Independent Contractor Agreement
An independent contractor agreement is a written contract that details the terms of the working relationship between a client and an independent contractor. This agreement can be referred to in other names, such as the following:
- Subcontractor Agreement
- Freelance Contract
- Consultant Agreement
- Consulting Services Agreement
An independent contractor agreement is a contract that every business engaging contractors/freelancers/consultants should have. The deal offers legal protections to both parties. Moreover, it ensures that each of the parties involved in the agreement adheres to the terms and carries out their considerations.
With this, this guide will take you through the essential aspects of an independent contractor agreement including how to draft an effective protocol that can withstand regulatory and judicial scrutiny, common pitfalls to avoid, and how to differentiate between an employee and an independent contractor.
Who is an Independent Contractor?
An independent contractor is a person or entity that is engaged to perform specific work or provide services for a specified duration. The work to be rendered by the contractor is usually short-term and to be delivered to a person or entity.
An independent contractor must not provide the same or a similar service to that of a current employee in the company. Therefore, the independent contractor can be considered as a person providing a service for hire, someone who delivers an assignment, or a person who has an explicit written agreement that he or she is an independent contractor for the company.
Some professionals have long been recognized and classified as independent contractors such as doctors, lawyers, accountants, and many others. However, with the rise of the gig economy, many other people are becoming independent contractors. In the U.S., it is estimated that a third of the workforce is engaged in independent contracting either on a part-time or full-time basis.
Difference between an Employee and an Independent Contractor
Many businesses have found themselves on the wrong side of the law and incurred fines and penalties due to the incorrect employment classification. As such, the IRS and the Department of Labor are increasingly becoming more aggressive in their audit of firms to identify cases of misclassified workers.
The primary reason why some entities may be tempted to classify employees as independent contractors are the payment of taxes and other benefits. For an employee, it is the employer’s responsibility to withhold income and other fees and remit them. They should also provide additional employee benefits defined by law. The regulatory bodies and the courts usually consider the following five factors in determining whether a person or an entity is an employee or an independent contractor.
The level of control over an employee in the course of performing their work, when they do it, how, and where they do it is higher compared to an independent contractor as they are more autonomous. An independent contractor decides when and where to work from. They can also work for more than one client subject to the clauses in the agreement. In a few instances, they may be housed in the client's premises for a specified duration of the project.
Tools and Equipment
Companies should provide employees with the tools for them to carry out their roles in the company. It is the responsibility of the company to ensure that its employees are well-equipped to deliver their goals. Contrastingly, independent contractions use their processes and must have their tools and equipment to complete the work.
Independent contractors bear any risk associated with the accomplishment of the task at hand. They may decide to incur insurance costs to mitigate any such risks. Employees bear almost no risk at all. The employer bears all the costs associated with mitigating risks.
Why Hire Independent Contractors
Independent contractors offer many benefits to a small business and these include the following:
Hiring an independent contractor is cost-effective, considering that you only have to pay for the length of service and the type of service delivered.
For taxation purposes, the burden of paying taxes is on the independent contractor. However, the hiring party may need to report a payment made but not pay the actual taxes.
Can Work Remotely
Another advantage is that you get to take advantage of talent no matter where they are based in the country and globally. A small company or an individual can hire a freelancer who is found in a different geographic location. This enables them to scout for the best no matter where they are located.
Affordable than Their Local Counterparts
Another essential advantage of freelancers is that due to the different costs of living across different countries, some independent contractors can offer competitive rates while still delivering high-quality work.
How to Negotiate an Independent Contractor Agreement
Negotiating with independent contractors requires skills and not losing sight of your goal, which is negotiating the service rendered with the best price within your desired timeframe. Therefore, it’s essential to reach an amicable position where both parties feel that their rights are adequately protected, their obligations are well defined, the remedies proposed are acceptable, and the payment terms are fair. Unfortunately, many people tend to focus only on the last point.
As discussed in an earlier chapter, agreements strengthen relationships between two parties. The negotiation process plays a crucial role in this. Parties get to understand each other better. What their values are, their procedures, and their work philosophy. Never agree to terms that you feel are unfavorable or to obligations you are not sure to meet.
