How to Pay Independent Contractors

Using independent contractors is an increasingly popular option for businesses to access affordable and flexible workers. Here we explain how to pay independent contractors, both within the United States, and internationally.

Key Takeaways

1. Different factors apply when you pay independent contractors based in the USA, and when you pay independent contractors based internationally.  

2. If using independent contractors, it is crucial to apply different rules than the rules that are applied to employees on payroll. This ensures compliance with tax and business regulations. 

3. No matter what the pay, and the arrangements involved, an independent contractor agreement should clearly set out what is expected of client and contractor

4. Payment mechanisms need to take into account the location and wishes of the contractor. Some payment methods are country-specific, while others, due to currency exchange fees, may add to the cost of doing business. 

How do I Pay Someone as an Independent Contractor in the United States?

Wherever you engage independent contractors, there are certain legal and tax obligations that apply to payment. Here we set out the key steps where a US company is using independent contractors located within the U.S. 

1. Separate Contractor Payment from Employee Payroll

Contractors are not a type of employee. This is reflected both in the way the business must treat independent contractors on a day-to-day level, and in the way that payment is dealt with. 

Independent contractors in the United States do not generally have taxes  or compulsory contributions withheld from their payments by clients (though note the possibility of default withholding tax below): It is the obligation of the independent contractor themselves to ensure that all applicable taxes are paid.

There are other ways in which independent contractor payment differs from employee payroll, including: 

  • Independent contractors are not usually reimbursed for expenses
  • Independent contractors do not usually receive holiday pay and other forms of paid leave.  

These differences mean that the general payroll processing of the company cannot be followed.  A failure to properly distinguish contractor payment from employee payroll runs the risk that the Internal Revenue Service (IRS) would consider the contractor a ‘misclassified employee’: This can result in significant backtaxes and penalties for the business that is deemed to have misclassified. 

Read more about the difference between independent contractors and employees at What is Employee Misclassification? 

2. Work out Contractor Pay Rates and Pay Schedule 

Fundamentally, the price that an individual independent contractor will be able to charge depends on the industry they are in, and how competitive their skillset is.

Furthermore, generally speaking, independent contractors will charge a higher price than an equivalently qualified and skilled employee.  There are a range of reasons why this is the case, these include:  

  • Independent Contractors Save Businesses on Operating Expenses
  • As payment is straightforward, independent contractors usually save a company on payroll processing costs. There are often other savings for businesses that hire independent contractors as well. For example, independent contractors often don’t require office space in the way that regular employees do. 
  • Independent Contractors Pay their Own Taxes and Social Contributions
  • Independent contractors are often required to pay their own self-employment taxes —taxes that employees don’t need to pay. This replaces the payroll tax in the US for employees, which both employer and employee pay a portion of.
  • This added cost for an independent contractor means that they may need to charge a higher price than the equivalent service provided by an employee. 
  • Independent Contractors Have Additional Processing Costs
  • Independent contractors must process their own invoices and calculate and withhold their own taxes. They also often pay additional payment processing fees. Generally speaking, independent contractors factor these costs into their rates. 
  • Independent Contractors May Have a Nationwide or International Market
  • More often than employees, independent contractors work remotely. Furthermore, employees are usually not allowed to be employed by a foreign company (usually, a ‘global PEO‘ solution is required). 
  • This may mean that they are willing to work both nationally and internationally. This in turn enhances their ability to charge for their services, and may raise the final price. 
  • Independent Contractors Can Deduct Business Expenses
  • Whether operating as a sole proprietor, or though another business structure, such as a limited liability company (LLC), an independent contractor is able to deduct a range of expenses from their income where a regular employee is not able to do so.
  • This may include, for example, home office expenses and transport costs. To some extent this gives independent contractors the ability to offset some of the additional costs of contracting, and may make their prices lower than they would otherwise be. 

Once contractor and client have agreed on a pay rate, or while agreeing to the pay rate, both parties need to consider how the pay will be distributed. Possibilities include: 

 

  • Hourly rate. A gross hourly rate can be agreed to, to be paid out at agreed intervals such as weekly, fortnightly or monthly. 
  • Fixed price. A fixed amount is paid into the individual either on a one-off or habitual basis. In order to ensure security of payment for both sides, the client and contractor might consider using an escrow service to hold that amount until the agreed work has been performed. 
  • Retainer. On a retainer model, a set amount is paid to the contractor with some agreed deliverables on a regular basis (e.g., monthly). This amount is then ‘topped up’ depending on the extra work that is performed. 

3. Draft and Sign an Independent Contractor Agreement 

Once the terms of the engagement have been agreed to, either client or contractor needs to draft a written independent contractor agreement, which both parties then agree to and sign. Key matters to include in the agreement are: 

  • The agreed payment and payment schedule;
  • Payment methods; 
  • Liabilities and warranties (i.e., who is  responsible in the case of liability for negligence or some other legal wrong); 
  • Necessary insurances, such as professional liability insurance; 
  • Contractual termination, cancellation and any damages owing if this occurs. 

