Most individuals who work a job receive a salary and benefits, such as healthcare and retirement accounts, such as 401(k) plans. Some industries, particularly certain jobs in the financial services sector, work on commission. This means that they are paid based on their performance. In this case, an employee would receive a very small salary while the bulk of their income would come from commission generated from the amount of business they bring in for the firm.
Key Takeaways
- If an individual is an employee who is getting paid commissions by the employer, the employer withholds the taxes and pays the IRS.
- If the individual is a self-employed independent contractor, the individual is responsible for remitting the taxes to the tax authorities.
- Depending on the filing status of the employee, the taxes on commission will be calculated in different ways.
Understanding Pay by Commission and Tax Withholding
Being compensated by commission is not ideal for everyone. Those who are employed in this manner generally have to be extremely active in procuring new business and maintaining existing business so as to maintain sales targets and make enough commission to support themselves financially. A commission is usually paid as a percentage of the sales value an employee generates.
In a standard salaried job, tax deductions are the responsibility of the employer. This is not always the case for an employee working on commission. The income tax filing responsibility for an employee who earns their living through commission is different depending on their employee status. In addition, the way in which the commissions are classified also plays a role in how taxes are calculated.
Reporting Taxes on Commission
An individual who receives commissions can be treated in the same manner as one who receives a straight salary. In this case, the employer would withhold taxes from the individual’s compensation and remit the amount to the tax authorities on the individual’s behalf. The withholding would be based on the elections the employee makes on Form W-4 and reported on Form W-2 at the end of the year by the employer.
Alternatively, the individual can be treated as a self-employed independent contractor, who would be responsible for remitting the taxes to the tax authorities by filling out Form 1099-MISC, signifying non-employee compensation.
FICA taxes would not be included in this designation and are accounted for when the employee files self-employment tax. The self-employment tax accounts for Medicare and Social Security. The self-employment tax rate is 15.3% for 2024, which consists of 12.4% for Social Security and 2.9% for Medicare.
As most employees in the United States know, each taxpayer is ultimately responsible for paying their income taxes to the Internal Revenue Service (IRS) and state tax authorities. Self-employed individuals who earn commissions may have to file estimated taxes on a quarterly basis. The IRS’s Publication 505 provides details on tax withholding and estimated taxes.
Calculating Taxes on Commission
Depending on the filing status of the employee, the taxes on commission will be calculated in different ways. If the individual is considered an employee as opposed to an independent contractor, the employer will withhold the taxes as normal if the commission is included in regular wages.
If the commission is paid separately as a supplemental wage, then an employer has two ways in which to determine the taxes withheld: the percentage method or the aggregate method.
The percentage method is a flat percentage deduction on commissions in the amount of 22%. However, if the commission is more than $1 million, the amount is 37% for 2024 withholding. The aggregate method involves adding the commission wages and the regular wages, classifying the total amount as regular wages, and withholding taxes using ordinary income tax rates.
Advisor Insight
Peter J. Creedon, CFP®, ChFC®, CLU®
Crystal Brook Advisors, New York, NY
The real question should be, is the person an employee or independent contractor? If an employee, it depends on your state’s employment law, but it’s likely the employer is responsible for withholding taxes on all compensation. If an independent contractor, then they are responsible for the taxes.
Employers need to be careful calling people working for them independent contractors when they are essentially performing employee functions. If the job requires regular hours and reporting to a manager, is open-ended (has no end date), and doesn’t offer any real autonomy on how or whether to work, the person stands a good chance to be considered an employee. The employer could be liable for benefits, overtime, taxes, and fines by the federal or state Department of Labor for deeming them independent.