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 is referred to in various ways including but not limited to:
- 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 protection to both parties. Moreover, it ensures that each of the parties involved in the agreement adheres to the terms and fulfills their obligations.
This guide will take you through the important terms to include in an independent contractor agreement and show you how to draft an effective agreement that can withstand regulatory and judicial scrutiny. It discusses common pitfalls to avoid and the salient differences between an employee and a contractor. Additionally, it goes over key motivational factors which might lead you to hire an independent contractor.
Table of Contents
• Why Hire Independent Contractors?
• Who is an Independent Contractor?
• Difference between an Employee and an Independent Contractor
• How to Negotiate an Independent Contractor Agreement
• Why Do You Need an Independent Contractor Agreement?
• Key Elements of an Independent Contractor Agreement
• Pitfalls to Avoid When Drafting an Independent Contractor Agreement
Why Hire Independent Contractors?
Independent contractors offer many benefits to a small business and this 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 cost of living across different countries, some independent contractors can offer competitive rates while still delivering high-quality work.
Who is an Independent Contractor?
An independent contractor is a person or entity that is engaged to perform specific work or provide services in a specified duration, usually a short term to another person or entity. 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 US, it is estimated that a third of the workforce is engaged in independent contracting either on a part-time or full-time basis.
If you are still not sure whether your worker is an employee or an independent contractor, check out this short 2-minute video by Ask Gusto where he talks about the three out of five areas of control which determine employees as opposed to contractors.
Hopefully, the video above will help you understand our more detailed discussion on the five areas of control in the section below.
Difference between an Employee and an Independent Contractor
Before we look at the structure of an independent contractor agreement, I feel it is important we first look at the differences between an employee and an independent contractor. Many businesses have found themselves on the wrong side of the law and incurred hefty fines and penalties due incorrect classification. The IRS and the Department of Labor are increasingly becoming more aggressive in their audit of firms to identify cases of incorrectly classified workers.
The major reason why some entities may be tempted to classify employees as independent contractors is to avoid payment of taxes and other benefits. For an employee, it is the employer’s responsibility to withhold income and other taxes and remit them. They should also provide other employee benefits as 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, and how and where they do it is much higher than over an independent contractor. An independent contractor decides when to work and where to work from. They can also work for more than one client subject to any clause in the agreement which limits them. In a few instances, they may be housed in the client's premises for a specified duration of the project.
- Tools and equipment
For employees, the employer provides all the necessary tools and equipment to accomplish a task. An independent contractor uses their own tools.
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.
An independent contractor can delegate some tasks. An employee performs all assigned tasks themselves.
An independent contractor has a temporary relationship with a client, which may be renewed as needed. An employee has an ongoing relationship with the employer.
There are many other differences, but these are the fundamental ones that the authorities will look out for to determine the status of a worker. In order to make a more conclusive determination, the courts will check for a combination of details involving the five areas of control. In general, the courts check the following details until they are satisfied that they can make a conclusive determination whether an employer - employee relationship exists or that the worker is merely a contractor:
- 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.
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 at 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 had 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 terms that you feel are unfavorable or agree obligations you are not sure to meet.
Another key strategy is to consider your interests and the interests of your prospect contractor and put them together into an agreement that is a win-win for both parties. Check out this video by the Kellogg School of Management which provides insights on this strategy:
In independent contractor agreements, some of the interests your contractor which may be worth considering when you craft you 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 breach.
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.
Despise 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 relationship. This is critical considering some businesses do this to avoid paying taxes, minimum wage, and providing other benefits.
Key Elements of an Independent Contractor Agreement
The structure of an independent contractor agreement is meant to capture as many details regarding the relationship as possible while providing legal protection to both parties. There is no defined structure of this type of contract. It varies by industry, client, contractor, and jurisdiction. We have put together a sample agreement for your guide. However, there are some universal sections that should be included. These sections are meant to pass any legal test that the agreement may be subjected to. One especially important test that the agreement will be subjected to and has to pass is the worker classification test. Taxing and labor authorities are keen to ensure employees are not classified as independent contractors.
These are the clauses that set out the relationship and clearly states that it is a client-contractor relationship and not employer-employee. Even though this is not enough, and other tests have to be applied, it is important to put in writing in the initial sections of the agreement. You can include the reasons why the independent contractor was hired and outline any special skills or competencies they have. You can also include the intended duration of time they will take to complete the task and whether the relationship will be ongoing.
