When you pay a subcontractor in the United States, you generally do not deduct federal income tax from the payment the way you would from an employee’s paycheck. Subcontractor tax withholding kicks in only as a backup measure: you withhold 24% of the payment when the subcontractor’s taxpayer identification is missing or the IRS has flagged a mismatch. Everything else is information reporting, meaning you collect a Form W-9 before the first payment and file Form 1099-NEC after year-end when the total hits the reporting threshold, which rose to $2,000 for the 2026 tax year.
Get a W-9 Before the First Payment
The single step that keeps you out of withholding trouble is collecting a completed Form W-9 from every subcontractor before you cut the first check. The W-9 gives you the subcontractor’s legal name, business name if different, entity type, address, and taxpayer identification number (TIN), which is either a Social Security number for an individual or an Employer Identification Number for a business. A signed, properly completed W-9 is what lets you pay the full invoice amount without holding anything back.1Internal Revenue Service. Instructions for the Requester of Form W-9
If the subcontractor refuses to hand one over, returns it with an obviously wrong TIN (fewer or more than nine digits, or letters in the number), or never returns it at all, federal law requires you to begin backup withholding on their payments immediately.2Office of the Law Revision Counsel. 26 USC 3406 – Backup Withholding Collect the form up front and you avoid that problem entirely.
Collect a W-9 even from subcontractors you expect to pay less than the $2,000 reporting threshold. A small March job can grow into $5,000 of work by December, and chasing paperwork in January is worse than asking for it in advance. The IRS also offers a free TIN Matching service through its e-Services portal that verifies a name-and-TIN combination against IRS records before you file. Using it is optional but heads off the penalty notices that follow a mismatched return.
When You Actually Have to Withhold: The 24% Backup Rule
Backup withholding is the one situation where you deduct federal income tax from a subcontractor’s payment. The rate is a flat 24% applied to the full payment amount.3Internal Revenue Service. Backup Withholding Four conditions can trigger it:
- The subcontractor never provides a TIN, or the one they provide is obviously invalid.
- You receive a CP2100 or CP2100A notice from the IRS telling you the name and TIN on a return you already filed don’t match IRS records.
- The IRS tells you the payee has underreported interest or dividend income. This trigger is aimed at financial payments and rarely comes up for contractor work.
- The payee fails to certify on the W-9 that they are not subject to backup withholding.
For most contractors hiring subcontractors, the first two are what you’ll actually see. When a CP2100 or CP2100A arrives, you send the affected subcontractor a “First B Notice” along with a blank W-9. If the same subcontractor appears on another notice within three years, you send a “Second B Notice,” and the subcontractor has to provide a copy of their Social Security card or an IRS Letter 147C to resolve it. Withholding continues on payments to that subcontractor until the problem is cleared.4Internal Revenue Service. Backup Withholding “B” Program
Reporting Payments on Form 1099-NEC
For the 2026 tax year, you must file Form 1099-NEC for any subcontractor paid $2,000 or more during the calendar year for services in the course of your trade or business. The new $2,000 figure replaced the longstanding $600 threshold and will be adjusted for inflation starting in 2027.5Internal Revenue Service. Publication 1099 – General Instructions for Certain Information Returns The threshold is measured against total payments across the year, not per invoice.
The form goes to both the IRS and the subcontractor by January 31 of the year after payment. No automatic extension is available, which makes this the tightest deadline in the information-return calendar. If you file 10 or more information returns in the year, you must e-file. The form reports the subcontractor’s name, TIN, address, and total nonemployee compensation. Any backup withholding you applied during the year goes in a separate box on the same form.5Internal Revenue Service. Publication 1099 – General Instructions for Certain Information Returns
Paying the Withheld Money to the IRS: Form 945
If you actually withheld money during the year, you report and remit it on Form 945, “Annual Return of Withheld Federal Income Tax.” Form 945 covers nonpayroll withholding, including backup withholding on subcontractor payments, and is due January 31 of the following year. Do not put backup withholding on Form 941. That form is strictly for payroll taxes withheld from employees, and mixing the two creates reconciliation problems that take months to unwind with the IRS.
If you didn’t withhold anything during the year, you generally don’t file Form 945 unless the IRS has specifically directed you to. Deposits of withheld funds follow the same schedule as other federal tax deposits, usually through the Electronic Federal Tax Payment System (EFTPS).
This All Assumes the Worker Is Really a Contractor
Everything above depends on the worker actually qualifying as an independent contractor rather than an employee. Misclassify someone, and you owe back payroll taxes, penalties, and interest on every dollar you paid them, regardless of how carefully you handled the 1099. The IRS weighs three categories of evidence rather than applying a single test:6Internal Revenue Service. Independent Contractor (Self-Employed) or Employee
- Behavioral control: whether you dictate how the work gets done or only the result. Telling a plumber which fixtures to install is fine; dictating tools, hours, and sequence looks like employment.
- Financial control: whether the worker has real investment in their own equipment, can profit or lose on the job, and markets their services to others.
- Type of relationship: whether the work is a permanent, integral part of your business or a defined project, and whether you provide employee-style benefits. A contract calling the person a “contractor” helps but does not settle the question.
No single factor decides it. When the answer is genuinely unclear, you can file Form SS-8 and ask the IRS to make the determination. If you already suspect you’ve been treating employees as contractors, the Voluntary Classification Settlement Program lets you reclassify workers going forward while paying just 10% of the employment tax liability for the most recent year, with no interest, no penalties, and no audit of earlier years.7Internal Revenue Service. Voluntary Classification Settlement Program That is a much better outcome than having the IRS find the misclassification during an audit.
Penalties for Getting It Wrong
For information returns due in 2026, the penalty for failing to file a correct 1099-NEC scales with how long the problem goes uncorrected:8Internal Revenue Service. IRM 20.1.7 – Information Return Penalties
- Corrected within 30 days: $60 per return, capped at $239,000 per year for small businesses (gross receipts of $5 million or less) and $683,000 for larger businesses.
- Corrected after 30 days but by August 1: $130 per return, capped at $683,000 for small businesses and $2,049,000 for larger ones.
- Not corrected by August 1: $340 per return, capped at $1,366,000 for small businesses and $4,098,500 for larger ones.
- Intentional disregard: $680 per return, no annual cap.
A parallel penalty applies for failing to furnish the correct copy to the subcontractor. The base statutory penalty is $250 per statement, reduced to $50 if corrected within 30 days and $100 if corrected by August 1. Intentional disregard raises it to $500 per statement or 10% of the amount that should have been reported, whichever is greater, with no annual cap.9Office of the Law Revision Counsel. 26 USC 6722 – Failure to Furnish Correct Payee Statements
Misclassification exposure runs on a separate and larger track. If the IRS reclassifies your contractors as employees, you become liable for the employer’s share of FICA taxes, a portion of the income tax that should have been withheld, and penalties and interest reaching back multiple years.
Two Things That Are Not Federal Subcontractor Withholding
Many states impose their own withholding rules on payments to out-of-state or nonresident contractors, separate from anything the IRS requires. Rates, thresholds, and exceptions vary by state, and some states let the nonresident post a bond or obtain a compliance certificate to avoid withholding. If you hire subcontractors from other states, check with your state’s department of revenue.
“Retention” in a construction context can mean two very different things. Construction retainage is a percentage of each progress payment, typically 5% to 10%, held back as performance security until the project reaches substantial completion. It protects the owner against defective or unfinished work and has nothing to do with tax. Tax withholding is what this article covers. The two are separate obligations, and holding retainage on a contract does not affect what you owe the IRS or what you report on the 1099-NEC.