Is your business planning to hire an independent contractor?Here's what you need to know before you do.
When you run a business, not everyone who does work for your company is considered an employee. Some may be considered independent contractors. For example, maybe you’ve outsourced the design of your website to an external web designer, or you’ve hired a freelance copywriter to create some marketing brochures for you. These workers aren’t considered your employees—they’re independent contractors.
This is more than just a difference in title—different tax authorities have very specific requirements someone must meet to be considered an independent contractor. In fact, the independent contractor classification is often scrutinized, so you don’t want to get this wrong.
Our guide will walk you through what you need to know before hiring a contractor.
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What Is an Independent Contractor?
Depending on where you operate your business, there are different definitions for an independent contractor.
In the U.S.
The IRS has a general rule about who qualifies as an independent contractor. Its definition is: “An individual is an independent contractor if the payer has the right to control or direct only the result of the work, and not what will be done and how it will be done.”
In practice, independent contractors generally have flexible work hours, options to work from home, and set their own rate. They’re also considered self-employed, which means they’re responsible for paying self-employment tax, and the company they do work for does not need to provide them with benefits.
The IRS isn’t the only organization that defines who qualifies as an independent contractor and who qualifies as an employee. Many states have adopted another set of more stringent requirements to be considered an independent contractor, known as the ABC test. This test has three separate criteria a person must meet in order to qualify as an independent contractor, rather than an employee:
- The worker is free from the employer’s control or direction in performing the work
- The work takes place outside the company’s usual course of business, and off-site of the business
- Customarily, the worker is engaged in an independent trade, occupation, profession, or business
Both the IRS requirements and any state-specific requirements are important to pay attention to because improperly classifying an employee as an independent contractor could saddle you with some big fines.
If you’re not sure whether the person you’d like to hire will be considered an employee or independent contractor, it’s a good idea to consult with an employment attorney who is knowledgeable about your state requirements.
The IRS also offers a review process where you can submit information about the situation, and they will offer advice as to whether the person would be considered an employee or an independent contractor. But they won’t advise you on any state-specific requirements your business might be subject to.
In Canada (in provinces other than Quebec), a two-step approach is used to determine whether a person is an employee or a self-employed individual.
Step 1: Understand the original intent of the contract.
Having a written agreement can be helpful if the CRA needs to determine whether both parties were aware of the contractor relationship and that was the intent of the working agreement.
Step 2: Questions of control, risk, and equipment
A number of questions can help determine whether it’s a true independent contractor relationship or whether it’s actually an employee/employer arrangement. These questions include:
The level of control the payer has over the worker’s activities
Who provides the tools and equipment — the payer or the worker?
Degree of financial risk or gain the worker has
Whether the worker can subcontract out work
In the U.K.
A contractor can be someone who is self-employed or who does work for a client but is employed by an agency.
According to HMRC, a person is considered self-employed if “they run their business for themselves and take responsibility for its success or failure.” When someone is self-employed, they aren’t paid through PAYE and don’t have the same employment rights and responsibilities as employees do.
Some guidelines for a self-employed person include:
- Someone who is responsible for the success or failure of their business
- They can decide when and where to work as well as what to work on
- They can hire someone else to help or perform the work
- They use their own money to buy tools or equipment needed to perform the job
- They are able to work for more than one client
Pros of Hiring an Independent Contractor
There are a lot of benefits to hiring a contractor that might be helpful to business owners, including:
When you hire an employee, you have expenses that extend beyond their hourly rate. It’s also your responsibility to pay for:
- Office space for them to work from
- Equipment needed to perform their tasks (i.e., computers and software)
- Benefits such as health insurance paid time off, and Canada Pension Plan CPP/QPP contributions
- Any additional taxes like National Insurance (UK) or FICA taxes (U.S.)
When you hire a contractor, you’re only responsible for paying their fee. You don’t need to pay for their benefits and they’re required to cover their own taxes.
You might find that contractors are paid a higher hourly rate than employees, but because you’re not paying these additional benefits, you’ll usually end up saving more money overall.
If your business has a lot of varied needs—say you need someone to do social media marketing, copywriting, and website updates—it can be difficult to find one employee that can handle all of those tasks well. Instead of having to hire one person to do all three jobs, or hire three separate people to handle these varied tasks, you can work with independent contractors.
