When speaking about processes, one of the main questions we get is: How do I pay my contractors?
If you're a founder, you'll almost certainly need to hire contractors at some time to help your company expand. Whether you're employing a freelancer for web development or an independent contractor to manage your social media marketing, knowing how to pay these employees properly is critical. This is where starting contractor payments come in.
In this blog post, we'll go over all you need to know about contractor payments. We'll discuss the differences between contractor and employee payments, legal requirements for contractor payments, contractor payment methods, invoicing and record-keeping best practices, and strategies for effectively handling contractor payments.
Understanding Contractor Payments
Several startups rely heavily on independent freelancers, and as they should! They can offer various services, from content creation to software development. Yet, it's critical to grasp the distinctions between contractor and employee payments, as well as the legal and tax implications of hiring independent contractors.
One of the primary distinctions between contractor and employee compensation is how they are taxed. You must withhold taxes from employee paychecks but not from contractor payments. Contractors instead pay their own taxes.
Unlike contractors, employees might also get benefits such as insurance, medicare contributions, and 401K contributions.
The IRS has specific criteria for assessing whether a worker is an employee or an independent contractor. While defining the classification, factors such as control, financial
independence, and the relationship between the worker and the business should be examined. For example, if you have co-founders with the role of a corporate officer, not paying them as an employee can result in legal risks. The federal income tax law defines a corporate officer as a “statutory employee.” That said, if things go south, you run the risk of them suing you for not putting them on payroll.
Legal Requirements for Contractor Payments
Okay. This may get confusing. The IRS uses two forms to report vendors/contractors' income:
- The 1099-MISC is used to report payments not subject to self-employment tax, such as rent.
- Form 1099-NEC is for reporting non-employee compensation that is usually subject to the self-employment tax. This is the one that you will need for your contractor work compensation.
It used to be that both forms were combined in the 1099-MISC, but that has been no longer the case since 2020. Both forms are due by January 31st.
What do I need to file a form 1099?
Here is your document checklist that you are compliant and legally protected :
1- Form W 9: it helps you gather the contractor information: their name or name of the business, address, TIN, and EIN. It’s recommended to ask for this at the moment of hiring.
2- Form 1099- NEC: You must submit this form to each contractor who paid more than $600 in one tax year and submit a copy to the IRS. This will allow the contractor to pay taxes on their income.
3- Accurate records of your contractor payments: This is why efficient bookkeeping is crucial here. Ensure that your accountant or bookkeeper keeps track of all of your contractor payments throughout the year. This will save you a ton of time at the end of the year. You will find more information on this below.
4- Contractor agreement: do not forget that hiring a contractor is a business transaction that should have an agreement. To protect yourself from any conflicts, make sure you include the following in your agreement:
- The scope of work
- Ownership of stated work
- Deadlines
- Compensation and payment terms
- Confidentiality clause
- Non-compete and non-solicitation clause.
Penalties and fines may apply if 1099 forms are not issued. You could face a $50 penalty for each 1099 form not filed.
Do I need to send a 1099 to a foreign contractor?
If the contractor is a non-US person - not a resident and not a citizen - the answer is no! The contractor might need to complete and file Form W-8BEN. In this case, you can keep it in your files for documentation purposes.
Payment Methods for Contractors
Let’s talk about processes. This is our favorite part.
For contractor payments, you have various options. The payment method selected will be determined by a number of considerations, including the contractor's location, the amount paid, the level of security, and the accounting process you have in place.
First, I would suggest choosing one or two options at most to streamline your contractor payments. A second option could be to pay your international contractors. Having many payment workflows can get really overwhelming, require more manual reconciliations and hinder your cash flow management.
Here is a list of options to pay your contractors, including our thoughts on each:
ACH:
This is one of the most typical payment methods for contractors. This is a great option if you have a bank that will allow you to automate the process for recurring payments. Our favorite tech-forward bank is Relay. You can make same-day ACH payments to contractors within the US for free and international wires to your non-US contractors for only $10. You cannot beat that! There are also plenty of features to maintain your vendors' data within the platform. Of course, this is a great process if Relay is a good banking option for you (a discussion for another blog).
Gusto:
You can use Gusto for both payroll and contractor payments which is great. Gusto can automate your payments and handle your 1099 filings at year-end. Gusto has pricing for contractor only payments that you can find here.
Stripe:
This is the best option if your contractors are paid in correlation with your revenue transactions (i.e., Uber). Stripe Connect can automate the workflow to pay the contractor right after a customer's credit card payment. Although Stripe might be one of the most costly options, it offers customizable workflows for tech start-ups.
Routable:
If you are a SaaS start-up that relies on multiple contractors, you will need a solution that handles multiple payments at once. Routable gives you the option to upload a CSV file of your thousands of contracts for a seamless payment process. Routable prices are very competitive. It’s worth giving a check.
Bill.com:
This platform can help you streamline all kinds of vendors. If you work with multiple US and foreign companies in addition to your contractors, this could be a good option for you.
Wise (Formerly Transferwise):
This is a good option if your international bank wires are too costly.
Zelle, Cash App, Paypal:
We recommend staying away from paying contractors through these platforms. It is often tempting to choose the easy route. Your processes must be streamlined to grow your company faster. Reconciliations get really difficult with seldom payments, and it is often difficult to recognize the transaction if a description is not included.
If you are unsure which platform to use, talk to an accountant or bookkeeper to help you set up the right workflows and integrations. Your business model plays a huge role in identifying the right processes.
Invoicing and Record-Keeping for Contractor Payments
Invoicing and record-keeping are critical components of contractor payment. You must have a record of all payments made by keeping accurate records and keeping invoices on file.
The platforms you choose for vendor payments should be integrated with your accounting software. On the back end, you must categorize those payments in the right contractor account in order to keep track of them throughout the year. This will also save you time at the end of the year to get your exact contractor payments for tax filings.
Your finance expert will be best to advise you on your workflows and setting up the integrations. Your finance expert will also handle reconciliations of your payments on a monthly basis to provide you with accurate and easy-to-read financial statements. If your contractor payments are recorded correctly, it will also facilitate your KPIs. Certain key metrics can show you if your contractor expenses are contributing to the growth of your business.
Conclusion
We hope that this article was educational and helpful to you if you want to improve your contractor payment processes. Founders will confidently pay their contractors and support the growth and success of their businesses if they have the correct information and processes in place.
If you are in doubt about your workflows and need help with keeping up with your contractors' payments and records, reach out for a hand here or visit our website.
