When you start paying certain employees through commissions, the complexity of your payroll process goes up a notch. How do you make sure commissions are calculated correctly? How do you stay compliant with tax rules?
At Paper Trails, we’re here to help small businesses navigate the confusing world of payroll, HR, and compliance. We know that when you’re trying to run your business, the last thing you want is a payroll mistake that leads to confusion, frustration, or even a tax issue. In this article, we’ll walk you through everything you need to know about handling commissions in payroll. You’ll learn:
- What commissions are and how they work
- The different types of commission structures you can use
- How to calculate commissions accurately
- Tax implications for commission payments
- Compliance requirements you can’t ignore
- Best practices for managing commission payroll
Let’s get started!
What are commissions in payroll terms?
Commissions are a type of payment made to employees based on their performance, typically tied to sales, revenue, or production goals. This means the more an employee sells or better they perform, the more they earn. Commissions can be an excellent way to motivate employees, but they also add complexity to your payroll management.
Types of commission structures
- Commission-Only Pay: Employees earn money purely based on their sales, and there is no base pay paid to the employee if no sales are generated. For example, if a salesperson earns 10% of each sale they make and they sell $500,000 of goods or services in a year, they would earn $50,000.
- Base Salary Plus Commission: Employees receive a guaranteed base salary plus additional earnings based on sales or production. This provides some financial stability while still offering performance incentives. For example, a worker earns $15 per hour plus $0.50 per widget produced. If they work 8 hours in a day and make 50 widgets, the employee would earn ($15/hour x 8 hours + $0.50/widget x 50 widgets) $145 for that day.
- Graduated Commission: Employees earn higher commission rates as they reach certain sales targets. For example, 5% for the first $10,000 in sales, 7% for the next $20,000, and 10% beyond that.
- Capped Commissions: There is a limit to how much an employee can earn in commissions. This type of structure helps employers control payroll expenses.
How to handle commissions through payroll
Calculating commissions doesn’t have to be overly complex. Start with these steps:
- Determine the Commission Period: This could be weekly, biweekly, or semi-monthly. Make sure this period aligns with your pay schedule so employees are clear on when they will receive their commission payments. Further double-check with your state for its laws on payment of wages. For example, in Maine employers must pay all wages, including commissions, to employees at least once every 16 days.
- Identify the Commission Base: This means calculating the total sales or revenue the employee generated during the period. Depending on your commission structure, this could include total sales, net sales (after returns), revenue from specific products, or number of widgets produced.
- Apply the Commission Rate: Multiply the commission base by the agreed-upon rate. For example, if your employee’s rate is 10% and they generate $5,000 in sales, they would earn $500 in commission. Make sure this rate is clearly communicated in your employee agreements.
- Factor in Graduated Rates: If your business uses a tiered or graduated commission structure, you will need to calculate commissions in sections. For example, 5% for the first $10,000 in sales, 7% for the next $20,000, and 10% beyond that. Carefully apply each rate to the correct sales range.
- Adjust for Deductions: Subtract any returns, refunds, or other adjustments before finalizing the commission. This ensures you are only paying commissions on finalized sales, not on returns or canceled deals.
Tax implications of commissions through payroll
Commissions are considered taxable income and are subject to payroll taxes, including federal income tax, Social Security, and Medicare taxes. Employers must:
- Withhold Federal Income Tax: Employers must withhold federal income tax from all wages, including commissions. Employers can choose between two methods: the percentage method (22%) or the aggregate method. The percentage method applies a flat rate, making it simpler, while the aggregate method combines commissions with regular wages, using the employee’s W-4 for calculations.
- Deduct Social Security and Medicare Taxes (FICA): FICA taxes on commissions are calculated using the same rates as regular wages. These standard rates are 6.2% for Social Security up to the wage base limit and 1.45% for Medicare, with an additional 0.9% for high earners over $200,000.
- Comply with State Income Tax Rules: If your state has income tax, ensure you are withholding the correct amount on commission earnings. Certain states have other payroll taxes, such as a 0.5% payroll tax in Maine for the Maine Paid Family and Medical Leave Program, that are applied to commission payments. Further, some states have specific rules for calculating and withholding tax on commissions, so be sure to check with your state.
Compliance requirements
If your employees earn commissions, you must ensure you’re compliant with federal and state labor laws, including:
- Meeting Minimum Wage Requirements: Even if employees are paid by commission, their total earnings (base plus commission or just commission) must at least meet minimum wage standards for each hour worked when calculated for each shift.
- Paying Overtime to Non-Exempt Employees: Even commission-based employees who are classified as non-exempt employees must receive overtime pay for any hours worked over 40 in a workweek. Commissions are considered compulsory payments and must be factored in when calculating overtime rates.
- Providing Paid Sick Leave Where Required: Some states require paid sick leave for all employees, including those who earn commissions. For example, under Maine’s Earned Paid Leave Law, employees must earn at least 1 hour of PTO for every 40 hours worked. Ensure you comply with state and local laws.
Best practices for managing commissions
- Be Transparent: Clearly explain your commission structure, including commission base, rate, pay period, etc., to your employees. This allows them to understand how their earnings are calculated, including how rates are determined and when they will be paid.
- Automate Calculations: Use payroll software to avoid manual errors and keep track of overtime, including commission wages. These automated systems ensure consistency, save time, and reduce the risk of mistakes.
- Regularly Review Rates: Regularly review your commission rates to ensure they remain competitive and align with your business goals. Adjust rates when necessary to help retain your employees and keep them motivated.
- Communicate Frequently: Maintain open communication with employees about their earnings. Provide regular commission statements, explain any deductions, and be available to answer their questions.
Conclusion
Handling commissions in payroll doesn’t have to be a headache. By understanding how commissions work, staying compliant, and using best practices, you can keep your employees happy and your payroll running smoothly. If you have questions or need help managing your payroll, Paper Trails is here to guide you every step of the way.