In 2021, there were approximately 23.9 million occasional independent workers in the United States, an increase from 12.9 million in 2017. The numbers show that the trend of hiring temporary workers is rising exponentially with no signs of stopping.
There are a lot of factors that contribute to the growing demand for independent contractors. Younger generations have a different concept of the workplace and environmental influences like the pandemic drove everyone indoors (forever changing the way we do business). Thus, it’s somewhat inevitable the majority of organizations will encounter a time when hiring a freelancer makes the most sense.
For employers and agencies, it’s absolutely critical you understand how the payment process for an independent contractor works. It differs greatly from a full-time employee.
In this article, we’ll look at the true definition of an independent contractor, what business owners need to know when working with them, and how to pay 1099 contractors.
What are 1099 Contractors?
A 1099 contractor goes by many names like freelancer, independent contractor, self-employed worker, influencer, affiliate, partner, W-2 employee, and more. A 1099 contractor is an individual who provides goods and/or services to business or companies, based on an agreed-upon verbal agreement or written contract.
Unlike regular employees, independent contractors only work as required. They are responsible for making their own tax payments (there’s no withholding taxes and payroll taxes) and freelancers are not eligible for employee benefits.
Companies face an array of challenges when managing and paying 1099 contractors. Some of the more common problems that arise include:
- Differences in how 1099 contractors are compensated (i.e. payment methods)
- Federal income tax requirements for varying locations
- The need to review, approve, and process multiple invoices
- Poor tracking and monitoring practices
- Inconsistent payment schedules and different pay cycles
Companies can also face tax penalties if they mismanage the financial relationship with an independent contractor. Itcan range from USD 50 to USD 500 for each 1099 that’s incorrect or late.
One of the more common errors is an incorrect Taxpayer Identification Number (TIN) on the freelancer’s W-9 form. This is typically just a social security number (SSN) if the person is acting as a sole proprietor (i.e. their own business entity).
The hiring company is responsible for verifying if these numbers are accurate, as consequences can include the IRS asking for backup withholding or a percentage of invoice payments.
What Do Companies Need to Know When Working with 1099 Contractors?
When it comes to hiring an independent contractor, there are quite a few factors you should understand before taking the plunge. Here’s what you need to know to get ready:
Understand Legal Requirements
This mostly means the worker classification. Since an independent contractor is not an employee, they cannot be treated as such.
However, you must still ensure freelancer tax compliance for anyone you intend to hire and pay. It means following a set of prescribed employment rules and abor laws, and making sure the proper documents are filed.
According to the IRS resource on reporting payments to independent contractors, a worker must meet certain conditions for you to consider them an independent contractor (with the need to file Form 1099-NEC).
NEC stands for nonemployee compensation, and the following four conditions set by the IRS, must be met to report a payment as NEC:
- You made the payment to someone who is not an employee
- You made the payment for services in the course of a trade or business (including government agencies and nonprofit organizations)
- You made the payment to an individual, partnership, estate, or a corporation
- You made payments of at least $600 during the year to the payee
Tax Forms the Contractor Needs to Fill Out
Have your contractor fill out a Form W-9, which will provide you with all of their identifying information (name, address, and TIN).
Make sure to keep the W-9 for at least 4 years, and pay close attention to the business classification (i.e. S corp, sole proprietorship, etc.) which is located on line #3. This will help a business determine whether or not they need to file a 1099-NEC in January.
A business should also check the W-9 on line #2, Part II.
This will indicate whether the independent contractor is subject to backup withholding. If they do not supply you with a TIN in Part I, you are required by law to deduct backup withholding from their earnings.
Failure to do this can leave a business responsible for any uncollected tax liability from the contractor. That’s why it’s always best practice to have the contractor fill out the W-9, prior to beginning work.
Ultimately, the independent contractor is responsible for their own income tax. For individuals that work for themselves, there are no paychecks with FICA taxes.
Instead, there is a separate self-employment tax, which consists of social security taxes and medicare taxes.
Tax Forms Companies Need to Fill Out
When working with an independent contractor that meets all of the IRS conditions above, you must file Form 1099-NEC at the end of the year. This form must both be filed with the IRS and also given to freelancers who are paid more than $600 in a calendar year.
Essentially, a 1099-NEC form is there to officially declare exactly how much an independent contractor made with a company. Thus, it’s important to accurately track your contractor business expenses.
Beginning with the tax year 2020, companies must use Form 1099-NEC to report all nonemployee compensation. This was previously reported in box 7 on Form 1099-MISC. Instructions for Form 1099-NEC are available here.
- If you file Form 1099-NEC on paper, the IRS requires you to submit it with Form 1096 (Annual Summary and Transmittal of U.S. Information Returns).
- If you file more than one type of information return on paper (like a 1099-NEC, 1099-MISC, or 1099-K) then you must prepare a separate Form 1096 for each one.
- Form 1096 is not required when you are filing electronically.
Choose Payment Method
It’s important to discuss and decide on a payment method with each independent contractor.
Restricting yourself into just one option may cause your business to miss out on top talent. The more payment options you can offer, the better. This can include anything from ACH (global and US) to wire transfers, credit cards, EFTs, online payment platforms, and much more. It just depends on the brand of technology you adopt and what they offer.
Payment Terms and Invoicing
Independent contractors have a variety of ways in which they are paid. Some of the more popular terms include:
- Upfront Payments - These terms are for trusted and highly sought-after contractors. In many cases, this may be a percentage of the total job cost.