4. Establish a Payment Method

As part of the independent contractor agreement, there should be agreement by both parties as to the desirable payment method. What options are available? Some of the key possibilities in the US include: 

  • Check 
  • This traditional method of payment has been phased out in many countries, but is still relatively common in the United States
  • Checks have some well-known advantages: They are flexible (amounts can easily be changed), and allow for easy bookkeeping by both client and contractor through the physical evidence of payment linked to an invoice (the check for the contractor, the check stub for the client). 
  • There are significant downsides to checks, however: Checks usually involved significant time delay (writing the check, mailing, depositing and check clearing can draw out the process significantly). They also require physical records to be kept in tandem with electronic records (bank statements proving payment) which complicates the audit trail. 
  • ACH Transfer
  • ACH, ‘Automatic Clearing House’, is the principal mechanism used in the USA to move funds between two different accounts. This can be done either via a direct deposit or an automatic payment. The payment usually takes a few days to clear. 
  • This is a useful payment mechanisms for contractors receiving smaller, regular, payments. It is cheap, and does not require that funds be available for transfer (though a penalty will apply where it is not). 
  • Wire Transfer
  • Unlike ACH, a wire transfer is a transfer between two banks, rather than two bank accounts. 
  • It is faster than ACH (usually processed within one business day), but is more expensive, often requiring payment from both sender and recipient. 
  • Wire transfers may be desirable if payments are for large amounts, and irregular, and where prompt payment is desirable. 
  • Digital Payment Services and Cryptocurrency 
  • Paypal, Wise (formerly ‘Transferwise’), Venmo and Revolut are alternatives to bank transfers that are increasingly popular.
  • These services usually charge a fee for payment or currency exchange, but can be advantageous for both sides. 
  • From the client side, payments can often be made by credit card. From the contractor side, these services can be cheaper, and easier to integrate with invoicing systems than using bank transfers. 
  • Cryptocurrencies, such as bitcoin are a desirable payment form for some businesses and contractors. 
  • Due to their prevalence in international contracting we discuss these options in further detail below. 

5. Collect a ‘Form W-9’ from Contractors 

The Form W-9 is a document which companies must use to record information about contractors, such as their name, tax number, birth date and social security number. 

This is used to report annually on contractor payments through Form 1099-NEC (see below), and can be used by the Internal Revenue Service (IRS) to reconcile the tax returns of client companies and contractors. 

If contractors fail to provide this form, they may be subject to a default withholding tax of 24 percent

6. Manage Ongoing Payments to the Independent Contractor

Once everything is agreed to and set up, it simply remains for the company to ensure that it pays the contractor, as agreed, and using the mechanisms set out in the independent contractor agreement. 

Companies should ensure that they maintain compliant records of contractor payments, both for taxation purposes, and for an audit trail in case the company is ever suspected of ’employee misclassification’. 

7. Submit Form 1099-NEC to the IRS

Form 1099-NEC (formerly 1099-MISC) should be prepared for each contractor that has been paid more than $600 in a year. This will detail the amount that the contractor was paid over the year.  

This should be send to the IRS, and a copy  sent to the independent contractor themselves by 31 January every year.  

These forms should be reconciled with the W-9 forms received from contractors to ensure that all details line up. 

How to Pay International Independent Contractors

There can be significant advantages to hiring independent contractors from outside the US — even for US companies. These individuals are often referred to as ‘international contractors‘. In many cases, foreign contractors may be available at a reduced price due to a lower cost of living. In other cases, hiring overseas contractors can mean access to talent that is hard or impossible to acquire stateside.

If you hire an international contractor, it is important to take the following steps in order to ensure those contractors are correctly paid. 

1. Separate International Contractor Payment from Local Contractor Payment and Payroll

As with any payments to contractors, payments to international contractors need to be kept separate from employee payroll processing. Furthermore, it is important that international contractors are treated distinctly from local contractors. This is crucial as different rules apply to the management of their payments: For example, in the US, Form W-8 BEN must be acquired from all international contractors to confirm that contractors do not have US tax obligations. 

In order to ensure full compliance with rules applying internationally, businesses could consider using the services of a contract management outsourcing (CMO) firm which specializes in these payments. 

2. Work out International Contractor Pay Rates

In setting the pay rates for international contractors, many of the same factors that apply to local contractors should be applied. For example, businesses should consider international market rates for a given skillset, given that it is likely that an international contractor will be able and willing to work for clients around the world. 

It is also worth considering the value of local currency and the cost of currency conversion (usually borne by the contractor), in setting that rate. Keep in mind, also, that depending on where the international contractor is located, they may need to pay ‘Valued Added Tax‘ or ‘VAT’ (e.g., in Europe), or ‘Goods & Services Tax’ or ‘GST’ (e.g., in Canada, Australia, New Zealand and India), on top of their income tax. This can add an additional 10-20 percent to prices, as well as additional bookkeeping and processing costs. 

3. Sign an International Contractor Agreement 

As well as the matters that would be required in a domestic independent contractor agreement outlined earlier, an international agreement should include: 

  • Specification of the currency of payment; 
  • Which country’s contract laws apply to the agreement; 
  • Where any disputes over the agreement, or arbitration, will be carried out. 

