What You Need to Know Before Hiring an Independent Contractor

Feeling unsure before hiring your first independent contractor? Unclear expectations, legal issues, lack of control, and pricing confusion are all challenges faced by SMB owners while hiring an independent contractor.

Don’t worry—hiring isn’t too complex. With the right resources and checklist, you can hire the perfect talent for your business. 

Although independent contractors bring valuable expertise to the table, misclassifying them can surprise you with unexpected tax liabilities and compliance issues. 

Having complete knowledge of contract terms speeds up the hiring process and brings the best talent to your company. In this blog, we talk about independent contractors and what you need to know before hiring an independent contractor to promote flexibility and cost efficiency.

Who is an Independent Contractor?

An independent contractor, also called a freelancer, is a self-employed person or firm offering goods or services to another business entity under a pre-signed contract or agreement.

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They don’t work as a full-time employee, instead, they are hired depending on the workload and their availability. This gives them the freedom to choose their employer and work whenever they want to.

Unlike full-time employees, contractors also manage their taxes and medical expenses by themselves. A good thing for the payer—they are not obligated to offer employment perks like health insurance and retirement plans.

For businesses that manage both employees and independent contractors, using an Excel staff holiday planner can be a simple and effective way to visualize team availability, track leaves, and prevent scheduling conflicts—especially during peak project periods.

Some popular independent contractors are doctors, dentists, veterinarians, lawyers, accountants, photographers, and auctioneers.

Their key characteristics are:

• Work ownership

Independent contractors have complete control over how they proceed with their work. They are not micromanaged by clients, giving them the headspace to be creative and efficient.

They decide the method, time, and location to accomplish their tasks, fostering a non-employer-employee relationship. This also allows them to work with multiple clients and scale their business.

• Financial responsibility

Independent contractors pay for the tools, materials, and business necessities by themselves. Their income depends heavily on the quality and frequency of their work—some months have great cash flow while some can experience a dry spell. This extends the responsibility of managing their financial reports and payment terms.

• Short-term engagements

“Independent contractors,” as the name suggests, are hired for pre-defined projects and fixed cycles (eg, six months or one year).

Companies hire them for their specialized knowledge to complete a specific project and conclude the relationship after project completion. This temporary nature of business allows business entities to employ specialized skills without committing to long-term employment.

While these characteristics explain the work culture of contractors, hiring them is a whole different process. You must classify them properly and obey legal regulations before hiring.

Let’s dive into the details!

Legal Considerations Before Hiring an Independent Contractor

Hiring contractors might seem like a simple employment of valuable expertise, but you must adhere to the checklist of legal considerations to ensure proper compliance with legal regulations.

The most common legal challenge firms face while hiring is classifying whether the worker is an employee or a contractor. This is because the obligations are distinct for an employee and an independent contractor. Here are the three key legal considerations before hiring:

Classification guidelines

The U.S. The Department of Labor (DOL) introduced the classification guidelines, effective March 11, 2024, to ensure accurate classification of workers as independent contractors rather than employees.

These guidelines are non-negotiable and can have serious legal and financial implications if not followed properly. Let’s understand the key components of classification guidelines:

1. Economic reality test

The economic reality test introduced by DOL evaluates workers on six primary factors to determine whether they are dependent on an employer for work or self-employed through business collaborations.

The former is classified as an employee and the latter as an independent contractor.

The six primary factors are:

• Control over work – To what extent does the employer dictate the work process?
• Financial risk – Opportunity for profit and loss due to business decisions.
• Nature of engagement – Classifying the worker as an employee or a contractor.
• Investment by both parties – Who is investing in the work, the contractor or the employer?
• Skills required – Evaluation of the skills required for the project.
• An integral part of the business – Determining the degree of importance of the services delivered by the worker.

2. Documentation 

Proper documentation is necessary for verified classification:

• Independent contractor agreement: 

This agreement is legally binding and highlights the payment terms, scope of work, duration, conditions for termination, NDA (non-disclosure agreement), and intellectual property rights.

• Tax forms:

Issue Form W-9 to contractors where they must write their taxpayer identification number (TIN). 

Note: Form W-4 is filled out by employees and not independent contractors.

• Payment terms:

Contractors are mandated to submit invoices after project completion and must be paid from accounts payable, and not payroll.

