Contractors typically get paid on a schedule written into the contract: a deposit at signing, progress or milestone payments as the work advances, a retainage held back from each payment, and a final release once the punch list is cleared. On the tax side, the person paying collects a Form W-9 before the first check goes out and files a Form 1099-NEC after year-end for any contractor paid $600 or more. The specific mix depends on the contract type and the size of the job, but every arrangement rests on those two pillars: a written payment schedule and the right federal reporting.
The Payment Schedules Contractors Actually Use
Which schedule applies depends on how the contract prices the work. Each structure shifts risk differently between the client and the contractor.
Fixed-Price
A fixed-price contract sets one total for the whole project. The contractor absorbs cost overruns, and the client gets price certainty. Most fixed-price jobs begin with an upfront deposit that covers early labor and materials. Some states cap that deposit by statute, with limits running from 10 percent of the contract price up to one-third of the total, and other states set no cap at all. If you are the one hiring, check your state’s home improvement rules before agreeing to a large upfront payment.
Time-and-Materials and Cost-Plus
Time-and-materials contracts bill actual hours worked plus the direct cost of supplies. That shifts overrun risk to the client, which is why these contracts often include a not-to-exceed ceiling. Careful timesheets and receipts on both sides are essential, because every hour and every receipt feeds the final number.
Cost-plus contracts work the same way but add the contractor’s profit on top, either as a fixed fee or as a percentage of total project costs. A cost-plus-percentage job might charge actual cost plus 15 percent; a cost-plus-fixed-fee job pays a flat amount regardless of how costs move. The fixed-fee version is more predictable for the client; the percentage version pays the contractor more when the project gets bigger.
Milestone and Progress Payments
Milestone payments release money when specific stages finish. A residential build might pay 25 percent at foundation, 25 percent at framing, and so on. Progress payments follow the same idea but are calculated as a percentage of overall completion rather than tied to named events. Either way, the contract needs to define what “complete” means for each stage. That definition is where most payment disputes start.
Retainage
Retainage is money the client withholds from each progress payment as insurance against defective work. The standard range is 5 to 10 percent of each payment. On a $100,000 project with 10 percent retainage, the contractor would not see the final $10,000 until the punch list is cleared. Many states regulate retainage on public projects, and some cap the percentage or require the withheld funds to sit in an interest-bearing account.
Substantial Completion and the Punch List
A project reaches substantial completion when the client can use the space for its intended purpose, even if minor items remain. In most construction contracts, that milestone triggers the release of retainage and starts any warranty periods. Remaining deficiencies go onto a punch list, typically walked by the general contractor, the client, and often an architect. The contractor assigns each item to the responsible subcontractor with a deadline. Until every item is resolved, the project is not formally closed and final payment usually stays held.
What Has to Be in Writing Before the First Check
Three documents belong in the file before any money changes hands: a signed contract, a completed W-9, and current proof of insurance (plus a surety bond, where the project calls for one).
The contract itself needs to spell out the total price or rate structure, the payment schedule, the retainage percentage, the change-order process, and what triggers final payment. Vague language here is what feeds later disputes.
Before paying a contractor, the hiring party should collect a completed IRS Form W-9. The form captures the contractor’s taxpayer identification number, which can be a Social Security number, an employer identification number, or an individual taxpayer identification number.1Internal Revenue Service. Forms and Associated Taxes for Independent Contractors Keep the W-9 on file for at least four years; the information on it feeds the year-end 1099.
If a contractor refuses to provide a W-9 or supplies an incorrect TIN, the payer must withhold 24 percent of every payment and remit it to the IRS. That is backup withholding, and it applies to all payments for independent contractor services.2Internal Revenue Service. Backup Withholding Withheld amounts get reported on Form 945 at year-end.3Internal Revenue Service. About Form 945, Annual Return of Withheld Federal Income Tax
Ask for a current certificate of insurance showing general liability coverage and, if the contractor has employees, workers’ compensation. Nearly every state requires workers’ comp for employers, though sole proprietors with no employees can often file an exemption. Confirm the policy is active, the coverage limits fit the project, and the certificate names you or your property as an additional insured.
A surety bond is different from insurance. Insurance protects the contractor; the bond protects the client. If the contractor fails to complete the work or does not pay subcontractors, the bond company compensates the client up to the bond amount. Many states require licensed contractors to carry a surety bond, with required amounts varying by license type and project value.