Tests Applied by the Courts to Determine Worker Classification
In testing whether a worker is an employee or an independent contractor, the courts will look at the following:
- Source of equipment, instruments, and tools;
- Location of work or service provided;
- Whether work is part of the regular business of hiring party;
- Duration of the relationship between the hiring party and contractor;
- Method or terms of payment;
- Whether the worker is regularly assigned projects;
- The extent of the hiring party's discretion over when and how long the hired party must work;
- The role of the contractor in hiring and paying assistants
- Whether the hiring party is in business;
- Whether employee benefits are provided to the contractor; and
- Tax treatment of appointed parties.
In many instances, no one factor will be conclusive in determining the classification of a worker. Instead, several of these factors are looked at to arrive at a ranking. It is essential to understand how the courts and other authorities approach this issue. It will help in drafting the Independent Contractor Agreement, as we shall discuss in the following chapter.
In independent contractor agreements, some of the interests of your contractor, which may be worth considering when you craft your independent contractor agreement, include:
- Regularity/Consistency of available work
- Favorable work hours
- Output based pay
- Predictability of payment schedule
Try to find out what your contractor’s interests are when putting your agreement together in writing and you may wind up with a better deal than you were originally bargaining for.
Why Do You Need an Independent Contractor Agreement?
An agreement between an independent contractor and a hiring entity is essential to protect the rights of the parties in the transaction, including the following:
Contracts offer legal protection to both parties in case one party fails to meet their obligations. While verbal agreements are still enforceable in the court of law, written contracts are more reliable, easy to prove, and efficient for any claims and breaches.
The contract indicates the contractor's classification against the employees of the hiring entity, which is essential. Outlining the business relationship as a client-contractor and not an employer-employee is critical, especially when it comes to compensations and tax obligations of the parties.
Disputes may arise in verbal contracts, and miscommunication can also cause confusion between parties. With this, a written contractor agreement ensures that everything is outlined and the parties have a document that they can refer to when disputes arise or that they can use to avoid any conflicts.
An independent contractor agreement also helps avoid sham contracting where the employer or hiring entity disguises your employment relations as a contractual employment relationship. This is critical considering some businesses do this to avoid paying taxes, minimum wage, and other compensations.
Key Elements of an Independent Contractor Agreement
The structure of an independent contractor agreement is meant to capture complete details regarding the business relationship between the parties. It also encompasses the legal protection for both parties. There is no defined structure for this type of contract as it varies per the industry, client, contractor, and jurisdiction.
Nonetheless, some universal sections should be included. These sections are meant to pass any legal test that the agreement may be subjected to. One of the most essential criteria of an independent contractor agreement is the worker classification test.
These are the clauses that set out the relationship and explicitly state that the contract is between a client and a contractor. The first term also includes the project's location and ultimately states and identifies the parties to the agreements. As much detail should be included. For large entities, the contact person can be included in this section.
You can include the reasons why the independent contractor was hired and outline any special skills or competencies they have. You can also add the intended duration of time they will take to complete the task and whether the relationship will be ongoing. Parties must also include the date that the parties enter the agreement.
Terms of Engagement
The terms of engagement include definite timelines of the project because authorities have a dim view of very long or indefinite engagements. The tools, equipment, and location where work will be performed should also be described. The terms of engagement must also outline how the tasks will be accomplished.
Description of the Project
The tasks and deliverables should be spelled out in the independent contractor agreement. The scope of the project should not be open-ended to avoid a legal challenge.
Terms and Termination Clauses
The clause outlines when the project will start, when the services will end, and when an extension is necessary, how the contractor or hiring company will extend the contract. Each party's rights to terminate the independent contractor agreement and the conditions that they must adhere to should be put in writing. Circumstances that give rise to termination should be spelled out in this section.
Payment Terms and Reimbursement of Expenses
This is very important to agree on and include in the agreement in writing. The contracting party may indicate whether or not specific deliverables' achievement is based on fixed periods such as monthly or after project completion. Nonetheless, the majority of independent contractor agreements are based on deliverables. In any case, avoid paying the independent contractor on the same frequency and schedule as you pay your employees.
Duties and Responsibilities of Either Party
The contract must outline even the small details of the responsibilities and duties of the parties involved. If a contractor is dealing with a big organization, the contact person/department should be established, and lines of communication established and put in the agreement.
