Report nonemployee compensation right with our 2024 business owner's guide
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.
- 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.
- 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.)