One boundary worth stating: all of this assumes the worker really is an independent contractor. If you set the hours, provide the tools, and direct the daily process, the IRS is likely to treat the person as an employee regardless of what the contract says. Misclassification exposes the hiring party to back taxes, penalties, and interest on unpaid employment taxes, and the IRS weighs the relationship using behavioral control, financial control, and the type of relationship between the parties.4Internal Revenue Service. Independent Contractor (Self-Employed) or Employee? When the classification is genuinely unclear, either side can file Form SS-8 to request a formal determination.5Internal Revenue Service. About Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding
How the Money Moves
Paper checks are still common on smaller jobs because they are simple and leave a built-in paper trail, though they need physical delivery and a few days to clear. ACH transfers move funds electronically between bank accounts. Standard ACH settles the next business day, and same-day ACH is available when timing matters. Most contractors prefer ACH for speed and reliability.
Some contractors accept credit cards, but expect a surcharge. Card networks let merchants pass processing costs along, typically capped at 3 to 4 percent depending on the network. A handful of states prohibit credit card surcharges entirely. On a $20,000 project, a 3 percent surcharge adds $600, so ask about accepted payment methods before signing.
For large projects, third-party escrow services hold funds in a neutral account until the contractor meets defined conditions. The contractor knows the money exists; the client knows it will not release prematurely. Escrow adds cost and administrative work, but on six-figure jobs the security often pays for itself. Whatever the method, request a receipt or paid-in-full acknowledgment for every payment.
Invoices, Receipts, and Lien Waivers
Every invoice should show the contractor’s name and business address, a unique invoice number, a clear description of the work, the amount due, the payment deadline, and accepted payment methods. Itemizing labor and materials separately helps the client match charges against the contract.
On cost-plus and time-and-materials work, the contractor is generally expected to attach original receipts or supplier invoices, because the client is paying actual cost plus a fee. On fixed-price work, the material markup is bundled into the total, so individual receipts usually are not required unless the contract says otherwise. Both parties should keep copies for at least four years, which lines up with the record-retention window for W-9s and 1099s.
On construction projects, lien waivers protect the property owner from a contractor or subcontractor later filing a mechanic’s lien for unpaid work. A conditional lien waiver is signed before payment and only takes effect once the payment clears. An unconditional waiver is signed after payment is confirmed and permanently releases the lien right for that portion of work. The standard practice is to exchange a conditional waiver with each progress payment and an unconditional waiver after the check clears. When subcontractors are involved, the general contractor should collect waivers from every sub who worked on the property. Lien waiver forms are governed by state law, and many states mandate specific statutory language.
Tax Forms When the Year Ends
Anyone who pays $600 or more to a non-employee during the calendar year must file Form 1099-NEC with the IRS and send a copy to the contractor. The rule covers payments made to individuals, partnerships, and estates in the course of a trade or business. Payments to corporations are generally exempt, with the notable exception of payments to attorneys.6Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC
The deadline for filing with the IRS and furnishing the statement to the contractor is January 31 of the following year.6Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC Miss that date and penalties climb quickly. For returns due in 2026:7Internal Revenue Service. Information Return Penalties
- Filed within 30 days late: $60 per form.
- Filed 31 days late through August 1: $130 per form.
- Filed after August 1 or not filed at all: $340 per form.
- Intentional disregard: $680 per form with no annual cap.
Penalties apply per form, so a business that paid ten contractors and missed the deadline entirely faces $3,400 before the IRS looks at anything else. Small businesses with average annual gross receipts of $5 million or less get lower annual caps, but the per-form penalty is unchanged.8Internal Revenue Service. General Instructions for Certain Information Returns
What the Contractor Owes on What They Received
Employees split Social Security and Medicare taxes with their employer. Independent contractors pay both halves. The self-employment tax rate is 15.3 percent of net earnings: 12.4 percent for Social Security up to an annual earnings cap that adjusts each year, and 2.9 percent for Medicare with no cap. Contractors with net self-employment income of $400 or more must file Schedule SE with their annual return. Contractors can deduct the employer-equivalent half of the self-employment tax when calculating adjusted gross income. That deduction does not reduce self-employment tax itself, but it does lower income tax.9Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes)
Because nobody is withholding, contractors generally must make quarterly estimated tax payments using Form 1040-ES. The due dates are April 15, June 15, September 15, and January 15 of the following year.10Internal Revenue Service. When to Pay Estimated Tax Missing them triggers an underpayment penalty that compounds. First-time contractors get caught by this often. The money feels like it is all yours when it lands, but roughly 25 to 30 percent of it, depending on tax bracket, is already spoken for.