Confidentiality and Non-disclosure
The terms of this clause must outline what information should remain confidential, the obligations of the parties, and relief to any confidentiality breach that will arise during the term of the agreement.
Dispute Resolution Mechanism
A clause that sets out how disputes will be resolved and choice of law and forum is a standard part of an independent contractor agreement. Arbitration in the first instance should be a desirable clause to include. The choice of the arbitration center should be agreed upon and put in writing.
Performance assurances from the contractor are standard clauses to include in the agreement. This ensures that their work/product/services perform as expected. Warranties or guarantees are some ways to ensure this. Holding up a certain percentage of the payment for a specified duration is common.
The independent contractor should indemnify the contracting entity against any claims, representations, and liabilities in regard to the work provided. The independent contractor should insure their work from any such claims. The requirement of insurance and proof of it should ideally be included in the agreement.
Any intellectual property created by an independent contractor belongs to the hiring party. The owner of any work for hire is the person commissioning the work. It is not the person who created the work. The same case applies to employees. For the avoidance of doubt, always include a clause in the agreement which states that the independent contractor is hired for the project and any copyright belongs to the hiring party.
Pitfalls to Avoid When Drafting an Independent Contractor Agreement
Whether you are a small entity or a big business, hiring independent contractors offers many advantages over hiring employees. However, these advantages come with certain risks that you should always be on the lookout for. A well-drafted contract will address and mitigate these risks. Here are some things you can do to avoid pitfalls.
Avoid engaging independent contractors without a written contract
Before entering working with an independent contractor, you should first enter into a written agreement. Do not ignore the importance of a written contract, even if you are working with a friend or family. The deal offers legal protection to both parties and averts costly disputes which may occur down the line.
You have a deficient contract
A deficient contract is ineffective. Insufficient arrangements often come about when people blindly use templates without adjusting them to reflect their peculiar circumstances. As a basic rule of thumb, a well-written contractor agreement should provide legal protections to both parties, spell out duties and responsibilities of each, define the terms of engagement, and pass the independent contractor test.
Misclassification of workers
This is a significant mistake that leads to costly fines and penalties. Some entities unintentionally or fraudulently misclassify employees as independent contractors to benefit self-employed workers while also having the benefits of an employee. This is illegal and may lead to lots of problems once the authorities catch up with you.
One thing you should always do is carefully proofread any contract/agreement before signing it. You often find many people quickly perusing a document and signing at the end without understanding what they have signed. This can be dangerous to your business. Always read carefully to understand, and if you cannot, find an attorney who can do it for you.
Use of excessive jargon
This can be a problem in case the agreement is contested later on. Technical terms should be defined or avoided altogether. This is mainly in the duties and responsibilities of the parties' clauses. Some legal terms known as boilerplate language, whose use and meaning have been widely accepted, should pose no problem. A well-written Independent Contractor Agreement should be simple, clear, and comprehensive.
This is very common that I cannot overemphasize it. Many independent contractor agreements do not specify the remedies if either party fails to uphold their obligations. This is a problem since even if you were to prove your claims against them, the remedies to be enforced are not present. Always include specific remedies for failure to meet any obligation put forth in the contract.
Dealing with Taxes
There is no obligation on the part of the hiring party, the client, to withhold any taxes before paying independent contractors. The independent contractor should file and pay any taxes due. Independent contracts are required to pay self employment tax, which means that the hiring party is not required to withhold or deposit taxes on behalf of the independent contractor.
However, it is essential that all workers are classified correctly, and small businesses should make sure they are not classifying employees as independent contractors by mistake.
Backup withholding is a tax deduction that the hiring party takes from the sum agreed for services rendered by the independent contractor. This occurs when independent contractors declare their income incorrectly on their tax return, or if they provide the wrong TIN number to the hiring party.
In the event that this happens, the hiring party must then deduct a certain percentage of the payment to the independent contractor, and deposit it correctly and on time with the IRS.
What Taxes Does An Independent Contractor Pay
Independent contractors are required to pay income tax and self-employment tax. The latter here refers to a combination of social security taxes and Medicare. The specific tax obligations of an independent contractor will depend on whether the business operated on a net profit or a net loss.
