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Updated: May 25, 2023
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.
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.
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.
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.
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:
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:
(If yes, the likelihood is that this person is an employee.)
“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:
(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.
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:
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
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.”
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.
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:
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).
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.
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.