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What is Nonemployee Compensation and How to Communicate it With Your Team

Paying contractors isn't just about compensation. When done right, nonemployee compensation can help build long-term relationships with your team members and protect you from potential tax consequences.

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Pilot Team

Published on March 24, 2022

The gig economy is rising. There were approximately 17 million people working independently during 2021 in the US alone. This growing trend of working contingently spells great news for businesses, as they can easily find and hire “nonemployees” — contractors, freelancers, and self-employed individuals — to handle one-off tasks. That said, compensating contractors isn’t as simple as paying them their work’s worth — there’s a lot more that goes into it.Nonemployee compensation, when done right, can help establish long-term relationships with your independent contractors and save you from potential tax consequences.

What is nonemployee compensation?

Nonemployee compensation is the total payment given to those who are not employees at your company for the services they provide to your business. Nicole Nesman, Vice President of People Ops at Animalz — a geographically-dispersed business that regularly hires international contractors — describes nonemployee compensation as, “Any monetary fees, commissions, prizes, and awards given to a contractor for services completed within their scope of work.”Nonemployee compensation isn’t part of standard payroll, unlike regular compensation given to full-time and part-time employees. It also doesn’t usually require you to withhold taxes, as there’s no employer-employee relationship. The nonemployee is responsible for managing and paying their own taxes as a self-employed individual.You are, however, required to withhold 24% tax as “backup withholding” if the nonemployee fails to provide a valid taxpayer identification number (TIN). This rule or exception does not apply to international nonemployees who belong to countries that have special tax treaties with the US.

Do I have to report nonemployee compensation to the IRS?

The Internal Revenue Service requires you (the payer) to report any payments made to an independent contractor (the payee) that exceed $600 in a given tax year. However, you don’t use the W-2 Form, which is what’s used to report wages paid to employees. Instead, payments made to nonemployees are reported by filing the new Form 1099-NEC.The due date for filing this form is January 31 of the tax year (whether you opt to e-file or through the mail). The nonemployee receives a copy of this form for self-employment income tax purposes.Up until 2020, nonemployee compensation was reported with the IRS Form 1099-MISC. While that form still exists, it’s now used to report miscellaneous income, such as rent, prizes, and attorney fees, among others. You can learn more about the differences between Form 1099-NEC and Form 1099-MISC in our guide.Make sure to steer clear of common filing errors, such as using the wrong code, specifying an inaccurate amount, or using the wrong TIN. This will help you avoid 1099 penalties from the IRS.

How to compensate nonemployees

Compensating nonemployees is a bit different than compensating employees. Instead of looking at industry comp benchmarks and competitors, it entails evaluating the work itself. Here are the steps you should follow, irrespective of the nature of your project.

Classify nonemployees correctly

It’s crucial to first ensure the person you’re hiring to do contingent work classifies as a nonemployee before determining compensation. A company that misclassifies its employees as nonemployees will get in trouble with its staff and the IRS. An example is the FedEx Classification Lawsuit, which resulted in the company agreeing to pay a $2.5 million settlement to its drivers for misclassifying them as contractors.The IRS has set certain conditions — called Common Law Rules — that determine the type of relationship between an individual and an employer. According to these rules, “anyone who performs services for you is your employee if you can control what will be done and how it will be done.” Keep in mind that this rule applies to hiring US-based nonemployees only. If you’re hiring internationally, make sure to comply with the laws of the country your nonemployee belongs to.More specifically, the relationship between a company and a nonemployee should tick the following boxes:
  • Behavioral: The company should have very little say in how the contractor performs their job. The nonemployee is free to do the job however they want as long as they deliver the desired result.
  • Financial: The business aspects of the job, such as the modes in which the nonemployee is paid and who provides the tools, must not be enforced by the company.
  • Type of Relationship: The contract should clearly state that the relationship between the worker and the company is contingent. Nesman says, “Companies should be careful to not define the scope of work as a permanent relationship and ensure they are not providing benefits to contractors which could classify them as employees (such as 401k, medical, etc.).”
Either you or the nonemployee can request the IRS to determine the status of your relationship by filing Form SS-8.

Determine the duration of the project

The duration of the projects you outsource to nonemployees will vary depending on the nature of the task and resource constraints. Thinking about how long the project would take will help you estimate how much you’d end up paying the nonemployee.Speak to the nonemployee and ask them about a realistic timeline they’d feel comfortable with. Refrain from constraining the time too much, as that would limit the contractor’s degree of freedom. It’s always healthy to come to a mutual agreement and set clear expectations early in the process.

Consider the scope and impact of the work

Be clear about the scope of the project from the get-go. Set expectations for what needs to be done. In doing so, you can estimate justifiable compensation for the work.Make sure to be clear when describing the scope in your contract. A vague scope leaves room for questions about what the job entails, which may result in conflict later. As an example, consider a contingent job for building a website. The contract should clearly state if the nonemployee would just design the website, code everything, or both.Similarly, the impact and difficulty of the work will determine how much the contractor should be compensated. “If you are going to hire a contractor who will significantly revamp your sales process, resulting in new revenue, you’re going to pay them a higher rate,” says Nesman.  In other words, the more valuable and difficult the job, the more the nonemployee deserves to get paid.

Create the compensation package

Make an offer after evaluating the duration, scope/difficulty, and impact of the work. You may also want to consider the nonemployee’s location, so you can determine a rate that (at the very least) matches their cost of living and other expenses.Also, consider offering small monetary perks along with the basic payments to attract talented contractors. For example, Nesman says that Animalz offers a $50 “Health and Wellness” stipend to its individual contractors. That said, avoid offering traditional benefits like medical plans, retirement savings, and stock options, as that might raise questions about the nature of your relationship with the nonemployees when hiring in the US. However, this rule may vary if you’re hiring internationally.

Communicating nonemployee compensation

Clearly state how much your business is going to compensate the nonemployee for their service in a contract, along with:
  • The scope of the project
  • Expected outcomes (defined with clear metrics if possible)
  • The way the contractor will be paid (by the hour or per milestone)
  • Any other perks the nonemployee will receive, such as any commissions, awards, or reimbursements
Nesman says, “Businesses should be very transparent when communicating nonemployee comp with contractors. I would recommend discussing the nature of the project and rate both on an offer call and have it carefully documented within the signed contracting agreement between the business and contractor.” Leave as few grey areas as possible to avoid conflict regarding scope, duration, and payment later. Discuss everything stated in the contract with your nonemployee and advise them to go through all clauses before they sign.

Legal Disclaimer:

The information contained in this site is provided for informational purposes only, and should not be construed as legal advice on any subject matter.

Offer compliant nonemployee compensation with Pilot

Managing compensation for nonemployees is certainly tricky and full of risks, especially when hiring internationally, as you need to comply with the local laws of different countries. Pilot can not only help you pay your contractors with ease but also file the correct tax forms.Let us collect Form W-9s and W-8s and pay contractors anywhere in the world. And when tax season rolls around, we’ll automatically fill out and file Form 1099-NECs on your behalf. Schedule a demo of our platform to learn how we can help make your life easier.

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