Preparing To Pay Taxes
Preparing to pay taxes is just as important as the actual act of paying them. There are many forms that need to be completed depending on the circumstances of the business and the independent contractor. Factors such as how much has been paid out to an independent contractor, and the way in which it was paid will play a part in which forms need to be completed.
Taxes can be complex to understand, and if any information is inaccurate, it can lead to penalties. Bookkeepers understand the way that the tax process works, and how to ensure that taxes are filed correctly, and on time. Most small businesses will find that using an outsourced bookkeeping service will ensure that their taxes are filed correctly, and that all payments to independent contractors are made and correctly logged.
This is an estimated tax for individuals form, and can be used by independent contractors to avoid a large tax bill. The IRS requires independent contractors to pay estimated taxes quarterly, and form 1040-ES is the one you need to do this. It is a pay as you go approach, and ensures that taxes are being kept up to date, and paid regularly so everything is not owed at the end of the year.
In order to fill out this form accurately, independent contractors will need to estimate their adjusted annual income as well as taxable income, deductions, credits and more. It may be useful to obtain a copy of the previous tax return to get an accurate estimate.
The hiring party will be required to fill out form 1099-NEC for nonemployee compensation if they have paid a total of $600 or more to nonemployees such as independent contractors. There are certain exemptions which preclude certain businesses from filing this form, so it’s essential that you look at the exemption criteria prior to filing. You do not have to file these forms for C-corporations or S-corporations unless it was for attorney’s fees. You do not have to file a 1099-NEC for payments made to a tax-exempt organization, or payments for merchandise, storage, freight and other similar items.
Businesses can get the personal information that they require from their non-employee from the W-9 that should have been filled out.
This is the form to use for non-U.S. citizens working outside of the U.S. This is because the worker is not subject to U.S. taxation.
Make sure to fill out these forms accurately, capturing the name, address, and social security number of each independent contractor and the exact amounts paid. The forms will then be compared to the income tax filed and funded by the independent contractor. Forms are supplied to each recipient by the end of January the following year and registered with the IRS by the beginning of March for paper forms and by the end of March for electronic forms.
The form should be completed by the independent contractor and must include the contractor’s tax identification number. This form is used to ensure that the name and TIN of the contractor are correct.
Bookkeeping is one part of the financial equation and needs to be taken seriously. Bookkeeping is the activity or occupation of keeping records of the financial affairs of a business, and is essential to keeping finances in order. Bookkeepers offer a range of other services such as the managing of business taxes on top of creating sense out of stacks of numbers.
In an independent contractor agreement, it should state that it is the responsibility of both parties to keep their own thorough records of finances paid out, or paid to them through any source. Both the hiring party and the independent contractor are within their rights to hire outsourced bookkeeping services if they require them, or hire their own in-house bookkeeper to keep these records.
A thorough and detailed account of finances should be kept for both tax purposes, and in case there are any financial disputes down the line. Receipts, bills, invoices and any other information used to create the bookkeeping logs will be useful to keep somewhere safe in case there is any need for them again.
Accounting Set Up
Each party is responsible for their own accounting practices, and this should be made explicit in the independent contractor agreement. It is not the obligation of the hiring party to do any more than pay the independent contractor the agreed upon sum for their time and work. All financial records, taxes, and financial responsibilities of the independent contractor are completely separate to that of the hiring party.
The use of software is going to make accounting and bookkeeping an easier task to manage, with all of the information laid out in one place, rather than a million reports scattered around. Though businesses are not obligated to handle the finances of the independent contractor, records still need to be kept and handled correctly for payments paid to the aforementioned contractor. Small businesses should keep these payments separate from anything to do with employees to avoid any confusion later down the line.
The Use Of Appropriate Software
There are various options when it comes to bookkeeping software that is available on the market. One of the pieces of software that is commonly used by small businesses is Quickbooks, as it’s known for its easy to use interface, and simple layout. If the hiring party already uses a specific piece of software, it should be made clear to the independent contractor in the independent contractor agreement. The independent contractor can then familiarize themselves with the software if it is not one that they have used in the past.
The increased adoption of independent contractors as an alternative to hiring employees and taking advantage of the talent in any part of the world has been a game-changer in how we view work. Work is no longer a place people go to but a role people play. It is estimated that the independent contractor industry, commonly referred to as the gig economy will continue growing exponentially due to the many benefits it offers both the hiring party and the independent contractors.