If you’ve ever hired an independent contractor or outside expert to do work for your small business, you need to understand what non employee compensation means. Below, we’re explaining what non employee compensation is, why it’s important to properly classify your workers, and how and when to report non employee compensation when filing your taxes.
What is non employee compensation?
Non employee compensation is the money you pay individuals who aren’t employees in your business, but who contribute work or expertise to your business. Think: independent contractors, consultants, and people who work for subcontractors and temp agencies. Non employee compensation can include fees, commissions, prizes, and awards for services completed.
As a small business owner, not only do you need to properly pay individuals who do work for your business, you also need to correctly report those payments.
Classifying your workers: employees versus non employees
For compliance and tax purposes, it’s crucial that you accurately classify the people who work for and with your business. Generally, these people fall into one of two categories: employees and non employees, commonly referred to as independent contractors.
An employee is someone who works for a single employer on a regular basis. An independent contractor, on the other hand, is usually a self-employed individual who’s contracted out by various employers to perform specific services or complete particular projects, either on an ongoing or short-term basis.
Employees and non employees don’t just operate differently in the workplace—they’re also treated differently. Here are some of the key differences between independent contractors and employees:
Expertise: Employees receive training for the jobs they’re hired for. Independent contractors, however, are hired because of their expertise and usually receive no training as a result.
Work processes: Employees are required to follow employer instructions when it comes to how and where they work. Independent contractors, however, can dictate how, when, and sometimes wherever they work. Employees use employer equipment and tools, while independent contractors are responsible for procuring and using their own equipment and tools to do work.
Compensation: Employees are usually paid a salary or hourly wage with weekly or bimonthly paychecks. Independent contractors generally charge per project or per hour, and invoice on their own schedule.
Benefits: Many employees are entitled to benefits from their employers, like health insurance and paid time off, but independent contractors don’t receive any benefits from the people they work with.
Protections: Most employees are protected by state or federal wage and hour laws (for overtime, breaks, and minimum wage requirements), workplace safety laws, employment discrimination laws, and retaliation laws. However, independent contractors generally don’t receive the same protections.
How to classify workers: 3 factors to consider
In most cases, classifying workers is straightforward. However, there are certain instances—like when you’re hiring a temp worker for three weeks, for example—where it can be tricky to know if someone is an employee or non employee. In those cases, the Internal Revenue Service (IRS) recommends examining three areas: behavioral control, financial control, and the individual’s relationship to the employer.
Behavioral control
Behavioral control refers to how individuals work, and how much control an employer has over a worker. Employees typically work set hours in a specific location determined by their employer. They use the company’s tools, equipment, and resources to perform their job, and they don’t usually have the authority to hire someone else to assist with their tasks. With an employee, the employer oversees the details of how the work is performed as well as the outcome, and generally conducts a performance review.
Independent contractors, meanwhile, have much more control over how they work. They usually dictate when, where, and with whom they’ll work, and they use their own equipment and tools. Most contractors also have the authority to hire other workers to assist them with their jobs. Unlike with an employee, employers don’t usually oversee a contractor’s work process—just the final result of the job or service.
Financial control
Financial control refers to how much financial autonomy a worker has relative to how much control over compensation and payment terms an employer has. Though employees are entitled to ask for a raise or negotiate their wages, employees’ wages are ultimately dictated by their employers. Employees are paid an hourly or salary wage, and get paid on a bi-weekly or monthly schedule. Employees aren’t usually responsible for paying for their own work tools and equipment; their employer covers those needs.
Independent contractors, however, set their own rates and create their own payment terms. They may charge per hour or per project, or set a monthly retainer fee for clients that have regular needs. Contractors invoice for their time or deliverables on their own schedule, and may request a percentage of the total payment upfront, or ask for the invoice to be paid with net 15 or net 30 terms.
Relationship to employer
The last factor to consider is the worker’s relationship to the employer. Employees perform work that’s essential to a business’s operations and usually get hired for an indefinite period of time.
Contractors, on the other hand, perform short-term, specialized work that may or may not be essential to a business’s operations. For example, an electrician might install new lighting in your office space. Or a diversity, equity, and inclusion (DEI) specialist might advise you on your employee compensation plan.
The Department of Labor (DOL) also has a similar set of factors to review, broken down into six categories or questions:
The extent to which the worker’s services are an integral part of the employer’s business (Does the worker perform the type of work the employer does for their clients/customers?)