- After Project Completion - This is for newer contractors because it is the least risky option. Just know, more experienced contractors probably won’t work without some payment first.
- Milestones - Milestone payments are made throughout the length of the contract. Whenever a goal is met, another payment is released.
- Hourly Pay - The independent contractor is paid an hourly rate. Automated time trackers and templates can be used for accurate reporting.
- Third-party Platforms - A third-party app collects payments for both parties, and then pays out accordingly (typically from funds in escrow).
At this time, you should also establish how and when the independent contractor wants to invoice. Typical payment terms are 30, 60, or 90 days.
Ground Rules and Contracts
All contracts should have concise language stating the exact timeline of the project, including what will happen if it is not completed. It should have the contractor rate and when payment is expected. Other details may be:
- A non-disclosure agreement (NDA) to protect privacy
- Establish how you will share resources
- Stipulations for when payments are made late
- Who has intellectual property (IP) rights
Don’t forget to have both parties sign and date the contract.
How to Pay 1099 Contractors?
Experienced independent contractors often have the option of picking exactly who they want to work with. One of their evaluation criteria clients who pay fast.
That’s why it’s critical to effectively communicate the payment terms and details prior to starting the project. This includes answering all FAQs, obtaining the right documentation, and ensuring everyone is on the same page.
Here are the best ways to pay 1099 contractors right now:
Pay Contractors Through Payroll
The easiest way to pay contractors is by putting them in your payroll software system. This is especially useful if you work with a lot of contractors and need to pay them often.
Once you have linked your bank account to a payroll services tool, mass payments can be sent out, and accounts created for your contractors.
Small businesses may find this option useful; especially since they don’t have responsibility for payroll tax on contractors.
How to Pay Using Payroll
Any type of payroll solution will give you the option to manage a lot of contractor direct deposits, simply by uploading a spreadsheet. This document contains all the necessary payment data to make bulk payments, saving both time and money.
The spreadsheet usually contains the following data:
- Worker ID (a unique number to identify the contractor in your payroll system)
- Name (3 columns: first, last, full)
- Payment amount
- Note (to give the contractor context on payment)
Some payment systems may have an API where ERPs can feed payment data directly into the app.
Direct Deposit for Contractors
Direct deposit for contractors is also a popular payment method. This is like sending an electronic check directly to their bank account.
It means funds are funneled through the Automated Clearing House (ACH) network, from your business bank account (payer) to the independent contractor’s (recipient).
In some cases, there is also the option to pay same-day ACH. It allows the transfer to happen on the same business day (typically for an extra fee).
It is a lot faster than a standard ACH, which can take anywhere from 3 to 5 business days to clear.
How to Pay Using Direct Deposit
To set up direct deposit for a 1099 contractor, they’ll need to fill out an ACH authorization form with their bank account number and routing number.
You will also need the account type (checking or savings) and the transaction type (one-time or recurring).
Pay Contractors via Wire Transfer
Wire transfers are usually reserved for larger transactions, although they can sometimes be used to pay independent contractors.
How to Pay Using Wire Transfer
This process works by taking money from a company’s bank account and depositing it into another person’s bank account.Most banks enable businesses to send wire transfers to vendors, suppliers, partners,etc. Your bank can provide you the terms and fees for wire transfer.
Paying Independent Contractors Online
Many companies are moving away from cash and opting for all kinds of payment platforms. However, P2P apps are not meant to run a business on, so be careful. Trusted brands like PayPal, Venmo, and CashApp are all okay when you have a few independent contractors on your roster.
But, as your business expands, you’re going to need a more robust contractor payments platform that can handle a high volume of global transactions, on a frequent basis.
Paying Independent Contractors Through Lumanu
How to Pay Using Lumanu
Brands like Lumanu fill the gap for companies that want to get involved in the gig economy.
The system handles everything revolving around partner payments, from accounting and bookkeeping to onboarding, tax form collection, and even working capital. Easily pay contractors outside of the United States at mid-market exchange rates, and give them immediate access to funds using EarlyPay.
Lumanu helps managers at the popular talent firm, Creators Agency, to automatically invoice clients, then push payment to individual 1099 creators that are owed from a single campaign. This unique feature, called “Payment Splitting,” simplifies the workflow for Creators Agency and keeps their top talent happy and paid. The founders know that the key to attracting and retaining the best talent is built through payment reliability, and Lumanu does that for them.
Unlike other P2P apps, Lumanu is the only creator economy startup that was built for brands who are paying 1099 and independent contractors at scale, and Lumanu’s terms of service reflect that. There are no fees for 1099 contractors who are accepting payments.
Final Thoughts: Paying 1099 Contractors
This list is just a start for all the different ways you can pay independent contractors. What’s important is that your business takes the time to set each one up for success. This includes everything from proper onboarding and training to resources, tax requirements, and more. Once taxes are in order and a job is completed successfully, you need the right kind of automation to get your people paid.
Lumanu is a tool that offers many advantages to a business building within the gig economy, including:
- Onboarding and tax form collection
- Pay contractors outside of the US
- Automatic payment reminders
- Mass payment in a single step
Lumanu helps managers at the popular talent firm, Creators Agency, to automatically invoice clients, then push payment to individual creators that are owed from a single campaign. This unique feature, called “Payment Splitting,” simplifies the workflow for Creators Agency and keeps their top talent happy and paid.