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How to Set Up Contractors and Manage Contractors Pay: A Comprehensive Guide for Small Businesses

How to Set Up Contractors and Manage Contractors Pay: A Comprehensive Guide for Small Businesses

Master the art of setting up contractors and seamlessly handle onboarding, payment methods, and tax compliance for a hassle-free contractor management journey. Simplify your processes and ensure a smooth experience managing contractors effectively.


Master the art of setting up contractors and seamlessly handle onboarding, payment methods, and tax compliance for a hassle-free contractor management journey. Simplify your processes and ensure a smooth experience managing contractors effectively.

The modern workforce is witnessing a remarkable transformation, with a rising trend of individuals embracing the “gig economy” as sole proprietors and independent contractors. This shift is projected to continue growing, with Upwork's recent study forecasting a substantial 40% surge in the number of independent contractors in the United States by 2027.

For small businesses, adapting to this emerging trend entails considering the benefits of hiring contractors to manage fluctuating workloads and tackle specialized projects. However, the complexity of paying 1099 contractors can be daunting, involving various forms, rules, and payment methods.

Thankfully, this article will guide you through the crucial steps of setting up contractors and unraveling the complexities of paying 1099 employees. Our comprehensive guide covers all the essentials, from comprehending IRS forms such as W-9s and 1099s, to selecting the most appropriate payment methods.

And if you're a self-employed contractor, this guide will also empower you to master your own payment processes. So join us as we seamlessly navigate you through contractor payroll and optimize your small business for the workforce of the future.

Why Embracing Contractors Can Be a Smart Move for Small Businesses

Small businesses are always looking for ways to save money and improve efficiency. One way to do this is by hiring independent contractors.

Independent contractors, also known as 1099 contractors, are self-employed individuals who provide services to businesses. They are not considered employees, so they do not receive benefits like health insurance or paid time off. This can save small businesses a significant amount of money.

In addition to cost savings, independent contractors can also offer other benefits to small businesses. They can bring specialized skills and knowledge to a project that may not be available in-house. They can also be more flexible than employees, which can be helpful for small businesses that need to scale their workforce up or down quickly.

Here are some of the specific benefits of hiring independent contractors for small businesses:

Flexibility and adaptability

Independent contractors can be engaged on a project-by-project basis, allowing businesses to efficiently manage fluctuating workloads. This adaptability ensures that the workforce aligns with current demands, avoiding the costs associated with maintaining a full-time staff during periods of lower activity.

Access to specialized expertise

Independent contractors often bring a wealth of specialized skills and expertise to the table. These professionals excel in niche areas that may not be available within the existing employee pool. By engaging contractors for specialized projects, small businesses can access top talent and ensure high-quality deliverables, enhancing their competitive advantage.


Hiring independent contractors can be cost-effective for small businesses. Unlike full-time employees, contractors are not entitled to benefits or other employer-related costs, such as healthcare, retirement plans, or paid time off. As a result, businesses can allocate resources efficiently and avoid fixed overhead expenses, contributing to improved financial stability.

Reduced administrative burden

Managing a workforce of independent contractors entails less administrative work compared to handling traditional employees. Contractors are responsible for their own taxes, including self-employment tax, income tax, and FICA tax. This reduces the administrative burden on small businesses, freeing up time and resources for other essential tasks.

Risk mitigation

By working with independent contractors, small businesses can mitigate certain risks associated with traditional employees. Contractors operate as separate entities, assuming responsibility for their work and potential liabilities, reducing the business's exposure to certain legal and financial risks.

Bottom line: By strategically integrating contractors into their workforce, small businesses can optimize their operations, successfully manage fluctuating workloads, and deliver exceptional results for specialized projects, ultimately contributing to their long-term growth and prosperity.

So, how do you determine if you’re hiring an employee or an independent contractor?

Classifying Workers as Independent Contractors vs W-2 Employees 

To determine if you're hiring an employee or an independent contractor, consider the nature of the working relationship.

  • Control: Employees are typically subject to more direction and control over their work, while independent contractors have more autonomy.

  • Work Relationship: An ongoing, long-term relationship suggests an employee, whereas a specific project-based arrangement may indicate an independent contractor.

