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Understanding the particulars of nonemployee compensation (and how independent contractors get paid) is important if you’re considering hiring freelancers to complete work for your business. In some ways, “nonemployee compensation” is exactly what it sounds like: you pay people to perform tasks (or complete projects) for your company who are not on your payroll as employees. Instead, you pay them as independent contractors, and they handle taxes on their own.
Even if you are unsure if this type of talent is the right fit for your business, their ranks are growing: Nearly 15% of workers in the US labor force are independent contractors, according to 2023 data from the National Bureau of Economic Research. So, it’s likely there’s a freelancer on the market who can be of service if you need help down the road. But before getting started, it’s important to understand the ins and outs of classifying independent contractors to ensure that you handle nonemployee compensation correctly (and avoid unwanted attention from the IRS).
In this guide, we’ll cover some ways to prevent confusion when classifying contractors, why it’s important to get this right, and forms to complete so everything is in order when tax time comes around.
What is nonemployee compensation and who receives it?
Nonemployee compensation is any money, fees, commissions, prizes, or awards that are paid by a business to an independent contractor who performs tasks or provides services, but is not a full-time employee. Compensation for these workers is slightly different than compensating employees (and processing the payroll taxes that come with it). That’s because employers withhold income, Social Security, and Medicare taxes (which make up FICA) from their employees’ paychecks, while independent contractors are responsible for calculating and paying their own self-employment taxes.
But how do you know whether an employee is an independent contractor or a staff employee? This is an important question because, according to a report commissioned by the U.S. Department of Labor, up to 30% of employers, if not more, have misclassified workers at some point.
Let’s take a look at some of the characteristics the IRS uses to define each type of worker.
How to classify your workers without confusion
Though it can be a little tricky, business owners must determine whether a worker is an employee or an independent contractor before paying them. Misclassification can lead to tax liabilities and penalties courtesy of the IRS (even if you unintentionally misclassify a worker). Later in the article, we have more information on what to do if you need to fix a misclassification.
To avoid any mix-ups, the IRS suggests employers consider factors like behavioral control, financial control, and relationships between parties when classifying workers.
Behavioral control
- Generally, do you direct a worker to complete specific projects, provide training, or generally have a laundry list of instructions they need to follow to complete a job?
- It’s likely they’ll be considered an employee.
- If workers get to choose the work they do (and how it gets completed)
- They usually fall into the category of independent contractor.
Financial control: Significant investment in tools or equipment
- Another important factor in classifying a worker is evaluating their level of financial control, meaning are their expenses coming “out of pocket” for any tools or equipment that’s necessary to complete the job? For example, are they purchasing software, maintaining vehicles used for work purposes, or making any other investments to complete tasks effectively?
- In this scenario, they’re most likely an independent contractor.
- Is the person using tools, programs, or software applications you pay for and provide?
- Chances are they fall under the category of employee.
What’s the relationship between the parties?
Written contracts
The nature of the relationship between your business and the person you’re handing projects to can also play a key role in deciding their worker status. To avoid confusion (or conflicts), having a written contract that outlines specific terms regarding project completion timeframes, payment schedules, and expectations on both sides can help establish a clear understanding of each party’s responsibilities.
Benefits
In some cases, employees may receive benefits like health insurance or access to retirement programs from their employers; however, independent contractors typically are not eligible (and don’t expect) to receive benefits from the companies they’re completing work for.
On top of the items the IRS advises being mindful of, the Department of Labor (DOL) takes a closer look at six different factors that can go a long way in determining a worker’s status. Though there’s a bit of overlap between the guidance provided by the two government entities, it is still useful to understand the DOL perspective:
- How essential are the worker’s contributions to the employer’s business?
- How long has the individual worked for the same company?
- Is the worker performing tasks with their own supplies, tools or equipment?
- Who is deciding on the hours being worked and rate of pay?
- Were there opportunities for the worker to make a profit by getting the job done more efficiently (or can they suffer a loss from an investment)?
- Does the worker market services to other potential clients and have a separate site where they conduct business?
This is a lot to keep up with. So, we asked Romeo Razi, a former IRS revenue agent and current CPA who is also teaching a worker reclassification course on CPAAcademy.org, for his thoughts. “At the end of the day, tax courts look at all the factors, weigh them, and whatever has more weight is the direction they go,” he explains. But generally, a good rule of thumb, he says, is to think of it this way:
- Is this person paid by the hour?
- Does the boss direct their work and tell them what to do?
- Is the person using the boss’s computer and provided equipment to complete a job?
(If yes, the likelihood is that this person is an employee.)
On worker classification
“At the end of the day, tax courts look at all the factors, weigh them, and whatever has more weight is the direction they go.”
— Romeo Razi, CPA, former IRS revenue agent, and founder of TaxedRight
On the flip side, let’s say you hire a person to help with a marketing campaign, and they take the reins to:
- Establish the timeline
- Come up with the costs
- Determine the deadline
- And pay for and use their own equipment, software, and tools to get the job done
(If yes, then the individual is likely an independent contractor.)
