Ask most small business owners what they struggle with most - or least like to do, in any case - and they will say it is dealing with the complexity of managing payroll and payroll taxes. State, federal, and local requirements change frequently and are difficult for the average person to stay on top of, and mistakes can be incredibly frustrating for employees and could create costly legal issues for the company itself.
What is an Employee?
The simple definition of an employee is someone who works for your company, but the legal definition is more complicated, and where payroll taxes are concerned, more important.
For tax purposes, workers are classified either as employees or as independent contractors. What is the difference? As an employer, you are responsible for handling employee payroll tax withholding and filing. Independent contractors are responsible for handling their own payroll taxes.
To determine whether an individual is legally considered to be an employee or an independent contract, the IRS uses several different "tests."
Behavioral Test. A worker is an employee when the employer has the right to, in large part, direct and control the worker. (In short, your business directly manages and oversees the employee.)
Financial Test. The financial test evaluates the degree of control the worker maintains over financial aspects of a job, including whether expenses are reimbursable and how the worker is paid. Plus, typically independent contractors are not formally tied to one particular business and can advertise services and seek other work opportunities. (You decide how your employees are paid and reimbursed; independent contractors negotiate those items, and eventually you agree to a financial arrangement.)
Relationship Test. The relationship test primarily focuses on the length of time a work engagement lasts. If a worker has been contracted to work until a certain date or until the end of a particular project, he or she is usually considered an independent contractor. If the work engagement does not have time or project boundaries, the worker is generally considered an employee. (Keep in mind you can hire an employee fully knowing the work will only take, for example, six months.)
Still not sure if a worker is an independent contractor or employee? Here are some other criteria. A worker may be considered an independent contractor if:
- The individual supplies their own equipment, materials, and tools
- All necessary materials and supplies are not supplied by the employer
- The individual can choose to come to work (or not) without fear of losing employment
- The individual can be terminated at any time
- The individual has control over hours of work
The IRS may decide an individual is an employee if the work they perform is integral to business functions.
If you determine a worker is an independent contractor, that independent contractor is paid a fee and is responsible for taking care of tax withholding, reporting, and deposits.
If you determine the worker is an employee, payroll tax management is your responsibility. You must pay state and federal unemployment tax, Social Security tax, and worker’s compensation premiums to your state.
Whether a worker is an employee or an independent contractor, a number of records and documents must be stored for at least three years (some states have different requirements): Time and attendance records, records of earnings, deductions, taxes paid, salary and wage schedules, and additional items like orders, shipping, and billing records.
Where employees are concerned, employers are also required to comply with regulations regarding Workers Compensation Plans, the Family Medical Leave Act (FMLA), short- and long-term disability, etc.
Then, reporting and depositing payroll taxes to the appropriate agencies is required. Deposits made late - or not made at all - can incur stiff legal penalties and costly interest charges.
Here’s a quick breakdown of the taxes and deductions a business is responsible for collecting and depositing:
- Federal Taxes. Federal income tax must be withheld each pay period from employee pay, and the employer is responsible for paying a matching amount. One of two basic tax tables is used: Wage bracket tables or percentage tables. The employer is responsible for determining which table to use.
- State Taxes. Most states also use tax tables; a few, like Alaska, Florida, Texas, New Hampshire, Wyoming, Washington, and Tennessee, do not require state income tax. Other states like Arizona tax as a percentage of the federal tax, while a few others, like Pennsylvania, tax based on a fix percentage of total wages.
- FICA. FICA includes Social Security and Medicare taxes; the employer and employee split the tax responsibility. People who are self-employed pay the entire amount; that tax is often called the self-employment tax.
- FUTA. Unemployment taxes are paid by the employer only, if:
- The company pays wages in excess of $1,500 per quarter
- The company has one employee on any given day for twenty weeks in a total calendar year
Managing the payroll tax process can be complicated. Some companies try to avoid the task by classifying workers as independent contractors. If you define a worker as an independent contractor and the IRS finds the worker was instead an employee, you may be liable for past taxes, including Social Security and federal unemployment tax. You may also be liable for any benefits the employee did not receive in the past.
If you are in doubt, talk to your accountant or to an experienced business attorney to insure you properly classify your workers - and to ensure you comply with all state and federal payroll tax guidelines and requirements.