How to hire a contractor: a guide for small business

Published Thursday 26 February 2026

Table of contents

• What defines a contractor?
• Understanding worker classification: contractor vs. employee
• Why hire an independent contractor?
• When not to hire a contractor
• How much does it cost to hire a contractor?
• How to hire an independent contractor
• Where to find qualified contractors
• How to vet and interview contractors
• Creating an independent contractor agreement
• How to pay and manage contractor expenses
• Getting the best results from your contractors
• Xero simplifies contractor management
• FAQs on hiring independent contractors

Key takeaways

• Verify worker classification using the IRS three-factor test (behavioral control, financial control, and relationship type) before hiring to avoid costly penalties and back taxes that can reach 100% of taxes owed.
• Create a comprehensive written independent contractor agreement that includes scope of work, payment terms, timeline, termination conditions, and intellectual property ownership to protect your business and establish proper contractor status.
• Collect a completed W-9 form before making the first payment and issue a 1099-NEC by January 31 if you pay a contractor $600 or more in a calendar year to meet IRS reporting requirements.
• Set clear expectations from the start by defining specific deliverables, deadlines, and communication preferences, then maintain regular check-ins and pay promptly to build strong working relationships and ensure project success.

What defines a contractor?

Understanding what makes someone a contractor is the first step in hiring one correctly.

An independent contractor is a self-employed worker you hire for a specific project or time period. Unlike employees, contractors run their own businesses and control how they complete their work.

Key distinctions to understand:

• Contractors set their own schedules, use their own tools, and work for multiple clients
• Employees follow your direction, use your equipment, and work exclusively for you
• Freelancers and consultants are types of contractors, though legal definitions vary by jurisdiction

The terms freelancer, consultant, and independent contractor often overlap. In the US, all three typically refer to self-employed workers who are not employees. The key factor is how the IRS classifies the working relationship, not the job title.

Misclassifying a contractor as an employee can trigger back taxes, penalties, and legal liability. According to the IRS, businesses with no reasonable basis for the error may be held liable for employment taxes for that worker. Before you hire, review IRS classification guidelines and consult a tax professional. If you're still unsure, the IRS recommends submitting a Form SS-8 to receive an official determination of the worker's status.

Understanding worker classification: contractor vs. employee

Now that you understand what defines a contractor, you need to know how to classify workers correctly.

Worker classification determines whether someone is legally an independent contractor or an employee. Getting this wrong can cost your business thousands in penalties and back taxes, and it's an issue government agencies take seriously. A Department of Labor initiative proposed allocating millions to address worker misclassification in partnership with the IRS.

The IRS uses three categories to evaluate worker status:

IRS tests for worker classification

• Behavioral control: Do you dictate how, when, and where the work gets done? Employees follow your instructions; contractors control their own methods.
• Financial control: Does the worker have unreimbursed expenses, invest in their own equipment, and offer services to other clients? These signal contractor status.
• Relationship type: Is there a written contract? Are benefits provided? Is the work ongoing or project-based? Permanent, benefited roles indicate employment.

Consequences of misclassification

Understanding the consequences helps you avoid costly mistakes.

Misclassifying an employee as a contractor can result in:

• Back payment of employment taxes (Social Security, Medicare, unemployment)
• Penalties of up to 100% of taxes owed
• Liability for unpaid benefits and overtime
• State-level fines and audit triggers

How to protect your business

You can take steps to reduce your risk of misclassification issues.

• Use a written independent contractor agreement for every engagement
• Document the business relationship and how work is performed
• Avoid providing benefits, equipment, or ongoing work without review
• Consult a tax professional if classification is unclear

Why hire an independent contractor?

Beyond classification, you should understand the benefits contractors offer.

Hiring an independent contractor gives your business flexibility, specialized expertise, and cost control that permanent hires can't match. Here are the key benefits:

• Access specialized skills: Bring in expertise for specific projects without long-term commitments
• Scale your workforce: Increase or decrease capacity based on demand without layoffs or hiring freezes
• Fill roles faster: Contractors in high-demand fields like tech are often available sooner than full-time candidates
• End engagements easily: Most contracts include termination clauses requiring only a few weeks' notice
• Reduce overhead costs: Skip benefits, paid leave, employer taxes, and retirement contributions
• Model cost scenarios: Use your accounting software to compare contractor costs against employee expenses for specific roles
• Limit legal liability: Contractors carry their own insurance and handle their own tax obligations

Contractors often bring strong skills and experience. Choosing self-employment takes confidence, so the contractors you hire are likely to be capable, motivated professionals.

When not to hire a contractor

While contractors offer many benefits, they're not always the best choice.

Contractors aren't the right choice for every role. Hire an employee instead when you need long-term commitment, team integration, or control over how work gets done. Here are specific situations where a contractor may be the wrong fit.

When you're building a team

Consider these situations where an employee makes more sense.

Stable teams perform better over time. Contractors cycling in and out can disrupt communication, slow decision-making, and weaken team dynamics. If the role requires close collaboration with your core team, a permanent employee is usually a better fit.

When you want to invest for the future

Growth-focused roles need a different approach.

