Commissions, certain finder's fees and "kickbacks" to sales persons for arranging financing or insurance are all taxable income. When determining how to report the income on a tax return, the important question is whether the sales person is an employee or an independent contractor. As an employee, the sales person works directly for the employing company, has tax withholding from each paycheck, receives a Form W-2 showing earnings and withholdings, and is covered by the employer's workers' compensation insurance policy in case of injury on the job.
An independent contractor usually works for more than one company, is not under direct management control, does not have any tax withholding from earnings, receives a Form 1099-NEC from all employers and is not covered by any employer's workers' compensation policy.
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A Look at Employee Commissions
An employee working directly for a company receives fringe benefits, has payroll withholding for taxes from each paycheck and is covered by workers' compensation insurance provided by the employer. The employee is told how and where to work, with direct supervision from a supervisor. From a tax point of view, the employee receives a Form W-2, showing total income, federal and state taxes withheld, Social Security tax and Medicare tax.
If you are an employee receiving a W-2, the information would be posted on the "wages, salaries, tips, etc." line of your Form 1040. The forms require the attachment of W-2's, showing the withholdings. This income is treated just like hourly wages or salary income, except that it was earned through a commission formula.
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Independent Contractor Commissions
An independent contractor usually works for more than one company, works without supervision and receives compensation without any withholding. This taxpayer is regarded as self-employed, receives a Form 1099-NEC reporting year-end income, and reports income and expenses on a Form 1040, Schedule C.
The Schedule C is like a profit-and-loss statement. Total revenue from all of the 1099-NEC forms is reported, along with expenses, to calculate the actual net income for the year. The self-employed person has the tax benefit of being able to subtract any and all business-related expenses to reduce the net income reported.
Consider Also: What Is a Schedule C Form: Who Needs to File & How to File
Taxes On Commissions
If you are an employee reporting commission income, the tax is calculated by including the commissions in your total taxable income and factoring it by the appropriate tax rate. It is just like receiving income as hourly wages or salaries.
The independent contractor's taxes are more complicated. The first tax computed is the Self-Employment tax shown on Schedule SE. This tax is levied on the net income, after reporting all expenses.
Since the independent contractor did not have Social Security and Medicare taxes withheld from compensation, the self-employment tax collects the equivalent with a rate of 15.3 percent. For employees, the Social Security and Medicare taxes are split between the employer and employee. For the self-employed, the full tax must be paid by the taxpayer.
The net income from Schedule C is added to all other income to determine total taxable income, which is factored by the appropriate tax rate.
Independent Contractor Advantages And Disadvantages
The independent contractor has the advantages of being able to work for multiple employers, having flexibility as to time and deadlines and charging a billing rate appropriate for an independent professional.
The disadvantages of being an independent contractor include having to pay the Self-employment tax, not having a steady weekly income, no fringe benefits and lack of workers' compensation insurance in case of injury on the job.
Consider Also: Independent Contractor Tax Deductions