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What's the real calculation for how are commissions taxed by the IRS

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A reader is finding customers for a construction firm. But is he being bulldozed?

Question: I need to know how are commissions taxed by the IRS, because I think I’m getting hoodwinked. I just started working for a construction contractor. I’m helping him find leads for future customers. He says he wants to “minimize risk” while paying me commissions on any jobs I give him. That means I have to choose between:

1. letting him take withholding taxes from my commissions, or 

2. filing for an LLC or a corporation. 

I am a sole proprietorship. People usually just send me 1099s. But he’s not going to do that unless I have a corporation or an LLC. Is he really minimizing his risk? Or is this B.S.? 

— Pete in California

Jacob Dayan from Community Tax explains “How are Commissions Taxed”…

Is it B.S.? Yes and no. I would call it an “imperfect application of common tax principal.” Let me explain.

[Community Tax co-founder Jacob Dayan]

Hi, I’m Jacob Dayan, CEO, and co-founder of Community Tax and this is “Taxing Questions.” I seldom get tax questions that are so concise, but the answer isn’t going to be concise, because we’re combining two complicated topics: taxes and employment law. If you run your own business, you already know terms like withholding, FICA Tax, and payroll taxes.

If you’re an employee, you know what a W2 form is, but you probably don’t know all of the work that goes into that tiny slip of paper. The key to answering this question is determining who a full-time employee is and who is an independent contractor. That makes all the difference in the world when it comes to taxes because the IRS has different rules for each.

If you want to know more, check out Debt.com where I break it down in detail. If you have tax problems yourself, give me a call.

In the small business world, there are few words more dangerous than “employee.” It’s a dangerous word because businesses with employees have additional requirements versus businesses with independent contractors alone. They also pay extra taxes.

For example, businesses with employees must…

  • withhold income and FICA tax from employee paychecks
  • pay 50 percent of the 15.3 percent FICA tax for each employee
  • file and pay payroll taxes
  • issue annual W-2 forms, among others

To avoid the extra time and expense of carrying official employees, small businesses classify workers as independent contractors.

But the test on whether a worker is an employee or independent contractors has nothing to do with a label. It depends on how much control the small business has over the worker. Does the business control scheduling, training, evaluation systems, degree of instruction, etc.?

Distinguishing an employee from a contractor

The more control a business has, the more likely that worker is an employee and not an independent contractor.

The IRS has the power to reclassify workers as independent contractors. When they do, they can levy massive penalties on the small business.

Many small businesses think they can limit the risk of an IRS reclassification challenge by requiring their independent contractors to obtain an EIN. “If a business pays another business,” the thinking goes, “the relationship is more likely to be an independent contractor relationship and not an employer/employee relationship!”

However, the test on whether a worker is an employee or independent contractor is based much more on control than on the labels the parties attach to one another. So paying a person with an SSN or a business with an EIN doesn’t make much difference.

Now, with all that in mind, let’s get to today’s question…

Based on the facts, it appears the construction contractor is giving you the choice. They can classify you as an employee or as an independent contractor. If you choose the independent contractor route, the construction contractor wants to limit the risk of the IRS deciding you’re an employee. If that happens, the IRS would levy penalties against the business. But, again, it’s about control more than it is about labels.

I struggle to call this “B.S.” because I think the employer sincerely is trying to limit their risk. But if IRS ever investigated the classification, they would look at the control the contractor has. Whether they put an SSN or an EIN on their paperwork wouldn’t matter. As such, I wouldn’t call the contractor’s EIN requirement B.S., per se. Rather, it’s an imperfect application of a common tax principal.

Have a debt question?

Email us at editor@debt.com and Howard Dvorkin will review it. Dvorkin is a CPA, chairman of Debt.com, and author of two personal finance books, Credit Hell: How to Dig Yourself Out of Debt and Power Up: Taking Charge of Your Financial Destiny. Either he or one of Debt.com’s other experts will answer you.

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The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the opinions and/or policies of Debt.com.

Meet the Author

Jacob Dayan

Jacob Dayan

Expert contributor

Jacob Dayan was born and raised in Chicago and worked in New York City as a financial analyst at Bear Stearns. In 2009, he returned to Chicago to be with his family and pursue a career assisting consumers and small businesses with various financial needs. In 2010, he co-founded Community Tax LLC, a full-service tax company helping customers nationwide with all of their tax resolution, tax preparation, bookkeeping, and accounting needs. He’s a licensed attorney in Illinois who graduated Magna Cum Laude from Mitchell Hamline School of Law and has worked with more than 60,000 clients – resolving more than $400 million in tax liabilities.

Ask the Expert, employment, income

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