How Is Commission Income Taxed?

An organization's human resources department is led by smart people with a big mission: motivate teams. A compensation plan is a powerful way to motivate employees to sell more or, in some other manner, act in ways that support a company's evolving business model and overall strategy.

Most leaders recognize that the ideal compensation plan is contextual, meaning that it's tailored to both the business strategy and the stage of growth the company is in. Some progressive companies, however, coax better team performance by treating employees like an investment portfolio, the elements of which require attention. One such consideration is the tax ramifications of a commission compensation plan.

An employee's compensation consists of items of value received in exchange for providing a certain service to the employer. Typically, compensation includes a base salary or wages and other incentives, which may include commission income that's based on achieving a certain performance level. That performance level is defined by one or more quotas. For instance, a sales compensation plan may be designed to provide a financial incentive in the form of variable pay if a salesperson closes $1 million in sales.

Variable pay is an element of a direct compensation plan that includes short- and/or long-term incentives, bonuses or employee ownership programs. Variable pay is an element of any commission structure that aligns an employee's financial reward with the achievement of one or more goals. Such goals include selling a certain quantity of product.

As suggested above, an employee's variable pay is determined by performance. For instance, when employees achieve a sales quota, they receive some form of variable pay. For example, the amount of a salesperson's commission may be based on the dollar value of a sale or on the total sales dollars that are attributable to that person's efforts.

​Read more:​ The Tax Differences Between a Bonus and a Commission?

An employee may be compensated with commissions instead of, or in addition to, base pay or wages. Commissions are a means to motivate employees to achieve specific objectives. Typically, the objectives for which the employee is compensated relate directly to the employer's bottom line, which is the organization's net income or net profit. Commissions may also relate to the top-line growth or the organization's sales or revenues.

A commission may take a variety of forms, including:

• ​Straight Commission:​ Employee's wage, the value of which is based on the sales generated.
• ​Graduated Commission:​ Commission an employee earns in addition to regular salary or wage.
• ​Piecework Commission:​ Commission that's based on an employee's output.

​Read more​: How to File Commission Taxes

According to the IRS, employee pay that results from a commission-based payment structure may be classified as supplemental income if it is paid or reported separate from, and in addition to, an employee's regular wages or salary. For instance, if you receive a commission check in addition to a paycheck, the former is classified as supplemental income. Supplemental income includes bonuses, commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, retroactive pay increases and payments for nondeductible moving expenses.

Taxes on commission income that you receive in combination with your regular pay are taxed at the tax rate that's associated with your tax bracket. In contrast, any separate supplemental payment you receive is withheld at a rate of ​25 percent​. Because both forms of pay are earned income, employers withhold Social Security and Medicare taxes from both.

Full details regarding the manner in which supplemental wages are taxed can be found in IRS Publication 15 (Circular E).