For more guidance on worker classification, we have a separate resource on W-2 employees vs independent contractors.
Now that we’ve covered the considerations when classifying workers you hire in detail, let’s look at how this affects filing and tax deposits.
Reporting nonemployee compensation correctly
Once you have worker classification under control and decide to bring a nonemployee in to complete work, ask them to provide you with a completed Form W-9 before they begin work or you start paying them. This is important because you need the contractor’s taxpayer identification number (TIN) in order to report to the IRS any payments that you make to the contractor.
Once you have that information, remember that you report nonemployee compensation using Form 1099-NEC (Non-Employee Compensation) if you pay an independent contractor $600 or more. Equally importantly, you are responsible for reporting this information annually on or before January 31.
For more details, next read our guide on how to complete and file Form 1099. Also, when you file Form 1099, you are also responsible for completing Form 1096, Annual Summary and Transmittal of U.S. Information Returns. You’ll want to:
- Send the completed Form 1096 to the IRS
- If applicable, any state departments
- Keep a copy on file for your reference
Steps to correct worker misclassification
So what happens in the event a worker is misclassified and a state or federal authority steps in to reclassify them? Employers could end up owing back taxes or back wages to employees, and in some cases, there could be penalties. Once more, we caught up with Razi to provide some insight into what could happen should errors come to pass, even if they’re not intentional. “In simplest terms, if you misclassify a worker and the DOL, state unemployment division, or the IRS reclassifies them, you will be on the hook for 50% of the FICA, state unemployment, and workers’ comp for any employees that need to be addressed, so these numbers could add up.”
“In simplest terms, if you misclassify a worker and the DOL, state unemployment division, or the IRS reclassifies them, you will be on the hook for 50% of the FICA, state unemployment, and workers’ comp for any employees that need to be addressed, so these numbers could add up.”
— Romeo Razi, CPA
Taking action against worker misclassification
If you accidentally misclassify a worker as a nonemployee and need to address any taxes you owe or reclassify them as employees, Razi recommends business owners look into a voluntary classification settlement program (VCSP) the IRS offers.
The program is designed for taxpayers who want to reclassify their employees as employees for employment tax purposes in future tax periods (and possibly receive partial relief from federal employment taxes). “So if you have been misclassifying workers and owe taxes, you can apply for this voluntary program, and the IRS will make a determination,” Razi explains. “There are times where employers end up paying a tenth of what they would normally pay in back taxes owed, but it depends.”
To start the process, you need to complete Form 8952, or Application for Voluntary Classification Settlement Program (VCSP)
In most cases, businesses must “promise not to classify people incorrectly again,” he says. At the end of the day, this path should involve an accounting professional. “If you’re misclassifying workers or unsure what the obligations are, it’s a good idea to talk to a tax professional,” he says. “And this IRS program is something you can look into as well.”
Employees and employers can complete Form SS-8
On the flip side, employers should know that if an employee feels that they have been misclassified, “they are able to communicate this to Uncle Sam using Form SS-8,” explains Razi. The form is also known as (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). The IRS could then review the situation and make a determination.
In addition, employers that are unsure how to classify their workers can also complete Form SS-8. While waiting for a response from the IRS, employers should treat workers whose classification is in question as employees. All fair wages and taxes should be reported and/or withheld for such employees.
Before we wrap up, let’s look at an example of how nonemployee compensation might work in practice.
A nonemployee scenario
Let’s say you need to get your website’s blog up and running, but you don’t have anyone on your full-time staff who has experience writing or editing content. You get referred to a creator named Ashley, who has years of experience developing content for websites (and who has other customers). You share what you are looking for, and she decides to work with you. After the meeting, you agree to pay $5,000 for Ashley to handle the blog, and she agrees to:
- Research the topics and create the schedule of when content will post
- Drafts, edits, and writes the articles
- Works from her home office (on her own laptop)
- Post the articles to your website after you provide credentials to your company’s content management system (which she accesses remotely).
This is an example of a freelancer who is an independent contractor. By January 31, you’ll enter $5,000 on 1099-NEC (and be sure to send her a copy as well).
Navigating nonemployee compensation is a good idea
Before working with freelancers or independent contractors, it can be a good idea to develop a full understanding of nonemployee compensation (and how to properly classify these workers). Doing so will keep you from running into any headaches when it comes to managing the paperwork you need to keep on file and reporting what you’ve paid these workers to the federal government. And if you have questions or wondering how an outside vendor can help, it could be time to see how a full service payroll plan can reduce time spent on these tasks.
Good luck as you grow your workforce, whether they are workers within or outside of your organization.
Please note all material in this article is for educational purposes only and does not constitute tax or legal advice. You should always contact a qualified tax, legal or financial professional, in your area for comprehensive tax or legal advice.
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.