This gives you access to everything from high-level network administration to top-tier copywriting.
You can also use contractors to manage increases in your business workload. Beyond having more skills at your disposal, contractors will enable your business to respond quickly to unexpected surges in business.
For example, say you run a CPA practice. There was recently a change to the tax law and you need to write new guides for your clients explaining the changes. You might hire an independent contractor who specializes in writing to help produce new materials for your clients. Since you don’t need them for long and this likely isn’t a full-time job, it could be the perfect role for an independent contractor.
Reduced Training Expenses
When you hire an independent contractor, you’re selecting from a wide array of specialists. It’s assumed that you won’t have to provide any paid training—they’re ready to go.
The only training required will be your onboarding procedure, which involves learning your policies and tailoring their skill set for your needs. You can easily automate this process with documented workflows, processes, and training materials.
Keeping with the CPA practice example, the writer should already be trained in how to write for clients, and how to take complex topics and break them down into easy-to-understand articles. You won’t have to train them on this, but you’ll need to give them any writing style guidelines that are specific to your firm.
Cons of Hiring an Independent Contractor
Everything isn’t always perfect when you hire an independent contractor. There are some drawbacks that you should consider before you use one for your business.
The IRS wants to ensure that companies haven’t misclassified workers who should be employees as independent contractors in an effort to save money on income taxes. With an independent contractor, business owners don’t have to provide benefits, pay unemployment insurance, withhold income taxes, or pay Social Security and Medicare taxes.
In the U.K., independent contractor relationships are scrutinized by the IR35 rules, to ensure that employees aren’t misclassified as independent contractors. These rules were created in 2000 to help reduce tax avoidance by classifying employees as contractors.
Turnover and Lack of Loyalty
You’re not going to build a loyal workforce with independent contractors. They come and go as needed. Contractors are drawn to this type of work largely because it gives them greater control over who they work with. Additionally, most businesses hire contractors for short-term jobs, which makes it difficult to cultivate loyalty.
Relying too heavily on contractors means dealing with a higher turnover rate than employees. You also risk losing your contractor without notice if a higher paying project comes along.
Potential Legal Issues
If you haven’t picked up on this recurring theme: You need to keep legalities in mind.
In addition to your lack of control, you also need to make sure contracts and paperwork are in order. Failing to outline expectations in a written agreement could mean that you don’t actually own the copyright to the work.
When you work with an employee, work created by them is automatically owned by the organization. With contractors, it must be specifically stated in a legal document.
What Documents Are Needed When Hiring a Contractor?
Hiring a contractor means a lot less paperwork than hiring an employee. But there are still a few things you’ll want to collect:
- Tax information number: You’ll need to know the tax information number for the independent contractor you’re paying. In the U.S., that will either be the social security number or employer identification number. In Canada, you’ll need to get the contractor’s business number.
- Resume: This isn’t required but you’ll likely want to get a resume for anyone that you hire, even if they’re an independent contractor. You’ll get a good understanding of their work experience and their qualifications.
- References: Ask for references from previous clients and check up on those references, to ensure they’re a good fit for your job. You may also want to perform a background check to ensure they are in good standing.
- Signed contract: Work shouldn’t be done without a contract signed by both parties in place. This helps to clear up any misunderstandings that may arise in the future. Be sure the contract covers the duration of the work, the pay, and intellectual property rights.
How to Pay an Independent Contractor
Paying a contractor is much simpler than paying an employee. That’s because you’re generally not required to withhold taxes or pay insurance for an independent contractor.
When it’s time to pay your independent contractor, you can do so via whatever payment method is most convenient for you: Check, direct deposit, PayPal, or via your payroll provider.
You’ll want to be sure you file any forms at the end of the year with the tax agency in the country. In the U.S., you’ll need to file 1099-NEC for any contractors which you’ve paid more than $600 during the year. In Canada, you’ll need to file form T4A.
A Final Note
The differences between an independent contractor and an employee may seem insignificant at first glance, but tax agencies take this very seriously. Do your research, speak with a professional, and ensure you properly classify workers as either employees or independent contractors. Once you understand the differences, you’ll know what requirements you need to adhere to, and how not to end up in hot water.