4. Establish a Payment Method  

It is important to agree to a payment method with an international contractor. Given the variation in available payment methods in different countries, and how different methods deal with currency exchange, this needs to be squared with the contractor. Possible options include: 

  • SWIFT Transfer
  • This is an international wire transfer between banks using the ‘SWIFT’ network. It is a well-established and trusted method, but usually involves a significant transaction charge, as well as transfer at the bank’s relatively high retail currency exchange rates. 
  • SEPA Transfer
  • A SEPA (‘Single Euro Payments Area’) transfer is a bank transfer method permitted between 36 European countries (the entire EU, and a range of other affiliated countries). 
  • It is a cheap transfer mechanism (no more expensive than domestic transfers, meaning that it is often free), and allows for payment via credit or direct debit options. 
  • International Money Order
  • This payment method means the amount of a payment is pre-paid by the client, and then sent through a secure provider to a destination country.
  • This is often provided by a postal service. For example, the United States Postal Services (USPS) provides thiis for US companies sending payments to 28 countries worldwide. This is a particularly common form of payment for contractors based in the Caribbean, Central America and South America. 
  • An international money order allows the international contractor to pick up payment at a designated location by providing ID — no bank account is required. 
  • This is an especially reliable mechanism from the contractor’s perspective: The requirement for pre-payment means that there is no risk of the payment ‘bouncing’. 
  • Retail Money Transfer
  • In a retail money transfer, money is transferred between two separate branches, or a branch and an agent, of an international transfer company (for example, Western Union). 
  • Payment can be picked up around the world in a range of locations. This is a particularly common payment form in Africa. 
  • As with an international money order, there is no requirement for the recipient to have a bank account, and money can be picked up in person at an office with valid identification. 
  • Paypal
  • Paypal is the most popular international payments system and has the most established reputation of any digital payment service. 
  • Payment can be enabled with a credit card, and it has distinct payment services, such as Xoom, which can facilitate the payment of international contractors. 
  • Paypal charges a payment processing fee as well as a currency conversion service charge (4.5 percent) on top of a retail exchange rate. 
  • It is worth noting that Paypal is not yet available for transfer to local bank accounts in many countries. 
  • Wise
  • Formerly known as Transferwise, Wise is a popular international payment provider which facilitates cost-effective transfers between different currencies. It too charges a transaction fee, though this is usually less than the cost of a bank-initiated transfer. 
  • One advantage of Wise over many of its competitors is that it permits individuals to have a multi-currency balance, with real bank account numbers. in various countries.  This makes it straightforward for clients to transfer money to a contractor without themselves changing the currency. 
  • Revolut
  • Like Wise, Revolut facilitates multi-currency transfers which can be used to  pay international contractors. 
  • A significant benefit of Revolut is that it provides an ATM/debit card which can be used extensively throughout the world. 
  • Cryptocurrency
  • Cryptocurrency (e.g., Bitcoin), also called ‘digital currency’ or ‘virtual currency’, is becoming increasingly common as a form of international payment. This is particularly true of clients and contractors within the cryptocurrency industry itself. 
  • Cryptocurrency is now integrated with various traditional payment mechanisms, such as Revolut. 
  • Clients and contractors using cryptocurrency for payment need to be particularly careful to ensure they comply with the tax regulations that apply to cryptocurrency in the client and contractor’s countries. 

5. Monitor Ongoing Payments to Independent Contractors 

Businesses should monitor their payments to international contractors to ensure that they continue to be in compliance with the law, and are following the terms of their original agreement. For example, US businesses need to ensure that any independent contractor that moves overseas to the US, is managed under the ‘Form W-9 process’ (see above). 

Frequently Asked Questions

Can You Pay an Independent Contractor a Salary? 

No. Usually the terms ‘salary’ and ‘wages’ are used to refer exclusively to payments to employees. Salary and wages are payments subject to employer withholding of taxes and benefit contributions. To pay an independent contractor an amount called a ‘salary’ would be to run the risk of ’employee misclassification’ (see discussion above). 

However, it is possible to pay independent contractors amounts on regular intervals that are equivalent to a salary or wages in monetary terms. 

How Do I Pay an Independent Contractor Online? 

Online payment options include traditional wire and bank transfers (such as ‘ACH’ or ‘SWIFT’), digital payment services and cryptocurrency. 

For discussion of the pros and cons of these different online payment options see discussion above under the heading ‘Establish a Payment Method’. 

How Do 1099 Employees Get Paid? 

‘1099 employee’ is the term sometimes used in the United States to refer to workers who require a ‘Form 1099-NEC’ to be filed with the IRS (see discussion above). 

Despite this being a common term, it is incorrect. Workers for whom a Form 1099-NEC is filed, are not employees, and should be referred to as ‘independent contractors’, ‘freelancers’, or some other term. 

They can be paid via check or any online payment method. 

Pay Independent Contractors Domestically or Internationally 

Using independent contractors means considering carefully how those contractors will be paid. It is essential, whether engaging independent contractors locally or internationally, that all payment matters are agreed between the parties and tax laws are complied with

For businesses engaging many independent contractors it is worth considering a contractor management services company to oversee the process. 

For more information, get in contact with New Horizons Global Partners

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