Long-term business growth requires people who are invested in your success. Employees build institutional knowledge, develop alongside your company, and contribute to culture in ways contractors typically don't.

Hiring contractors for extended periods often costs more than hiring employees when you factor in higher hourly rates and lost continuity. Use your accounting software to model both scenarios and consult your accountant before deciding.

When you want to develop key HR assets

Skill development is another consideration.

Training takes time and money. When you invest in developing an employee's skills, that knowledge stays with your business. Contractors take their training with them when the project ends, which means you may need to repeat the investment with the next hire.

How much does it cost to hire a contractor?

Understanding costs helps you budget effectively.

Contractor costs vary widely based on skill level, industry, and project scope. Understanding rate structures helps you budget accurately and compare options.

Contractor rate structures

First, understand how contractors structure their fees.

Contractors typically charge in one of three ways:

• Hourly rates: Best for ongoing or variable-scope work; rates range from $25 to $150+ per hour depending on expertise
• Project-based fees: A fixed price for defined deliverables; reduces budget uncertainty but requires clear scope
• Retainer agreements: A monthly fee for ongoing access to the contractor's time; works well for consistent needs

Contractor vs. employee cost comparison

Comparing contractor and employee costs helps you make informed decisions.

Employees cost more than their base salary. When you add benefits, payroll taxes, equipment, and overhead, the true cost is typically 1.25 to 1.4 times the salary.

Contractors charge higher hourly rates but you avoid:

• Health insurance and retirement contributions
• Paid time off and sick leave
• Payroll taxes (Social Security, Medicare, unemployment)
• Equipment, software, and workspace costs

For short-term or specialized work, contractors often cost less overall. For ongoing roles, employees may be more economical.

Hidden costs to consider

Watch for these additional expenses that can affect your budget.

• Onboarding time: Contractors need context to deliver quality work
• Management overhead: Coordinating external workers takes effort
• Revision cycles: Unclear scope can lead to additional charges
• Gaps between projects: You may pay a premium for last-minute availability

How to hire an independent contractor

Once you've decided to hire a contractor, you need a clear process.

Follow these steps to find, vet, and onboard the right contractor for your project.

1. Define the role and deliverables. Write a clear scope of work including tasks, deadlines, and success criteria. Specify whether you need ongoing support or a one-time project.
2. Set your budget. Determine your rate range based on market research and project value. Decide whether hourly, project-based, or retainer pricing works best.
3. Source candidates. Post on freelance platforms, ask your network for referrals, or reach out to contractors directly via LinkedIn.
4. Review proposals and portfolios. Evaluate relevant experience, communication style, and alignment with your project needs.
5. Interview top candidates. Assess skills, availability, and working style. Ask about their process, past projects, and how they handle challenges.
6. Check references. Contact previous clients to verify quality, reliability, and professionalism.
7. Draft and sign a contract. Include scope, payment terms, deadlines, confidentiality clauses, and termination conditions before work begins.
8. Onboard the contractor. Provide access to tools, introduce key contacts, and clarify communication expectations.

Where to find qualified contractors

Sourcing candidates is a critical step in the hiring process.

Finding the right contractor starts with knowing where to look. Here are the most effective channels:

• Freelance platforms:Upwork, Fiverr, and Toptal connect you with vetted contractors across industries
• Professional networks: LinkedIn lets you search by skill, review work history, and reach out directly
• Industry job boards: Specialized sites like Dribbble (design), GitHub (development), or Contently (writing) attract niche talent
• Referrals: Ask colleagues, business contacts, and your accountant for recommendations
• Professional associations: Industry groups often maintain contractor directories or job boards

When posting a job, include a clear description of the project, required skills, timeline, and budget range. Specific listings attract better candidates.

How to vet and interview contractors

After finding candidates, you need to evaluate them carefully.

Thorough vetting reduces the risk of hiring the wrong person. Here's how to evaluate candidates effectively.

Review their portfolio and past work. Look for projects similar to yours in scope and complexity. Quality matters more than quantity.

Check references from previous clients. Ask about reliability, communication, and whether the contractor met deadlines and budgets.

Conduct a skills-based interview. Ask how they would approach your specific project. Listen for clear thinking and relevant experience.

Assess communication style. Contractors who respond promptly and ask clarifying questions tend to deliver better results.

Consider a paid test project. A small paid assignment reveals working style, quality, and compatibility before you commit to a larger engagement.

Red flags to watch for:

• Vague answers about past work or process
• Reluctance to provide references
• Unrealistic timelines or pricing
• Poor communication during the hiring process

Creating an independent contractor agreement

A solid contract protects both you and your contractor.

An independent contractor agreement is a legally binding document that defines the working relationship, protects both parties, and helps establish contractor status for tax purposes.

Essential contract clauses

Start with these fundamental elements.

Every contractor agreement should include:

• Scope of work: Specific deliverables, tasks, and project boundaries
• Payment terms: Rate, payment schedule, invoicing requirements, and expense policies
• Timeline: Start date, milestones, and completion deadline
• Termination conditions: Notice period and grounds for ending the agreement
• Independent contractor status: Statement confirming the worker is not an employee

Protecting intellectual property and confidentiality

Protecting your business information requires specific contract provisions.

