It’s not uncommon for business owners to have projects for which they simply don’t have the bandwidth or expertise to handle themselves. This could be a product roll-out, marketing campaign, or integration of new technology. Given the limited scope and length of these projects, it may not make sense to hire new full-time employees.
But paying an independent contractor is not the same as paying a regular employee. Unlike employees, independent contractors are self-employed, set their pay rates, and can negotiate payment options and schedules. The tax implications of independent contractors differ from employees as well.
This article will take a look at the most cost-effective ways to pay contractors while remaining tax-compliant. Each of the payment methods discussed in this article has a unique combination of strengths and weaknesses and deciding which is best for you starts with evaluating your circumstances.
Things to consider before choosing how to pay your contractor
Deciding how best to pay your contractors depends on a number of factors. Among the most important are taxes, the number of contractors you plan to hire, how frequently and how much you pay them, and where they are located.
How to handle taxes?
Unlike employees, independent contractors pay their own taxes. The contractor provides the hiring company with a W-9 form (similar to the W-4 form that employees fill out) and at the end of the year, the hiring company generates and sends a 1099-NEC form (formerly known as a 1099-MISC form) to the contractor to file with their taxes.
While the process is simple, it’s important that the information on the W-9 form is accurate and that the contractor is appropriately classified. Mistakes, like having an incorrect taxpayer identification number, can lead to backup withholding which requires the hiring company to set aside income tax on wages paid to that contractor. Misclassification can also be costly, so be sure to check the IRS guidelines before making any hiring decisions.
How many contractors do you plan to hire?
The more contractors you hire, the more labor-intensive payroll becomes. It’s important to plan ahead for this because you will have to produce tax forms, track hours and/or projects, and issue payments to each individual. Remember that contractors can negotiate how they are paid, so theoretically, each contractor could negotiate a different form of payment. This can quickly become an administrative nightmare, so it’s important to have a clear idea of how many people you’re going to hire before negotiating payment terms and methods.
How frequently (and how much) will you be paying your contractors?
Different forms of payment have different cost structures, so it’s important to understand payment amounts and how frequently you’re going to be paying your contractors. For example, let’s say you need to make a one-time payment to a contractor of $50,000. It might make sense to do a wire transfer at a transfer fee of $30. However, if you’re paying a contractor $2,000 a week for 25 weeks, you’ll be charged 30 dollars each time. This will cost you $750 in transfer fees over the course of the contract.
Where is your contractor located?
In some cases, you may need to hire an independent contractor who is working abroad. In this scenario, currency exchange rates come into play. Depending on how you pay these employees, the fees can become costly, not to mention the added security concern.
With these considerations in mind, let’s take a look at the six best ways to pay independent contractors.
The 6 Best Ways to Pay Contractors
Tried and true, checks are simple, relatively cheap, and there’s no need to sign up for an app or money transfer service. But despite their simplicity, there are some downsides.
Checks are slow. Once a check is written, it has to be mailed to the recipient, the recipient then has to deposit it into their bank account, and it can take up to 2-5 additional business days for the check to clear and the funds to be made available in the contractor’s account.
Additionally, the funds are not guaranteed. This often makes contractors wary of accepting checks from a new company that they are not familiar with. A bounced check can leave them with fees from their bank as well as delay their payment.
One of the more overlooked downfalls of checks is security. While the recipient does not have to share any of their banking information, the issuing party’s bank account information is printed right on the check.
All things considered, checks remain a cheap, reliable form of payment but given their lack of security and slow processing time, they are best reserved for one-off situations where recurring payments are not necessary.
2. ACH Transfers
ACH transfers are the most common form of payment between employers and employees (i.e. direct deposit). While contractors are not employees, they can be set up with one-time or recurring ACH transfers in the same way. This is particularly convenient if you’re using software that can automate recurring payments.
Additionally, ACH transfers are paperless and thus relatively secure. The contractor will have to share their bank account info with the hiring company, but most people are comfortable with this as anyone who has received direct deposit has been through this process before.
3. Credit Cards
Credit card payments are another quick and easy way to pay contractors. The allure of credit cards comes primarily from their security. Credit cards offer a layer of protection by keeping your bank account information private and separate from your daily transactions.
Additionally, because you’re paying with a line of credit, you have the ability to dispute and resolve errant transactions without putting any of your actual money at risk. And when it comes to erroneous or fraudulent charges, credit card companies are typically more willing to resolve disputes quickly and often cover the total amount of the charge until the issue is resolved. Many companies take it a step further by offering zero fraud liability for their customers.
However, in order to pay a contractor via credit card, the contractor must have a merchant account with their bank or another merchant service like Square, so this isn’t always an option.
4. Wire Transfers
Wire transfers are one of the best options when speed is paramount. If you need to make a payment quickly, a wire transfer is one of the quickest ways to make the funds available.
While international transfers can take a few days, domestic transfers usually process within 24 hours. This speed though comes at a cost. For domestic and international wire transfers, the sender and recipient usually incur fees. Fees for domestic transfers average $15-$20 for recipients, and $20-$30 for senders. International transfers cost even more.
The most important thing to consider before initiating a wire transfer is how well you know and trust the recipient. Once the funds have been transferred to the recipient’s account, it’s much more difficult to reverse. This is particularly true for international wire transfers.
In short, wire transfers should be reserved for time-sensitive payments. For small or routine payments, the relatively high cost and risk associated with wires make them less attractive than the other options we’ve looked at thus far.
5. Online Payment Systems
Online payment systems are another great option for business owners. Paypal, the world’s leading online payment system, definitely leads the pack. It is available in over 200 countries and has over 300 million active users.
Paypal is lauded for its security because it keeps your personal bank account separate from the transaction you complete. Paypal links to your bank account so you can transfer funds between the two. To pay another Paypal user, you simply transfer the funds from your bank account to your Paypal account and then process the transaction. The recipient will receive the funds in their Paypal account and can then transfer the funds to their bank account.
In order to use Paypal in a commercial setting though, your contractor will need a Paypal business account, so choosing Paypal is only convenient if the contractor already has that set up. If they do have an account though, Paypal automatically produces a 1099-K form at the end of the year which saves you the hassle of having to send a 1099-NEC form.
It’s worth noting that if you plan on making frequent or large international contractor payments, other systems like Xoom (owned by Paypal) and Transferwise might be more cost-effective options. These platforms handle currency exchange and could prove cheaper than using Paypal. For a more in-depth look at these services, take a look at our Transferwise vs. Xoom comparison.
6. Accounting Software
While this isn’t necessarily a payment method, it’s worth pointing out that using accounting/payroll software is especially handy if you’re hiring multiple contractors. Accounting Software like Quickbooks and Intacct are powerful tools that integrate with other systems to automate tracking, invoicing, tax preparation, and payments. These platforms reduce administrative costs by keeping everything housed in one place and automating tasks that would otherwise be performed manually.
The reality is, you likely won’t find a one-size-fits-all solution. Your contractors may have varying preferences and you’ll have to balance a combination of payment methods and schedules. Understanding the tools and methods available is the best way to maximize efficiency and minimize the cost of managing your payroll.