Also, in the introductory clauses, the parties to the agreement should be clearly identified. Just like many other contracts/agreements, always begin by wholly and correctly identifying the parties to the agreements. As much detail should be included. For large entities, the contact person can be included in this section.
Terms of Engagement
The terms of engagements include factors such as timelines, which should be definite. Authorities have a dim view of very long or indefinite engagements. The tools, equipment, and location where work will be performed should be described. Independent contractors are meant to facilitate how the tasks will be accomplished. The clients should not provide these things to them.
Description of the Project
The tasks and deliverables should be clearly spelled out. The scope of the project should not be open-ended to avoid a legal challenge.
Payment Terms and Reimbursement of Expenses
This is very important to agree on and include in the agreement in writing. If payment is pegged on the achievement of certain deliverables or is based on fixed periods such as monthly or after project completion. Most independent contractor agreements are based on deliverables. In any case, avoid paying the independent contractor on the same frequency and schedule as you pay employees.
Duties and Responsibilities of either Party
This should be clearly spelled out and even the small details put in writing. 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.
Like in any other contract, termination clauses are very important. The rights of each party to terminate the independent contractor agreement and the conditions that they must adhere too should be put in writing. Circumstances that give rise to termination should be spelled out.
Confidentiality and Non-disclosure
This is very important to the client since the contractor will come across information that might hurt your business if shared with competitors or any other person.
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 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, 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 for 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.
These elements are quite a handful to digest and may be challenging to incorporate into an independent contractor agreement depending on your industry. Check out this video from KEYTLAW to tune in on a discussion on the most essential contract elements and what you need to look out for in order to come up with an airtight agreement.
Pitfalls to Avoid When Drafting an Independent Contractor Agreement
Whether you are a small entity or a big business, having an effective process of drafting independent contractor agreements is very important. Independent contractors offer 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. There are some pitfalls/mistakes that many attorneys have observed over the years in disputes involving independent contractors. I will give a brief explanation of these and how to avoid them in your contract drafting process.
Engaging independent contractors without a written contract
This is by far the most common pitfall. Many entities, especially small businesses, and contractors tend to ignore the importance of having a written contract. It doesn't matter who the independent contractor is, they may be your friend or relative, but you need to have a written contract. It offers legal protection to both parties, and averts costly disputes which may occur down the line.
Having a deficient contract
Having a deficient contract is as ineffective as not having one in place. Deficient contracts 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.
Incorrect Classification of Workers
This is a major mistake that leads to costly fines and penalties. Some entities unintentionally or fraudulently incorrectly classify employees as independent contractors to gain the benefits of independent 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 proof read 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 especially 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. It is the obligation of the independent contractor to file and pay any taxes due. This is a major advantage of hiring independent contractors as the tax burden automatically shifts to the independent contractor. This is often a big relief to small businesses and individuals who don't want to deal with this obligation.
In the United States, the client should, however, report any payment made to an independent contractor that is above $600 to the tax authorities through Form 1099. This is different from the W-2 form used for employees. Actually, let's take some time to look at the taxation obligation in regard to different classes of independent contractors.
Check out this quick video guide from Artisan Talent which talks about the forms which correspond to independent contractors and those which correspond to employees. This guide will ensure that you provide your contractor assurance that no taxes are being taken out of the amount that they are receiving from you.
The only obligation to clients is to file these forms for reporting purposes. However, this is a serious obligation that you should acquaint yourself with to avoid fines, penalties, and back taxes, which can lead to the closure of your business. There are three main forms that you should be aware of. The 1099-Misc, 1099-K and the W-88EN forms
This the most common form. It is required if your payments to independent contractors exceed $600 for the tax year. This is for money paid in cash and checks only.
This is the form to use if the payment is made in the form debit card, credit card, Paypal, and other electronic forms of payment. These payments should only be reported by the hiring entity if they exceed $20,000 or 200 transactions. The independent contractor should, however, pay their income taxes as appropriate, even if the hiring party was not obliged to report. They risk paying penalties and back taxes if the business is ever audited by tax authorities, and these payments discovered.
This is the form to use for non-US citizens working outside of the US. This is because the worker is not subject to US taxation.
Make sure to fill in these forms accurately, capturing the name, addresses, 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 paid by the independent contractor. Forms are supplied to each recipient by the end of January the following year and filed with the IRS by beginning March for paper forms and by the end of March for electronic forms
The increased adoption of independent contractors as an alternative to hiring employees and taking advantage of 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.