How to Account for Independent Contractors in Your Business Taxes (4 Questions You May Be Asking)
With nearly 60 million Americans identifying as independent contractors, it’s important to understand how your business should account for these types of workers come tax season. Your company may hire independent contractors for a wide variety of projects, many of which fall outside the scope of your existing team’s responsibilities.
With an increasing freelancer workforce, you may be considering how you can leverage independent contractors for your own business. This post guides you through four questions you may be asking about accounting for independent contractors in your business taxes this year, including:
- What is an independent contractor?
- Are independent contractors treated as a payroll expense?
- What independent contractor documents should my business retain for tax purposes?
- How do I deduct independent contractor expenses from my business taxes?
How Does the IRS Define an Independent Contractor?
The IRS provides specific guidelines to determine whether a person is an employee or an independent contractor. There is a fine line between the two classifications so it’s important your business understand the difference.
Generally, your business can determine how to treat this difference by understanding the business relationship. You can do this by following the IRS’s Common Law Rules – three distinct questions to help you determine the degrees of control your business has in the relationship:
- Behavioral Control – Ask yourself this: “Does my company control what the worker does and how the worker does their job?” This question will help you determine the type of instruction you provide the individual, the degree of the instruction, and the evaluation system you use to measure the details of the job.
- Financial Control – Ask yourself this: “Are the business aspects of the worker’s job controlled by me, the payer?” The financial control question gauges how significant of an investment the relationship is, any unreimbursed expenses, and the payment method.
- Type of Relationship – As yourself this: “Are there written contracts or employee-type benefits, including insurance or paid vacation?” This question will help you determine how you and the worker perceive the working relationship. Employee benefits and the timeline of the worker-business relationship can help you determine if the worker is truly an independent contractor for tax reasons.
If you need more guidance on this issue, check out the IRS’s Independent Contractor or Employee guide.
Are Payments to Independent Contractors a Payroll Expense?
As we’ve just determined, hiring an independent contractor shares many similarities with hiring an employee. However, just as there is a difference in the relationship, there is a difference in the way you pay your workers.
When you hire an employee for your business, you request that they fill out a Form W-4. You then pay for certain standard employee benefits and taxes.
You would not do the same for independent contractors. Because each independent contractor is responsible for paying his or her own payroll taxes, unemployment insurance, social security, and other payroll taxes, you would not treat independent contractors as a payroll expense.
Rather than a payroll expense, independent contractors should be treated like any contract work. Your business likely hires other service professionals like lawyers and accountants on a contract basis. Independent contractors fall under this same category. And, as such, the work they perform should be treated as a tax-deductible expense.
What Independent Contractor-Related Documents Do I Need to Retain For Tax Preparation?
Hiring an independent contractor for your business requires far less recordkeeping than hiring full-time employees. Because independent contractors handle most of their own important tax documents, you may only need to retain a few important documents for tax filing purposes.
Before hiring an independent contractor, ensure you have the following three documents in place:
- A Form W-9 with updated contact information for the independent contractor, including a taxpayer ID number (EIN or SSN). Note that your business is not required to send the completed W-9 form to the IRS. Ensure you keep the form for recordkeeping purposes in the case of an audit or other concerns.
- A written contract outlining the scope of work the independent contractor is being hired to complete, including deliverables, timeline, and ownership. Both parties should sign the contract and retain a copy for their records.
- Any payments made to the independent contractor, including deposits before work begins and invoices for expenses or materials your business is responsible for covering.
These are three important documents to retain for tax-paying purposes, but you may want to consider the need for other documents. Including sub-agreements like confidentiality, non-solicitation, or non-compete agreements are documents aimed at protecting your business trade secrets, your clients, and your unique business process.
How Do I Deduct Independent Contractor Expenses From My Business Taxes?
The first step in deducting independent contractor expenses from your business taxes is retaining compensation documents. If your business has paid an independent contractor more than $600 for the year, you must complete Form 1099-NEC. This form serves to report how much your business paid independent contractors and other nonemployees for the year. You should fill out this form and then submit a copy to the IRS and the freelancer by January 31st each year.
You can download a copy of Form 1099-NEC from the IRS here.
Once you have properly filled out Form 1099-NEC, reach out to an expert accounting firm like Cook CPA Group. We’ll help you file Form 1099-NEC and other eligible business deductions to save your business money this tax season.