Moreover, if payments to an independent contractor exceed $600 in a year, you must issue Form 1099-MISC to report earnings.

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3. Eliminating misclassification risks

Documentation alone doesn’t eliminate misclassification, monitor the practices after completion of the hiring process.

• Reimbursements:

Independent contractors exercise the power of setting charges for their services. This showcases the contractor’s economic independence.

So, you must not reimburse their business expenses as covering business expenses imply an employer-employee relationship.

• Traditional benefits:

Avoid providing employee benefits like health insurance, sick leaves, retirement plans, and paid vacations and holidays. Keep these benefits limited to full-time employees.

• Payments:

Release payments after project completion and not on an hourly, weekly, or monthly basis. Finalize a flat fee payable at regular intervals before assigning the work.

Learn more in our full guide: How to pay yourself as a sole proprietor.

Risks of misclassification

Misclassifying workers is the most expensive mistake a company can make. This is because classifying an employee as a contractor prevents you from paying specific taxes levied by the government.

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The primary risks of misclassification include:

Legal penalties

In the U.S, the penalty for misclassifying an employee goes up to $1000 per employee. Violating the rules set by the Internal Revenue Service (IRS) obligates the company to pay hefty fines and back wages to employees.

Back wages are wage payments inclusive of overtime paid to employees as per their correct classification. For example, Arise Virtual Solutions, a gig economy, paid $2 million to 250 workers for committing a misclassification scheme.

Misclassification Lawsuits

Under the Fair Labor Standards Act (FLSA), misclassified employees can file lawsuits demanding back wages, compensation, and social security. The DOL strictly monitors these lawsuits and hires investigators to review wage compliance.

This not only incurs financial loss but also disrupts the reputation of the business.

Loss of business

After facing such legal repercussions, businesses lose a fair share of the market and are blocked out from multiple revenue streams. Businesses operating globally lose clients and face difficulty in rebuilding the trust and reputation of their company.

Notable legal precedents

Some notable legal precedents are:

• FedEx Group Package Settlement, 2015

The misclassification case made FedEx face a $228 million settlement for misclassifying 2,300 drivers as independent contractors. 

This settlement sent a powerful message across California and set a precedent for legal consequences in misclassifying employees.

• Dynamex Operations vs. Supreme Court (2018)

This case in California highlighted the “ABC test” to prove the worker status. Here’s a brief breakdown:

• They are free from the employer’s control and direction.
• Their work is outside the usual course of the employer’s business.
• They are engaged in an independently established trade or business.

• Instacart Settlement, 2019

The San Diego City Attorney’s Office sued Instacart for misclassifying 308,000 delivery workers. This lawsuit made Instacart pay $46.5 million in restitution, highlighting the necessity of proper employee classification.

Essential Contract Elements With An Independent Contractor

Although hiring independent contractors provides specialized skills, you cannot overlook the essential contract elements. Let’s break down the must-have elements of a contract:

Must-have clauses in the contract:

1. Scope of work

This element of the contract clearly outlines the services the independent contractor will provide and the expectations of the hiring party. The key pointers under this section are:

• A detailed explanation of the deliverables and a deadline to complete the work.
• Specify the requirements like:
  Expected work quality
  – Industry standards to be followed
  – Licenses and certifications
  – Required tools and subscriptions

2. Payment conditions

This section mentions the compensation structure, reimbursements, and payment cycles.

• Clearly outline the payment rate or the total amount payable to the contractor. This includes:
  – Bonuses and commissions, and the process for claiming them.
  – Any expenses that the hiring party might cover—accommodation and business-related provisions.

• Mention payment cycles and invoice submission procedures.

3. Confidentiality agreement

Independent contractors work with multiple clients, so it is important to keep business data confidential.

• Mention about non-disclosure agreements (NDA) and other professional conduct like:
  – Prohibiting involvement with other businesses during the contract.
  – Restricting the exchange of any confidential data with a third party.
• Clearly define which data is considered sensitive, like business strategies and client lists.
• This section of the agreement keeps both parties on the same page regarding their rights and limitations.

4. Intellectual property (IP) ownership

Here, you must state the ownership rights to any intellectual property created during the contract. It includes:

• The right to use the intellectual property after completion of the agreement.
• A “work for hire” clause where the client owns the intellectual property after the final payment.
• The procedure for handing over the intellectual property to the hiring party.

