In almost all cases, everything that an employer pays to their employees for services rendered must be reported on the W-2 and is subject to regular income tax withholding along with Social Security and Medicare tax withholding, unemployment insurance requirements, and anything else required by state law. The employer is avoiding these taxes, either through ignorance or intentionally. (The only exception I know of are “spiffs“, commissions paid by car manufacturers directly to sales people, bypassing the dealership that employs them.)
Assuming your spouse is not a car sales person, then all their income should have been reported on their W-2. When you enter the 1099, there should be a listing of special circumstances and there is a box to check for “this money was paid by my employer and should have been on my W-2.“ this will cause TurboTax to include a form 8919 with your tax return which will collect the employee half of Social Security and Medicaid tax, 7.65%, but you will not have to pay 15% self-employment tax. You will also have to pay regular income tax, of course.
If you did not make estimated tax payments during the year and did not have withholding from this money, because of the employer’s actions, you may also be assessed a penalty for underpayment or late payment. TurboTax should offer you the option of calculating and paying the penalty or waiting and letting the IRS calculate the penalty. I would choose the second option and let the IRS send you a bill. If the IRS assesses a penalty, you can request a first time forgiveness of the penalty, or a waiver of the penalty for cause, which in this case would be the employer‘s improper action.