If the contractor will be creating original work for you, the contract should specify who owns the intellectual property (IP). You should also include a non-disclosure agreement (NDA) or confidentiality clause to protect any sensitive business information they may access.

• IP assignment: Specify who owns work product upon completion and payment
• Confidentiality clause: Prevent disclosure of sensitive business information
• Non-disclosure agreement (NDA): Consider a separate NDA for highly sensitive projects
• Non-compete provisions: Use sparingly and ensure enforceability in your state

Termination and dispute resolution terms

Clear exit terms prevent disputes when engagements end.

Outline the conditions under which either party can end the contract. Include a clause that defines how you'll handle any disagreements, such as through mediation or arbitration, to avoid costly legal disputes.

• Notice period: Typically 14 to 30 days for either party to end the agreement
• Dispute resolution: Specify mediation or arbitration before litigation
• Governing law: Identify which state's laws apply to the contract
• Final payment terms: Clarify payment for completed work upon termination

Have a lawyer review your template before first use. A solid contract prevents misunderstandings and protects your business.

How to pay and manage contractor expenses

Payment practices affect both compliance and contractor relationships.

Paying contractors correctly protects your business and keeps working relationships strong. Here's what you need to know.

Setting payment terms and schedules

Start by defining how and when you'll pay.

Establish clear payment terms before work begins:

• Payment timing: Net 15 or Net 30 are common; faster payment builds goodwill
• Invoice requirements: Specify format, detail level, and submission process
• Milestone payments: For large projects, tie payments to deliverable completion
• Late payment policies: Define consequences for overdue invoices

Pay on time, every time. Your reputation affects your ability to attract quality contractors in the future.

Understanding 1099-NEC requirements

Tax reporting requirements apply to most contractor payments.

If you pay a US-based contractor $600 or more in a calendar year, you must:

• Collect a completed W-9 form before the first payment
• Issue a 1099-NEC form by January 31 of the following year
• File copies with the IRS by the same deadline; note that businesses filing 10 or more information returns are required to file them electronically.

Track all contractor payments throughout the year to simplify tax season.

Tracking contractor payments in your accounting software

Good record-keeping simplifies tax compliance and budget management.

Use your accounting software to:

• Record each payment with the contractor's name and project
• Categorize expenses for accurate reporting
• Generate reports for 1099 preparation
• Monitor project budgets against actual spending

Cloud-based tools like Xero let you track contractor expenses, send invoices, and prepare for tax filing in one place.

Getting the best results from your contractors

Hiring is just the beginning. Managing contractors well ensures project success.

Strong contractor relationships lead to better work and smoother projects. Here's how to set your contractors up for success.

Set clear expectations from the start. Define deliverables, deadlines, and communication preferences before work begins. Ambiguity leads to frustration on both sides.

Communicate regularly. Schedule check-ins, provide feedback promptly, and make yourself available for questions. Contractors work best when they understand your priorities.

Include them where it matters. Add contractors to relevant meetings, email threads, and project tools. Integration improves output quality and reduces rework.

Track time and costs. Use your accounting software to monitor contractor hours and expenses against your budget. Regular reviews help you spot issues early.

Pay promptly and fairly. On-time payment builds trust and makes contractors more likely to prioritize your work and accept future projects.

You'll find the right balance of employees and contractors for your business needs.

Xero simplifies contractor management

The right tools make contractor management easier.

Managing contractors doesn't have to be complicated. Xero helps you track expenses, send invoices, and stay organized from hire to payment.

With Xero, you can:

• Record contractor payments and categorize expenses automatically
• Generate reports for 1099 preparation at tax time
• Monitor project budgets in real time
• Access your financial data from anywhere

Spend less time on paperwork and more time growing your business. Get one month free and see how Xero makes contractor management simple.

FAQs on hiring independent contractors

Here are answers to common questions about hiring and managing independent contractors.

Is it cheaper to hire a contractor or employee?

It depends on the role and duration. Contractors cost more per hour but you avoid benefits, payroll taxes, and overhead. For short-term or specialized work, contractors are often more economical; for ongoing roles, employees may cost less over time.

How do I classify a worker as a contractor vs. employee?

The IRS evaluates three factors: behavioral control (how work is done), financial control (who pays expenses and provides tools), and relationship type (contract terms and permanence). Workers who control their own methods and serve multiple clients are typically contractors.

What should I include in an independent contractor agreement?

Include scope of work, payment terms, timeline, termination conditions, IP ownership, confidentiality provisions, and a statement confirming independent contractor status. Have a lawyer review your template before use.

How do I pay independent contractors and handle taxes?

Pay contractors according to your agreed terms, typically via check, bank transfer, or payment platform. Collect a W-9 before the first payment and issue a 1099-NEC by January 31 if you paid $600 or more during the year.

Where can I find independent contractors for my business?

Look on freelance platforms like Upwork and Fiverr, professional networks like LinkedIn, industry-specific job boards, and through referrals from colleagues and business contacts.