The new 2020 IRS Form W-4 eliminated withholding allowances. However, many states continue to use withholding allowances to determine state income tax withholding.
Typically, employers provide hourly or salary wages to workers. However, some business owners pay commission to employees. What is commission?
What is commission pay?
Commission is what you pay to employees when they make a sale or accomplish some other goal. Commissions can be a percentage of a sale, or they can be a flat amount based on the sales volume. These types of payments are based on results. Sales positions, like a car salesman or real estate agent, commonly earn commissions.
Let’s say your employee is a salesman. The employee sells a $1,000 computer and receives a 6% commission on the sale. That means the employee earns $60 in commission income for selling the computer.
The IRS classifies commission as a type of supplemental pay. Supplemental wages are payments made to an employee that aren’t regular wages. Other types of supplemental wages include bonus payments, overtime pay, accrued personal time off, and back pay.
You provide commission payments either as an employee’s sole wages or in addition to regular wages.
Salary vs. commission
With a regular salary, you pay an employee a set amount of wages. Salaries are given regardless of whether the employee sells anything or not. Commission, on the other hand, is determined by an employee’s sales.
Some businesses choose to offer a base salary and commissions. This guarantees the employee will go home with wages even if they don’t receive any commissions. Think of waiters and waitresses—they make lower wages in addition to the ability to accept tips. Or, you can choose to pay employees only in commissions.
You can also choose to offer capped or uncapped commissions. With a capped commission, the employee can only earn up to a certain amount. For example, they can receive up to $20,000 in commissions. An uncapped commission means the employee can earn as much in commissions as they are able to sell.
Some businesses that have commission-based employees and employees who are salaried choose to put a cap on commissions. This way, the salaried employees do not feel like the commission-based employees earn a lot more than them.
Commission-based pay laws
You are required to provide overtime pay to nonexempt employees. Overtime pay is time and one-half for hours worked over 40 per workweek.
If a commission-based employee meets the following three conditions, you are not required to offer overtime pay to them:
- The employee is employed by a retail or service establishment
- The employee’s regular rate of pay is more than one and one-half times the state’s minimum wage for every hour worked in a workweek in which overtime hours are worked
- Over half the employee’s total earnings in a representative period consist of commissions
According to the FLSA, the representative period is set by the employer, and it must be at least one month but not more than one year.
For more information on these FLSA requirements, consult the U.S. Department of Labor.
Taxes on commission income
As an employer, you are required to withhold taxes on commissions. You need to withhold payroll and federal income taxes.
You withhold payroll taxes on commissions the same way you do for regular wages. Payroll taxes include Social Security and Medicare taxes, which are flat rates you withhold from each employee’s wages. Social Security and Medicare taxes are known as FICA tax. The FICA tax rate is 7.65% (6.2% for Social Security and 1.45% for Medicare). And, you contribute a matching amount for FICA tax. There is a Social Security wage base as well as an additional Medicare tax you need to know about.
According to the IRS, you must withhold federal income taxes for commissions differently than regular wages. For commission income paid in addition to regular wages, you might be wondering what the commission tax rate is.
As supplemental wages, there are two ways you can tax commission payments for federal income. You can either use the percentage or aggregate method. If an employee receives more than $1 million in supplemental wages, there is a separate commission tax rate for the excess money.
The percentage, aggregate, and <$1 million methods all show you how much to withhold for federal income tax.
With the percentage method, you tax the employee’s regular wages and their commission separately. Withhold a flat rate of 22% on the employee’s commission income for federal income tax. And, you withhold taxes on the employee’s regular wages like normal.
The amount you withhold using the aggregate method is based on an employee’s claimed withholding allowances on Form W-4. Use the employee’s claims on Form W-4 in conjunction with IRS Publication 15 to determine how much to withhold.
For the aggregate method, you need to combine an employee’s commission income and regular wages paid at the same time if you decide to use the aggregate method to calculate federal income tax.
This method is more complex than the percentage method, so here’s a step-by-step process:
- Add the commission income and regular wages.
- Using the employee’s number of personal allowances and Publication 15, find the total amount to withhold on the total income (commission income + regular income).
- Find the tax amount for just the regular income.
- Subtract the taxes withheld from the regular income from the total tax amount to find the commission tax amount.
- Withhold the amount you find in Step 4 from the commission income.
In some cases, you will withhold less in taxes using the aggregate method than the percentage method. However, the employee will be required to pay the same amount in taxes come tax return time, regardless of the method you use.
<$1 million in supplemental wages
You also need to know how to handle federal income taxes if your employee earns over $1 million in supplemental wages in one calendar year. Under these rules, you must withhold 37% of the employee’s supplemental wages that exceed $1 million.
Make sure you keep records and stay organized so you run payroll correctly and legally for commission and regular pay. Although taxes on commission are different than taxes on regular wages, getting commission-based employees set up on your payroll doesn’t have to be a challenge.
If you use payroll software, you can specify the type of payment you give employees. For example, you can select regular wages, commission, bonuses, etc. And, the software withholds taxes on commission wages, so you don’t need to calculate the values by hand.
Ready to simplify payroll at your small business? Patriot’s online payroll software makes it easy to pay commission-based employees. Simply select the type of pay and let our software do the rest. Get your free 30-day trial today!
This article was updated from its original publish date of May 3, 2012.
This is not intended as legal advice; for more information, please click here.