Hiring independent contractors, rather than employees, can be beneficial for businesses. This is because you cannot control them as you do employees since they work as consultants and are self-employed. You save resources regarding training them and also don’t need to pay bonuses. However, you should document the independent contractor agreement carefully since they need to sign it to avoid issues with the Internal Revenue Service (IRS). The independent contractor agreement is very important if you contract the consultant to develop software, a product, a manual or book, or any other type of intellectual property.
As the contracting party, you need to document what rights you expect to retain with the end product so that the independent contractors cannot interfere with the intellectual product. However, you have to first understand what an independent contractor agreement is, along with things you consider when drafting it. So, what does this contract entail? This article highlights what an independent contractor agreement is, what you should consider when drafting it, and the guide to the contract. We have also addressed key tax and business issues you will encounter when dealing with consultants or independent contractors.
What Is an Independent Contractor Agreement?
An independent contractor agreement is basically a written contract between two parties for a specific project or service. It usually applies where a company or a person is hiring another to help on a short-term task or project. It differs from an employment agreement since it clearly spells out why the consultant or independent contractor is not an employee for tax and legal purposes.
The independent contractor agreement mainly addresses several elements. It specifies the hiring entity or person that may need special services in the short-term and establishes that there is no need for hiring them as an employee. It has to encompass a contractor who is the entity or person hired for a task or project. It must include the services offered. For services offered, the agreement should specify the task to be performed or delivered. It has to stipulate the compensation, which is how much the contractor will be paid. It includes the effective date which is when the agreement begins and when the job starts.
It has to specify the termination process. This is whether the hiring entity or person can end the relationship at any time. This is what is referred to as an “at will” contract. It should also address the number of days a written notice is needed to end the contract. It also includes the fringe benefits, which specify that the contractor cannot participate in any of the hiring entity’s employee health, pension, sick pay, health, or any unemployment benefits. The entity can also hire its own assistants, but is solely responsible for the expenses like Medicare or Social Security taxes.
The contract may also be referred to as:
- Company contractor agreement
- Client/service freelancer agreement
- Independent consultant agreement
- Freelance contract
- Freelancer agreement
- Contractor agreement
- Freelancer contractor agreement
Advantages and Disadvantages of Working with Independent Contractors
Working with independent contractors has a number of advantages, including:
- You can use contractors for a project or task when needed
- Contractors provide special expertise
- You establish a flexible relationship with the contractor
- You will cut on costs on tax contributions
However, it has its downsides, including:
- You may end up paying high fees to the contractor
- You do not have full control over the contractor
- There is a chance you will run into tax problems
- You cannot establish continuity in the relationship with contractors, instead, an employee here would be preferable
Things to Consider When Drafting Your Agreement
A good independent contractor agreement includes the following aspects:
The agreement needs to spell out when the services are to be performed. Here, the hiring entity should consider including a late-penalty fee if the services are not delivered in the documented time or when the product is delivered late.
The contract spells out the services that the independent contractor will perform. Here, you should specify all the things that you expect to be done by the independent contractor so that he or she can be paid.
The contract needs to spell out when progress reports should be made by the independent contractor and to whom he or she reports. You should be careful here not to have excessive control over the contractor since it could potentially lead to the identification of the contractor as an employee as far as tax is concerned.
The contractor expects to be paid but only if he or she delivers the product or services. The clause regarding payment in the contract should address the amount that the contractor will be paid, the manner in which he or she will be paid (per hour or per project), and when the payment is due. From the perspective of the hiring company, it should ensure that the product or service is of reasonable quality before being obligated to pay the entire amount. Otherwise, you do not have to pay until you’re satisfied with the work.
If the contractor expects to use subcontractors, he or she should provide approval over them, and we recommend that they execute an appropriate contract with you.
In the contract, you need to spell out any warranties from the contractor, including the contractor’s warranty that the services or product delivered should be of high-quality, timely, and professional.
7.Work for hire
The contract should stipulate that the work product that the contractor develops for the hiring company is considered a work for hire under the copyright laws and owned only by the hiring entity and not the contractor.
The contract needs to clarify that the contractor must keep any proprietary information about the hiring company confidential and that the contractor will not use any information that the entity provides other than for the benefit of the hiring company.
Your Guide to an Independent Contractor Agreement
Protecting Your Interests
Prior to hiring an independent contractor, you have to first do a background check to establish whether the person is the right person to perform the job. If you want to verify the information that the person provides, have the person sign a background check just to make sure the information provided is accurate.
Confidentiality and Invention Assignment Contracts
Have the contractor or consultant sign a confidentiality agreement, especially if you run a tech-oriented firm since you’ll pass a significant amount of confidential information. Since the contract comes up with a product or business idea, it is your best interest to maintain ownership. In areas where you are sensitive about confidentiality and the company’s ownership of the product, ensure that the contractor or consultant signs the Confidentiality and Invention Assignment. This will ensure that the contractor doesn’t pass on confidential information and that the final product or idea belongs to the company, not the contractor.
Tax laws demand that you treat contractors and employees differently. Contractors are beneficial since you reduce the tax liability but you need to be careful to correctly fill out tax forms and agreements to avoid the IRS disagreeing with your assessment. For tax purposes, the following is required for independent contractors:
- No Social Security contributions
- No Medicare taxes contribution
- No withholding of federal taxes
- File Form 1099-MISC with IRS if you pay the contractor $600 or more per year
- No compensation insurance
- No contribution to unemployment insurance funds or taxes
- No sick leave or holidays
- No overtime payments
- You do not have the right to control how the contractor works, what you’re interested in is the final product
- You don’t have the right to control the business aspects of the worker’s activities
If the IRS determines that the contractor should have been classified as an employee, rather than a contractor, you may be penalized as follows:
- Pay Medicare contributions that would have been withheld
- Pay federal income tax that should otherwise be withheld from the employee
- You’ll be penalized for failing to properly pay taxes and file tax returns
- Criminal sanctions, you could be imprisoned or face fines up to $100,000
- A larger penalty if it is established that you were negligent or fraudulent
- Pay tax interest should have been withheld
- Pay personal liability for corporate officers, up to 100% of the amount that would otherwise be withheld
Independent Contractor Tax Forms
IRS requires you to fill the following forms:
1. Form W-9: This requires you to collect Social Security numbers or the Employer Identification Number (EIN).
2. Form 1099-MISC: Once you pay the contractor $600 or more in a year, send the form to IRS and to the contractor at the end of the year.
It is vital for a business to first establish whether the person providing services is an independent contractor or employee so you understand if you have to withhold taxes, pay unemployment tax on wages, pay and withhold Social Security and Medicare tax, or provide benefits to this person. For independent contractors, you don’t have to withhold or pay any type of tax when working with them. When working with contractors, the hiring entity must first ensure that the person or company signs the independent contractor agreement.
The contract includes aspects like timing, services offered, reporting mechanisms, payment, subcontractors (if any are involved), warranties, work for hire, and confidentiality. For tax purposes, ensure you file with the IRS Form W-9 and Form 1099-MISC. We hope that this article has adequately addressed what an independent contractor agreement is, what you should consider when drafting it, and key tax and business issues involved.