As a small business owner, you might hire independent contractors to address business-related needs. When you pay an independent contractor, they receive nonemployee compensation. What is nonemployee compensation?
What is nonemployee compensation?
Nonemployee compensation is the money you pay to an independent contractor who performs work for you. Nonemployee compensation includes fees, commissions, prizes, and awards for services.
You will treat nonemployee compensation differently than employee wages. You do not withhold taxes for an independent contractor because they are not on your payroll.
Before paying nonemployee compensation and reporting the wages, you must determine whether a worker is an employee or an independent contractor.
Classifying a worker: Independent contractor or employee?
You must figure out if the worker receives nonemployee status. Determining whether a worker is an employee vs. independent contractor can be difficult. Misclassifying workers comes with paying back wages, taxes, and possibly penalties and court fees.
To decide between employee or independent contractor status, pay attention to your relationship with the worker. If workers can choose the work they do and how to perform tasks, they are usually nonemployees.
The Department of Labor (DOL) looks at six economic realities (factors) to determine the worker’s status. Here are some questions you need to ask about the worker, according to the DOL:
- Does the worker play an integral role in the business?
- How long has the worker worked for the same company?
- Does the worker use his/her own tools or equipment?
- Who decides hours and pay rate?
- Can the worker earn a profit by performing the job more efficiently?
- Does the worker have a separate business site and/or advertise independently?
Let’s use these questions to answer whether a worker might be an independent contractor or employee. You hire a worker, Clark, to redesign three offices in your business.
- The worker does not play an integral role in business operations.
- Clark has worked for multiple companies for about two months at a time.
- He brings his own tools and decides when he will come in to do work.
- Clark gets paid more as he takes on more projects.
- Clark hands out business cards promoting his services.
You would classify this worker as an independent contractor.
Classifying workers and taxes
Accurately classifying workers is important for filing and depositing taxes. When you have an employee, you withhold taxes from their wages. Once you pay a worker as a nonemployee, the worker must pay self-employment taxes.
Employees and independent contractors pay different tax rates. Withhold federal income tax and FICA tax (Social Security and Medicare taxes) from an employee’s wages. The federal income tax rate is determined by what the employee claimed on their Form W-4. With FICA payroll withholding, you withhold 7.65% of the employee’s wages (6.2% for Social, 1.45% for Medicare). And, you also contribute a matching employer portion of 7.65% of their wages. This totals 15.3% for FICA.
When you pay an independent contractor, you do not withhold taxes from their pay. As a result, you do not need to pay the employer portion for FICA. Instead, the independent contractor pays the self-employment tax rate of 15.3% of their wages. Self-employment tax goes toward Social Security and Medicare taxes, just like FICA. But, the worker pays more in self-employment tax since there is no employer.
What if the worker thinks you’ve misclassified them?
If there’s suspicion that the worker was misclassified, you or the worker can submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, to the IRS. This form requests that the IRS review the situation and make an official determination.
If you paid an independent contractor $600 or more, you need to file Form 1099-MISC, Miscellaneous Income.
In order to fill out Form 1099-MISC, the independent contractor needs to complete Form W-9, Request for Taxpayer Identification Number and Certification, when they begin work for you. Form W-9 tells you the worker’s name, Taxpayer Identification Number (TIN), and address, which you need to complete Form 1099-MISC.
Form 1099-MISC Box 7
Report nonemployment compensation in Box 7. Here is an image highlighting Form 1099-MISC Box 7, courtesy of the IRS:
When you complete Form 1099, send a copy to the independent contractor, the IRS, and the state tax department (if applicable). Save a copy of the form for your records. Form 1099 should be received by all parties by the 1099 filing deadline, January 31 of the year following payment.
If you file Form 1099, you must also fill out Form 1096, Annual Summary and Transmittal of U.S. Information Returns. Be sure to send Form 1096 to the IRS and state department (if applicable) when you send them Form 1099. Keep a copy for your business records as well.
Where to get 1099 forms
Some 1099 software providers give you access to unlimited Forms 1099 and 1096. Regardless of if you have one or 20 independent contractors working for you, you can create and print the forms easily.
If you don’t use 1099 software, you can order Forms 1099 and 1096 from the IRS.
Correcting Form 1099-MISC after it has been filed
If you make an error on Form 1099-MISC, you must issue a corrected 1099. First, identify the type of error you made on the form. Then, enter the correct information and check the “corrected” box on a new Form 1099. You are also required to complete a new Form 1096.
After the new forms have been completed, mail Form 1099 to the independent contractor, the IRS, and the required state tax department (if applicable). Keep a copy for your records. Send a corrected Form 1096 to the IRS, any state tax departments, and keep one for your records.
Examples of nonemployee compensation
Sometimes, it’s not easy to tell who is an independent contractor. Here are three examples to help you make that decision.
Let’s say you own a flower shop. You make deliveries with a company van, but one day the van breaks down. You pay an independent mechanic (who does not work for an employer) $800 to fix the van. You paid the mechanic with nonemployee compensation.
You need to send the mechanic Form 1099. In the nonemployee compensation box, 1099-MISC Box 7, you will write $800. When you pay the mechanic, you do not withhold federal income tax or FICA tax (Social Security and Medicare taxes), which you would do with an employee.
Still the owner of the flower shop, you also own a car that is your personal vehicle. You do not use your personal car for business operations. Your car also needs to be fixed, so you pay the same mechanic $600 to repair it.
Because the mechanic is fixing your personal car (not a business vehicle), you do not need to give him Form 1099. The mechanic is not an independent contractor doing work for your business.
Now let’s say you hire a freelancer to run your company’s website. You paid her $2,500 throughout the year to run the website. As a freelancer, she is not your employee. Instead, she is an independent contractor. You paid her $2,500 in nonemployee wages.
Enter $2,500 in the nonemployee compensation box (Box 7) and send her a copy of Form 1099. Again, you will not withhold taxes from her paycheck.
Key points on nonemployee compensation
Workers who receive nonemployee compensation are independent contractors, not your employees.
- The independent contractors must do work for your business for payment to be nonemployee compensation.
- Fill out Form 1099-MISC for each independent contractor you pay. Send a copy to the worker, the IRS, the state tax department (if applicable), and keep one for your records. Send Form 1096 to the IRS and state tax department (if applicable), and keep one for your records.
- Do not withhold taxes from nonemployee compensation.
Do you hire independent contractors to do work for your business? Patriot’s online 1099 software helps you pay, record, and report nonemployee compensation. You can print as many Forms 1099 and 1096 as you need. Try it for free today!
This article was updated from its original publication date of July 15, 2013.