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.
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 to pay independent contractors
Whenever a business is engaging and managing contractors, there are certain legal and tax obligations that apply to the 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 (e.g., PAYE in the UK) 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.
Read more in our Expert Guide to Independent Contractor Taxes.
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 equivalently qualified and skilled employees. There are a range of reasons why this is the case, these include:
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:
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:
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:
5. Collect a ‘Form W-9’ from Contractors
The Form W-9 is a document that 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 sent 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 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-8BEN must be acquired from all individual contractors to confirm that contractors do not have US income tax obligations. For entities (such as independent contractors that operate through a limited liability company the form is W-8BEN-E. Where, these forms have not been collected, and any income tax liability is unclear, businesses need to withhold 30 percent of payments for potential income tax.
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 the 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:
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
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.
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’.
‘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 Horizons.