​What Is Nonemployee Compensation? A Comprehensive Guide for Businesses

In 2023, almost 12 million Americans worked as independent contractors, freelancers, and gig workers. These workers, frequently classified as nonemployees, provided services in industries ranging from arts and media to business consulting, construction, and real estate. Rather than working on an organization's payroll, they received nonemployee compensation for services provided under a contractual arrangement.

According to guidance from the IRS, a nonemployee is not economically dependent on an employer for their work. Classification depends on factors such as the role's degree of permanence, how much and what kind of control the worker has over what they do, and how integral the work is for your business operations.

Because misclassifying workers can result in legal penalties and fines, it's essential to classify workers under applicable laws including the Fair Labor Standards Act and understand how employees and nonemployees may be part-time workers and what that means for tax purposes.

Defining Nonemployee Compensation

Nonemployee compensation can refer to payments made to workers who are not employees under the applicable laws for services provided. Because they are not employees, these workers are responsible for paying their own taxes, and they may not receive benefits.

According to the IRS, nonemployee compensation is characterized by:

• No employer-employee relationship
• No withholding of income taxes, Social Security, or Medicare taxes
• No benefits such as health insurance, retirement plans, or paid time off. (Note that some states do require time off for gig workers.)
• Payment based on completed projects or services

Examples of Nonemployee Compensation

Independent contractors, freelancers, and certain gig workers can receive nonemployee compensation in various forms:

• Freelance Payments: Payments to designers, writers, photographers, programmers, and other freelance professionals for completed projects or deliverables.
• Consulting Fees: Payments to business consultants, marketing professionals, financial consultants, or legal consultants for advisory services.
• Professional Service Fees: Fees paid to attorneys, accountants, IT specialists, maintenance/repair professionals, and other providers for independent professional services.
• Gig Worker Compensation: Payments made for individual services provided by gig workers such as ride-share drivers, food delivery drivers, or musicians.

Employee vs. Nonemployee Compensation: Key Differences

There are several differences between the types of compensation received by employees and nonemployees. Employee compensation is paid to individuals classified as employees of a company. In contrast, nonemployee compensation is paid to independent contractors, freelancers, or other self-employed individuals who provide services to a company but are not on the payroll.

These differences affect workers in several ways:

1. Tax withholding: Employers must withhold income taxes, Social Security, and Medicare taxes for employees as part of their employee compensation. For nonemployee compensation, no taxes are withheld by the company. Independent contributors must pay their own self-employment taxes.
2. Benefits: Employees typically receive benefits, including health insurance, retirement plans, and paid time off. Nonemployees typically do not receive these benefits.
3. Control and autonomy: Employees work under the direct supervision and control of the employer. Nonemployees have greater autonomy over how, when, and where they complete their work.
4. Employment protections: Employment laws and protections, such as those establishing minimum wage, overtime, and anti-discrimination protections, may not apply to nonemployees.

Understanding Worker Classification

Correctly classifying workers as either employees or independent contractors helps to protect your business from potential penalties. It also can help you ensure your compliance with tax and employment laws.

Misclassification may expose organizations to substantial legal and financial consequences, including back taxes, penalties, interest, and liability for unpaid benefits and wages. Improper classifications could also result in costly litigation and damage to your company's reputation. These issues can create operational disruptions, drain financial resources, and establish ongoing compliance challenges for businesses.

IRS and DOL Guidelines

Correctly classifying a worker may seem straightforward, but working relationships can become complex depending on the nature and extent of the work provided. To ensure accurate worker classification, the Internal Revenue Service (IRS) and Department of Labor (DOL) have created several guidelines and tests employers can use:

• IRS Behavioral Test: Does the company control what the worker does and how they do it? If so, they should be classified as employees.
• IRS Financial Test: Does the worker have a say in the method of payment? Do they have the chance to profit? Can they seek their own business opportunities without the direction of the company? If so, they should be classified as a nonemployee.
• IRS Relationship Test: Does the worker receive benefits from the company? Is the relationship governed by a written contract, and is their work a key aspect of the business? If so, they should be classified as an employee.
• DOL Economic Reality Test: The economic reality test lists 6 factors that should be considered when classifying a worker. Each of these is considered significant, but none are definitive. Companies can use these factors to evaluate a worker based on issues like degree of relationship permanence, nature and degree of control, independent marketing, and others.

If you are still unsure how to classify a worker, you can request a determination from the IRS using Form SS-8. Once a determination has been issued, it is binding and will be used as the basis for future tax matters.

Tax Implications and Filing Requirements for Nonemployees

Because nonemployee compensation is taxed differently from employee wages, businesses must understand the nuances and requirements for both.

Key differences for nonemployee compensation filing include:

• Tax Withholdings: Unlike employees, independent contractors and other nonemployees must handle tax obligations themselves, including income taxes, Social Security, and Medicare taxes.
• IRS Form 1099-NEC: Instead of receiving a W-2 form, nonemployees should receive a 1099-NEC form reporting their earnings. Based on this form, they are responsible for paying the full 15.3% self-employment tax (covering both the employer and employee portions of Social Security and Medicare), plus income tax on their earnings.
• Form 1099-NEC Filing Deadline: If your business pays a nonemployee $600 or more during the tax year, you must file Form 1099-NEC with the IRS and provide a copy to the recipient by January 31st of the following year. Failure to meet the deadline will result in penalties.

How To Report Nonemployee Compensation With IRS Form 1099-NEC

Be sure you have obtained a completed W-9 form from each contractor before making payments. This form can help you confirm their taxpayer identification number and address for reporting purposes.

To report nonemployee compensation, follow these steps:

1. Fill out the form with the contractor's legal name, business name, personal address, Social Security Number or Taxpayer Identification Number, and payment details
2. File Copy A with the IRS
3. Send Copy B to your contractor
4. Keep Copy C for your records

Best Practices for Managing Nonemployee Compensation

Working with independent contractors can help you reduce hiring and workforce costs, connect you with skilled individuals who add value to your existing teams, add workforce flexibility, and increase project efficiency.

Here are 5 best practices that can help you fully realize your potential while maintaining proper documentation and avoiding penalties.

• Implement Payroll and Accounting Software: Simplify nonemployee compensation tracking and manage contractors more efficiently with payroll and accounting software. These systems automatically flag contractors who meet the $600 reporting threshold, generate necessary tax forms, and handle electronic filing with the IRS.
• Create Clear Contractual Agreements: Develop comprehensive written agreements for all nonemployee relationships. These agreements should clearly define the scope of work, deliverables, payment terms, and independent contractor status. They should also explicitly state that contractors are responsible for their own taxes.
• Maintain Thorough Documentation: Create a standardized contractor onboarding process that includes signing contracts and collecting completed W-9 forms before issuing any payments. Document all communications about project changes, payment adjustments, or relationship modifications. This comprehensive paper trail simplifies year-end reporting and protects you during potential IRS audits or classification disputes.
• Establish Consistent Payment Processes: Create standardized processes for invoice approval, payment processing, and record-keeping. Set clear payment terms with all contractors (net 30, net 15, etc.) and adhere to them consistently. Payroll software can simplify this process by automating payments, recording transaction details, and creating reliable tax documentation.
• Conduct Regular Classification Audits: Review contractor classifications annually to identify potential misclassification issues before they trigger costly penalties. Use the IRS and DOL tests to examine factors like the contractor's degree of control, financial relationship, and integration into your business operations.

Consider consulting with an HR professional or tax professional to review your classification criteria.