Who can receive nonemployee compensation?

Only independent contractors and other workers who aren’t classified as employees can be paid nonemployment compensation. What separates employees from contractors is the level of control you have over when, how and where their work is done. Workers must meet criteria in the following categories to be considered an independent contractor by the IRS.

Financial control. Does your business have the right to control financial aspects of a worker’s job? Examples of this include:

• How is the worker paid? Employees are usually paid by the hour, week or other period of time and guaranteed to receive a wage. Contractors may be paid a flat fee per job rather than wages on a regular basis.
• Who pays for the worker’s tools and equipment? Is the worker reimbursed for expenses? Independent contractors often aren’t reimbursed for their expenses, but employees usually are.
• Is the worker allowed to seek other business opportunities? If you don’t allow them to work for other employers, they are likely to be considered employees.

Behavioral control. This category concerns your right to control the work performed by a worker, even if you don’t exercise that right. Consider:

• Is the worker given detailed instructions about when and where they’re expected to work? If you control their schedule, the worker is probably an employee.
• Do you provide ongoing or periodic training on how you expect work to be performed? Contractors usually don’t receive training and work according to their own methods.
• How is the worker’s performance evaluated? For independent contractors, work is typically evaluated based on the end result of a job. Employees may receive more thorough evaluations on the details and processes of their work.

Relationship. The type of relationship your business has with a worker and how the worker perceives their interaction with you can be used to classify them as an independent contractor or employee.

• Do both you and the worker expect that the employment relationship will continue indefinitely? Independent contractors don’t have this expectation because they perform work for a specific project or period of time.
• Does your business provide benefits to the worker, such as health insurance, retirement contributions, vacation time and sick days? Such benefits are generally not given to independent contractors.
• Is there a written contract between you and the worker that establishes your relationship? This can be helpful in determining whether the worker is an employee or independent contractor, although a contract alone isn’t sufficient proof.

How to pay contractors

Request your worker’s Taxpayer Identification Number

If you’ve determined that a worker should be classified as an independent contractor, you need to have them fill out IRS Form W-9. This form is used to request the worker’s Taxpayer Identification Number (TIN), claims for exemption and certain certifications. It also serves as an agreement that the contractor is responsible for withholding their own taxes from income earned from your business. You won’t send Form W-9 to the IRS, but you’ll use the information provided on it to report payments made to workers on Form 1099.

All independent contractors need to provide you with an accurate TIN on their W-9 before you begin paying them. If a worker doesn’t provide a TIN, you’re required to withhold 24% of all payments made to the worker and remit the amounts to the IRS. This is called backup withholding, and the IRS uses it to ensure taxes are paid in advance when a TIN isn’t provided.

Agree on terms of payment

Independent contractors are most often paid by the project rather than on an hourly or weekly basis. Ideally, you should get an estimate of project costs and arrange payment terms with the contractor before work begins. There are several options to consider:

• Pay half up front and half upon project completion. You can also make payments as specific milestones are met. This is usually the preferred arrangement for both employers and contractors.
• Pay the total amount after the job is complete. This option may not be ideal when the contractor needs funds to work on your project.
• Pay the total amount up front. This can be preferable if you have an established relationship with the contractor and trust them to do the work as agreed.

Whichever method you choose, be sure to keep detailed records of all payments made to the contractor. These payments are considered nonemployee compensation and need to be reported to the IRS via Form 1099-NEC.

Complete Form 1099-NEC

In 2020, the IRS introduced Form 1099-NEC for reporting nonemployment compensation earned by independent contractors. Previously, this income would be reported on the 1099-MISC.

You’re required to file Form 1099-NEC for each worker if all of these conditions apply:

• You paid someone who isn’t your employee.
• The payment was made to an individual, corporation, partnership or estate.
• Payment was for services rendered in the course of your business or trade.
• You paid the worker $600 or more during the year.

Submit 1099-NEC forms to the contractor and the IRS

The deadline for submitting 1099-NEC to each contractor who worked for you and the IRS is on or before the first of February. You need to submit copies of the form to the following recipients:

• Submit Copy A to the IRS with Form 1096, if applicable. Form 1096 provides the IRS with a summary of the information provided on all of the 1099 forms you sent to contractors. This form is only used for paper submissions. If you file 1099 forms electronically, you don’t need to submit Form 1096.
• Give Copy B to the contractor.
• Keep Copy C for your business records.
• Submit Copy 1 to your state’s department of revenue.

Nonemployee compensation FAQs

Do I have to report nonemployee compensation?

Your business is legally required to report all nonemployee payments above $600 a year to the IRS on Form 1099-NEC. If you submit this information late or don’t report it at all, you’re subject to IRS penalties ranging from $50 to $550 per return or statement.

Does an employer have to pay taxes on a 1099 employee?

Workers who receive Form 1099 are considered contractors, not employees, so you aren’t responsible for paying taxes on their earnings. If you improperly classify an employee as an independent contractor, however, you can be held liable for paying employment taxes for the worker.

What is the difference between an employee and an independent contractor?

In general, you have greater control over how, when and where an employee can work for you compared to an independent contractor. Contractors have more freedom over how the job is done and typically pay for their own tools, travel costs and business expenses. If you’re unsure how a worker should be classified, you can request a worker status determination by filing Form SS-8 with the IRS.