independent software developer to create an application for your business. You might establish certain milestones where you’ll issue payments incrementally instead of upon completion.
It’s common practice for independent contractors to dictate their terms. But certain things, like payment schedule, can be up for negotiation.
Contractor agreements help you maintain compliance and protect your business if you get certain things in writing. You may want to clearly spell out that the working arrangement does not imply employment, and the contractor can work with other clients.
You may even want to add non-disclosure clauses or non-compete clauses to the agreement as well. For example, you wouldn’t want a contractor to take your trade secrets and bring them to one of your competitors.
Some of the best HR software makes it easy to manage contractor relationships. So you can store any contractor agreements in the same place where you’re storing other employee files.
Strategy #2: Issue 1099s to Independent Contractors
If you pay $600 or more to an independent contractor during a calendar year, you need to generate a 1099. Form 1099-MISC is an IRS document used for reporting income.
Since independent contractors are responsible for paying their own taxes, this document shows the IRS how much you’ve paid them during the year.
There are always at least three copies of a 1099—one for you, one for the contractor, another for the IRS, and sometimes one for the state. If you’re using a payroll and HR solution like Gusto, these forms will be automatically generated and sent to the appropriate parties.
This really makes your life easier in terms of tax compliance. You won’t have to worry about manually generating any forms and mailing them to the appropriate agencies—Gusto takes care of everything on your behalf.
Your contractors will appreciate this convenience as well.
First, they can get paid electronically via direct deposit. This is much easier than having to deal with physical checks for payment collection. Then at the end of the year, they’ll automatically get sent their 1099s.
Strategy #3: Adjust Your Management Style
You can’t manage independent contractors the same way you manage your regular staff. Remember, independent contractors are not your employees. So you don’t have the same rights and luxuries when it comes to assigning tasks and telling them what to do.
For example, you can’t dictate hours or change things outside of the contractor agreement.
While you might be able to tell a full-time employee, “I need you to work Saturday mornings from 8-11,” this won’t fly with a contractor. Unless specific work hours are discussed in the contract, independent contractors tend to make their own hours and get work done on their schedule. As long as they meet the deadlines you’ve mutually agreed upon, you should not be dictating how or when they work.
You need to understand that most contractors perform work for other clients as well. So expecting them to reply to your emails within 10 minutes isn’t really fair or realistic. You can set certain expectations with an employee but not a contractor.
Avoid asking your contractors to do anything outside the scope of your arrangement.
Let’s say you’re hiring a developer or designer to work on your website. You could provide them feedback to say what you’re happy with and what needs improvement, but calling them into a meeting for a formal performance review isn’t appropriate—this is something for employees.
When you hire a contractor, you’re the customer in the relationship. Customers don’t give orders to businesses they patronize—they make requests.
There are two major reasons why you need to adjust your management style with contractors.
For starters, there’s the compliance issue. Certain things could be perceived as an employer-employee relationship, which could get you into trouble with labor laws and tax laws.
But your management style also has a direct impact on long-term success in this relationship. If you want to work with contractors long-term, you need to treat them like the self-employed business owners they are. Otherwise, you’ll have problems keeping contractors for the long run.
Strategy #4: Issue Payments On-Time and Compensate Accordingly
There’s a misconception out there that independent contractors are cheap labor. This couldn’t be further from the truth.
It’s cost-effective to use contractors because you’re not paying payroll taxes, benefits, training hours, and all of the other expensive costs associated with employees outside of their salaries.
Contractors typically offer highly specialized services. In some cases, the rates will be high. But it’s often worth it for the value of the service you’re getting in return—and still cheaper than an employee.
For example, let’s say you want to retain legal services for your business. Generally speaking, you’ve got two options to consider—in-house counsel or a law firm.
In-house counsel would classify as an employee. The average annual salary for this position in the US is roughly $227,500.
Hiring an outside lawyer would be an example of an independent contractor. This attorney makes their own hours, sets their own rates, and works with other clients. Even if they’re charging you $500 per hour, it’s likely going to be much less expensive than hiring a full-time employee to do this job.
Like lawyers, other contractors like developers, graphic designers, writers, photographers, translators, and more have specialized skills that demand a certain pay level.
Don’t expect contractors to stick around if you’re not paying them on time or you’re underpaying for their services.
Some businesses pay contractors late because paying them is inconvenient. But this is another reason why using a tool like Gusto can help you out.
There’s no need to write checks, lick envelopes, or walk to the mailbox. You can use Gusto to pay contractors with just a few clicks from your computer or mobile device.
Most Common Mistakes Managing Independent Contractors
There are several common mistakes that businesses make when hiring and managing independent contractors. These mistakes can damage the relationship with your contractors and potentially land you in hot water in terms of compliance.
Here are the top mistakes you need to avoid:
- Miscategorizing employees as independent contractors: You can’t just classify an employee as a contractor to save money and avoid giving them benefits. Workers must qualify as contractors as dictated by FLSA, the IRS, and other local laws.
- Micromanaging: Independent contractors shouldn’t be managed like employees. Allow them to perform the service you hired them for without micromanaging every detail of what they’re doing.
- Not having contracts in place: Failing to create a contractor agreement makes the arrangement too ambiguous. But having a signed contract can protect your business and keep everyone on the same page.
Lots of businesses are using independent contractors as a cost-effective way to work with highly skilled individuals. Use this guide as a resource for hiring contractors and managing contractor relationships while remaining compliant.