  • Independence: Independent contractors can work for multiple clients, while employees usually work exclusively for one employer.

  • Tools and Equipment: Providing tools/equipment points towards an employee, while contractors generally use their resources.

  • Payment: Employees often receive a regular salary or hourly wage, while contractors are paid based on invoices or project completion.

  • Taxes: Employers withhold taxes for employees, while contractors are responsible for their taxes.

Remember, if your organization encounters difficulty in determining worker classification, you can address the issue by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. However, individual circumstances may vary, so it's crucial to seek advice from legal and tax experts to ensure compliance with employment laws and regulations.

Now you might be wondering… 

Why Is Proper Classification of Independent Contractors and Employees So Important?

The classification of workers as independent contractors or employees is a critical issue for businesses of all sizes. The IRS has strict rules regarding worker classification, and misclassifying employees as independent contractors can result in significant penalties, including back taxes, interest, and potential liability for unpaid overtime under the Fair Labor Standards Act (FLSA).

It is important to note that the IRS is not the only authority that enforces worker classification rules. The Department of Labor (DOL) and state governments also have their own regulations. As a result, it is essential to seek legal advice to ensure that your business is in compliance with all applicable laws.

The worker classification also impacts compensation processes. For employees, employers must withhold income taxes, FICA taxes, and other deductions from paychecks, while independent contractors follow a different payment system.


What Payroll Taxes Are Independent Contractors Responsible For?

When it comes to independent contractor payroll taxes, it works a bit differently. Contractors or freelancers handle their own federal taxes known as self-employment tax, covering Social Security and other aspects. They typically make quarterly tax payments using Form 1040-ES, ensuring they pay tax as per estimated requirements.

Note: In rare circumstances, the service recipient, which is the person or company paying the freelancer, may need to withhold taxes from the contractor's pay. This is called backup withholding and happens if the contractor provides incorrect tax information.

Speaking of taxes, let's talk about Form 1099. Form 1099 is a tax form that reports income received outside of wages, salaries, and tips. 

There are three different versions of Form 1099, each with a different purpose:

  • Form 1099-NEC reports nonemployee compensation, like what businesses pay independent contractors.

  • Form 1099-MISC is for miscellaneous payments like rent to property managers.

  • Form 1099-K reports payment card transactions through third-party networks.

If you paid a nonemployee $600 or more in a calendar year, you are required to file Form 1099-NEC with the IRS and provide a copy to the nonemployee by January 31 of the following year.

To complete Form 1099-NEC, you’ll need to do the following: 

  • Get the form from the IRS website or from a payroll service provider.

  • Make sure to include the correct names, addresses, and taxpayer identification numbers (TINs) for both the payer and the recipient.

  • Calculate the total compensation paid to the independent contractor.

  • If backup withholding was applied, be sure to note the amount withheld.

  • Send copies of the form to the IRS and the independent contractor by January 31 of the following tax year.

So, how do you set up contractors the right way?

A Simple Guide to Setting Up 1099 Contractors 

Setting up your contractors the right way involves following essential steps to ensure compliance and a smooth working relationship.

Here’s what you’ll need: 

  • Worker Classification: Accurately classify contractors as independent contractors or employees based on IRS guidelines to avoid misclassification.

  • Written Contract: Create a detailed written contract outlining the work scope, payment terms, deliverables, and other relevant terms to prevent misunderstandings.

  • Obtain W-9 Form: Request completed W-9 forms from each contractor to obtain necessary tax information for reporting.

  • Payment Terms: Agree on payment methods (e.g., direct deposit, checks) and establish a clear payment schedule.

  • Track Work and Hours: Implement a tracking system to monitor work hours or completed deliverables for accurate payments.

  • Tax Withholding: Do not withhold income taxes from contractors' payments; they are responsible for their own taxes.

  • 1099 Reporting: Issue Form 1099-NEC to contractors who earn $600 or more during the year for tax reporting purposes.

  • Regular Compliance Check: Regularly review contractor arrangements to stay updated on any changes in regulations.