The permanency of the relationship (How long has the worker worked for the same company?)
The amount of the worker’s investment in facilities or equipment (Does the worker use their own tools?)
The nature and degree of control by the employer (Who sets the pay rate?)
The worker’s opportunities for profit and loss (Can the worker earn a profit by performing the job more efficiently?)
The level of skill required in performing the job and the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent enterprise (Does the worker have a separate website advertising their services?)
Want a fast way to check your worker classification? Check out our handy infographic to find out whether someone is an employee or a contractor.
Tax classifications for employees versus non employees
There are three important differences in tax classifications for employees versus non employees:
Employees get taxes withheld from their paychecks; non employees are responsible for calculating their own withholding. With part-time and full-time employees, you withhold money from their wages to cover state and federal income tax, Social Security, and Medicare taxes. When you pay a non employee’s bill, you don’t withhold any amount for taxes.
Employees and non employees are taxed differently. The amount you withhold from an employee’s paycheck depends on how much they earn and what they claim on their W-4 forms. However, according to the IRS, the Social Security tax rate is 6.2% for the employer and employee each (12.4% total), and the Medicare tax rate is 1.45% for the employer and employee each (2.9% total). That matches the self-employment tax rate, which is 15.3% (12.4% for Social Security and 2.9% for Medicare).
You use different forms to report to the IRS for employees and non employees. To report employee compensation, you ask employees to fill out Form W-2, then you file Forms 941, 943, 944, or 945. For non employee compensation, you fill out Form 1099-NEC, which used to be Form 1099-MISC (more on this later).
What do you do if you misclassify a worker?
If you accidentally misclassify a worker, either you or the worker can submit Form SS-8 to the IRS. This form requests that the IRS make an official determination of worker status for the purpose of federal employment taxes and income tax withholding.
Benefits of hiring an independent contractor
There are a multitude of reasons why you might need to hire an independent contractor. You may want temporary marketing support to fill in the gaps after your full-time marketing manager quits, for example. Or you might need to hire an HR consultant to update your employee handbook. Or maybe you just want help with a few projects you and your employees don’t have the bandwidth for.
No matter your reason, here are some benefits of hiring an independent contractor:
You don’t have to train a contractor; you hire them for their expertise and knowledge.
You don’t have to oversee their work process.
You don’t have to provide a performance review.
You don’t have to pay for their tools or materials.
You don’t have to provide them with benefits.
You have a lot of flexibility in how and when you hire contractors.
You can save money on full-time employee costs, like a yearly salary, bonuses, and benefits.
You don’t have to go through the process of firing and rehiring someone if you no longer need their support.
Examples of non employee compensation
To get a better idea of what non employee compensation looks like, here are three examples:
Example 1
You hire a freelance web designer to overhaul and redesign your business’s website. That includes creating a blog resource section, redoing your landing page, adding a customer support chatbot, and updating and reorganizing your web pages, among other things.
The web designer agrees to charge a flat rate of $15,000 and invoices you for 50% of the money upfront. You’ll need to save this invoice, fill out a 1099-NEC form and write the total amount as $15,000, then send a copy to the web designer.
Example 2
You hire a contractor to renovate your business’s storefront, which will include installing a new customer service counter, tearing down a wall, and adding new tile flooring. The contractor has a team of professionals who come with them, and estimates that the renovation will take four to six weeks. The contractor quotes you an estimated price of $30,000, invoices you for $10,000 upfront, then bills you by the hour every week.
You need to save your invoices, fill out a 1099-NEC form with the total amount of the project once it’s complete, and send a copy to the contractor.
Example 3
You hire a social media manager to consult for your business, create a social media content calendar for the next six months, and manage your accounts for that period of time as well. The social media manager sets a retainer fee of $5,000 per month, and invoices at the beginning of each month.
As with the other examples, you’ll need to file your invoices away, fill out a 1099-NEC form with the total amount for $30,000, and send a copy of the form to the contractor.
How to pay non employees
Paying non employees works differently than paying employees, but it’s fairly simple. Follow these steps to pay non employees:
Agree on payment amount and terms: Make sure you agree in writing (whether via email or through a signed contractor agreement or statement of work) on the payment amount and terms. That includes how much money you expect to owe the contractor, when the payment is due, how the contractor would like the payment delivered, and what will happen if payment is late.
Have the contractor fill out Form W-9: Send the contractor Form W-9, which they’ll fill out with their basic contact information, social security number or business ID number, and signature.