5. Termination clause

This section highlights the conditions under which the contract is terminated. The conditions include:

• Not meeting the expected quality standards, incomplete service, and contract breach.
• Notice periods to be served before discontinuing (eg, 30-day notice period).
• Any post-termination obligations like:
  – Return of intellectual property
  – Drafting a final report
  – Deleting sensitive business data

These are the legal components that legally bind the relationship between the contractor and the employee.

Compliance & Business Obligations

Here are the most important regulations:

1. Tax responsibilities

The tax responsibilities of an independent contractor are distinct from full-time employees.

Self-employment tax

Contractors are obligated to pay federal, state, and local income taxes. Moreover, an additional self-employment tax is imposed if they earn more than $400 a year. These taxes include social security and medicare taxes.

The total tax is 15.3%, comprising 12.4% for social security and 2.9% for Medicare taxes.

Quarterly tax payments

Unlike employees, Independent contractors pay taxes by themselves. This payment is made by estimating the yearly income and filing a return at the year’s end. These quarterly tax payments are generally due on April 15, June 17, September 16, and January 15 of the following year.

Deductions

Deductions often called “write-offs” are deducted from the taxable income to cover a necessary business expense specific to the employer’s industry.

Common tax deductions include:

• Office supplies and furniture
• Advertising
• Equipment depreciation

2. Insurance and liability coverage

As a 1099 independent contractor, you are prone to getting sued like any other small business. If you don’t have coverage, you pay the penalty from your pocket.

And that penalty is—Hefty!

Here’s an example of insurance costs:

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There are mainly two types of insurance:

1099 General Liability Insurance:

This insurance protects you from any damage caused to the third party or their property. For example, if you paint walls and break furniture by mistake, general liability insurance covers the expense for the damage caused.

It also protects you from:

• Bodily injury
• Reputational harm
• Copyright infringement

Professional Liability Insurance:

Professional liability insurance is also called the errors and omissions insurance, protecting you when a client sues you for inadequate performance and negligence in delivery.

You can claim it in situations like:

• Breach of contract
• Professional negligence
• Mistake in delivering the service
• Missing deadlines

Both types of insurance are either added to the agreement by the employer or purchased individually as per convenience.

3. Industry-specific compliance

This regulation refers to having the necessary licenses and permits for accurate compliance with labor laws.

Regulatory compliance:

Independent contractors must obey the industry standards and regulations related to their work. For example, construction contractors require permits and licenses to proceed with their work.

IR35 Regulations:

UK implements IR35 regulations to avoid disguised employment for tax purposes. This means these regulations determine whether the workers should be treated as employees or contractors.

Its key components include:

• Providing Status Determination Statements (SDS)
• Monitoring contractor status
• Right of Substitution
• Mutuality of Obligation (MOO)

Managing the Working Relationship

While completing the legal procedures is important, building a healthy work relationship with the contractor is also necessary. The best practices for managing work relationships are:

Clear communication & expectations

• Clearly define project scopes, timelines, and deliverables in simple language.
• Keep communication free of jargon, specifying the roles and responsibilities regarding deadlines, payment receipts, and expected quality standards..
• Respect their professional boundary and don’t dictate the process of work completion to the contractor.
• Communicate regularly by doing check-in calls to take weekly updates.

Evaluating performance

• Give honest feedback to the contractor because it helps them understand the expectations.
• Be specific with your comments and try to explain the issue with an example for a better understanding.
• Break bigger projects into smaller milestones to track responsiveness and turnaround times (TAT).

Handling disputes & conflict resolution

Delayed payments, work misunderstandings, and contract breaches are common disputes. Handle them by:

• Negotiating the issue and agreeing on a mutual solution.
• Involve a third party to neutralize the situation, honoring the interests of both parties.
• Resort to arbitration, a formal process where a third party hears both sides and makes a binding decision.
• Litigation is the last resort where a legislative body makes a legally binding decision. It is expensive and isn’t confidential.

Successful Hiring of Independent Contractors

Getting an independent contractor on board offers in-depth expertise and valuable skills, but you cannot overlook the legal considerations before hiring. Misclassifications, delayed payments, reality tests, and documentation are integral parts of hiring independent contractors.

You must adhere to the labor laws, ensure proper compliance, and use software to track daily business operations. Start by exploring the features of Billdu to streamline invoice payments and create financial reports.

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