  • Communication: Maintain open communication with contractors to address any concerns and ensure a positive working relationship.

If you’re unsure about any aspect of contractor setup, consult legal and tax experts to avoid potential risks and liabilities.

Now, you might be wondering, how do contractors get paid? 

The Easiest and Best Way to Pay Independent Contractors

Paying contractors doesn't have to be complicated. By following a structured approach, you can ensure that your workforce is compensated promptly and accurately while maintaining compliance with payroll tax regulations.

Here are a few simple and manageable steps to follow:

Step 1: Determine the Method for Paying Contractors

When you hire independent contractors, deciding how to pay them is essential. Choose your preferred payment method, such as checks, direct deposit, or other options. 

For a more stress-free approach, consider using payroll software or opt for a reliable payroll service, the key is to find a method that suits your business needs with ease. Additionally, consider if you'll pay contractors hourly or based on the project, and be mindful of payroll taxes.

Digital payments are popular among tech-savvy contractors and freelancers who lack traditional bank accounts. These choices offer convenience and accessibility, ensuring efficient payments for all your contractors.

Step 2: Request the Independent Contractor's Form W-9: Obtain Taxpayer Identification Number and Certification

Before your contractors start working, make sure they fill out W-9 Forms. These forms provide crucial information like their taxpayer identification numbers (TINs) and Social Security numbers. This information is vital for year-end reporting on Form 1099-NEC (Nonemployee Compensation).

Step 3: Set Up Contractors in Your Payroll System

Once you've obtained the necessary information from the W-9 Form, it's essential to organize your contractor details in your payroll system. Whether using dedicated payroll services, software, or traditional methods, maintaining meticulous records streamlines the payment process and guarantees accuracy in compensating your contractors.

Step 4: Process Payments and Be Aware of Your Tax Situation

Time to compensate your contractors! Once you decide on the payment method, like checks, direct deposit, or PayPal, consider the processing times to avoid any delays for your contractors or payroll system.

Now, before you process their payments, you must comply with all relevant tax regulations. Be sure to familiarize yourself with NEC (Nonemployee Compensation) reporting on tax forms.

Keep in mind, if you receive a backup withholding notice from the IRS, be sure to deduct a 24% tax from future payments of your independent contractor. Staying informed and proactive will help you smoothly manage your payment processes.

Step 5: Send 1099-NEC Forms

As the year ends, prepare and distribute 1099-NEC Forms to contractors who received over $600 in payments from you. Keep copies for your records and submit them to the IRS and state tax agency as required.

Now, before you move forward with the steps above, here are a few additional factors to consider: 

Compliance Matters: Avoid Misclassification 

Properly classifying independent contractors is critical to avoid legal and financial consequences. Differentiating employees from contractors is essential under federal law to prevent misclassified fines and taxes. 

Understand Backup Withholding Tax if Necessary

Throughout the process, be mindful of taxpayer identification numbers, social security numbers, and backup withholding taxes if needed (this only applies to rare situations). Compliance with state income tax laws and guidelines from the Internal Revenue Service (IRS) is crucial.

By understanding these key steps and requirements, you can confidently navigate the world of independent contractor payments. However, remember that seeking professional advice and using reliable payroll services can provide invaluable support in ensuring accurate and compliant contractor payments.

This brings us to… 

The Ultimate Payroll Software for Setting Up Contractors

Setting up, paying, and managing contractors can be a complex and time-consuming process. But it doesn't have to be that way. With Practice, you can effortlessly streamline your contractor management and focus on what truly matters: Growing your business.

Practice is a powerful payroll software that simplifies handling all aspects of contractor management. From onboarding contractors to processing payments and ensuring tax compliance, Practice has you covered. Its user-friendly interface makes it easy to get started and navigate, saving you valuable time.

Moreover, Practice isn't just for businesses; it's also an invaluable tool for sole proprietors and independent contractors looking to streamline their own operations. As the workforce landscape evolves, Practice empowers you to adapt with ease and efficiency.

No more grappling with complexities; instead, focus on the growth and success of your business or independent contracting career. Embrace the power of Practice and see how it can help you take your business to the next level. Try us for free today! 

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