Pay according to the contractor’s terms: Once you agree with the contractor’s terms, make sure you abide by them, whether that means paying within net 30 or sending a check on the first day of every month.
Keep records: Save copies of the initial payment agreement or contract, the contractor’s invoices, your payment receipts, and the contractor’s W-9 form for tax time.
For more information on paying a 1099 contractor, read our guide here.
How to report non employee compensation
Just like you file employment taxes for your employees, you’re required to report non employee compensation on your tax return come tax season. Here are the IRS forms you need and all the steps to report your workers:
1. Download Form 1099-NEC
If you paid any non employee $600 or more in a calendar year, you need to download and fill out a tax form known as Form 1099-NEC (formally known as 1099-MISC). You’re required to use this form for each worker for whom 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.
2. Fill out Form 1099-NEC
Follow the IRS’ instructions below:
In the top box where it says payer, write your business’s name, street address, and phone number.
In the boxes below, write your taxpayer identification number (TIN) and the non employee’s TIN.
In the large box below that where it says payee, write your non employee’s name, street address, and phone number.
In the box that says “account number,” write the account number if you have multiple accounts for a recipient for whom you are filing more than one Form 1099-NEC. If that’s not the case, you can leave this box blank.
In Box 1, enter the total amount of non employee compensation (above $600) you paid this individual in a calendar year.
In Box 2, check an “X” in the box if you made sales that totaled $5,000 or more of consumer products to a person on a buy-sell, deposit-commission, or other commission basis for resale (by the buyer or any other person) anywhere other than in a permanent retail establishment.
In Box 4, write the total amount of backup withholding. People who haven’t given their TINs to you are subject to withholding on payments required to be reported in Box 1.
You can leave Boxes 5-7 blank if you like. The boxes are for your convenience only and don’t need to be filled out for the IRS.
3. Submit Form 1099-NEC to the IRS
You have to submit Form 1099-NEC to the IRS on or before January 31 of the year following the tax year you paid the non employee compensation. For example, if you hire an independent contractor for the tax year 2023, you need to submit Form 1099-NEC for that contractor by the filing deadline January 31, 2024.
You can e-file with the IRS or use a tax filing software system. You can also submit a copy via post to the following addresses:
Business Location | Address to Use |
Alabama, Arizona, Arkansas, Delaware, Florida, Georgia, Kentucky, Maine, Massachusetts, Mississippi, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Ohio, Texas, Vermont, Virginia | Internal Revenue Service Austin Submission Processing Center P.O. Box 149213 Austin, TX 78714 |
Alaska, Colorado, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Montana, Nebraska, Nevada, North Dakota, Oklahoma, Oregon, South Carolina, South Dakota, Tennessee, Utah, Washington, Wisconsin, Wyoming | Internal Revenue Service Center P.O. Box 219256 Kansas City, MO 64121-9256 |
California, Connecticut, District of Columbia, Louisiana, Maryland, Pennsylvania, Rhode Island, West Virginia | Department of the Treasury Internal Revenue Service Center 1973 North Rulon White Blvd. Ogden, UT 84201 |
Outside the United States | Internal Revenue ServiceAustin Submission Processing CenterP.O. Box 149213Austin, TX 78714 |
4. Submit a copy of Form 1099-NEC to the non employee
You also need to submit a copy of Form 1099-NEC to the contractor in question on or before the due date of January 31 of the year following the year they were paid. You can send this to the contractor’s physical address via mail, or email a secure, downloadable copy.
Non employee compensation FAQs
What is non employee compensation? Non employee compensation is money you pay individuals who aren’t employees in your business, but who do perform work for your business either on an ongoing or short-term basis.
Do you have to report non employee compensation? Yes, you have to report non employee compensation to the IRS come tax time. You use Form 1099-NEC and submit one copy to the IRS and another to the non employee you paid.
Do you have to pay taxes on a 1099 worker? No, you do not have to pay taxes or withhold income for an independent contractor who uses a 1099-NEC.
When do you file Form 1099-NEC? You have to file Form 1099-NEC by the filing deadline of January 31 of the year following the year you paid the non employee in question.
I keep hearing about Schedule C. Do I have to fill that IRS form out?
No. If you are the employer (and the payer), you do not need to fill out this form. This is a form that the payee may have to fill out. If the worker is self-employed, it is possible the worker will have to fill out Schedule C come tax season, but that is not a form that the payer fills out.
