Determining if you are an employer can be complicated. Many small companies hire family members and hope that they can avoid paying payroll taxes. Unfortunately, this doesn't work. Family members must pay most employer taxes. Other companies try to avoid payroll taxes by hiring independent contractors. Because this is a popular tax loophole, the IRS is now carefully investigating whether independent contractors meet the required criteria. If they don't, the employer can be held liable for all the employee's taxes.
Before we begin, are YOU an employee?
Are your other workers employees?
IRS rules determine this, not an agreement between you and the worker. The IRS presumes that, except for statutory non-employees described below, all workers are employees unless the hiring firm can legally prove otherwise.
Corporations: Are shareholders, officers or directors employees?
If you work for a corporation and receive compensation for your work, you are an employee - even if you are the only shareholder. You should pay regular employment taxes on these wages.
Corporate directors are generally paid as independent contractors. However, this only applies to payments for services they render as a corporate director. Any income that they receive for general services must be taxed as a regular employee.
Corporate officers' income must be taxed as regular employees.
Corporations: Can you pay dividends instead of salary?
Some sole shareholders try to avoid employment taxes by paying themselves a very small salary and "distributing" the remainder of the corporation's profits as dividends. Before you do this, remember that you may be audited and will have to show that:
There is an exception: Income from royalties are not considered wages for employment tax purposes, but are earnings based on the corporation's assets.
The IRS has two classifications
The IRS has two classifications for workers: non-employees and employees.
Non-employees
Non-employees include independent contractors and statutory non-employees.
Independent contractors must:
Statutory non-employee Specific laws designate that the following workers are automatically non-employees:
If you use non-employees in your business, you do not have to withhold or pay any employer taxes. Send your non-employees annual 1099Misc forms.
Employees
Any non-owner who was not described under non-employees above is an employee. There are two categories of employees: statutory employees (where a specific law automatically makes them an employee) and common law employees.
Statutory employees
Common law employees
If you have employees: you will have to file employer forms and withhold and pay employee-employer taxes.
Warning if you want to use independent contractors
If you plan to hire independent contractors instead of employees, it is NOT enough to rely on the three characteristics listed above. There are additional rules and specific do's and don'ts that you must follow or you will be vulnerable to substantial government fines.
The IRS and other agencies conduct routine audits and fine companies that ignore these rules. Many (if not most) companies lose the audits. The fines and back taxes can easily be $25,000 for one misclassified worker.
Independent contractors...the bottom line
In a true independent contractor relationship, the hiring firm has no right to control the worker or the work. The hiring firm can only control (specify) the results of the work - not how the work is accomplished. If you hire independent contractors, you must be willing to give up control over their actions. That means:
Myths that cause firms to lose audits
Independent contractor status is NOT determined by whether the worker:
The only test to a true independent contractor relationship is whether the hiring firm had the right to control the worker or the process of his work.
The IRS looks at three things: Behavioral Control, Financial Control, and Relationships of the Parties. It is looking for the RIGHT of the hiring firm to control. Click here for an IRS pamphlet called Independent Contractor or Employee.
Contract for Services
We have included a standard contract for services to use for independent contractors. You do not have to have a contract to satisfy IRS rules, however, it helps both you and the contractor stay within the normal bounds of an independent contractor relationship. Please note, that signing the contract without following it, will not help. Click here for the contract for service agreement.
IRS forms
There are two optional forms you can use for an official ruling on whether a worker is an independent contractor.
SS-8 Determination of Workers Status is used for an official IRS ruling on whether a worker is an employee or a contractor. Please note that even if you get a positive ruling, if later, you treat the worker as an employee, the ruling will be invalid.
W-9 Request for Taxpayer ID Number is used by some businesses for the contractor to certify that they are providing you their correct taxpayer ID number. Since this form is never sent to the IRS and does not help you in an audit, it is of questionable help.
Questions? You can also call the IRS information hotline (800) 829-4933. For forms, call (800) 829-3676 or obtain them online at http://apps.irs.gov/app/picklist/list/formsPublications.html.
Your first obligation is to pay your employees, and with them, Uncle Sam. You can use this tool to calculate payroll taxes and net pay.
Remember, that when you pay the withheld taxes to the government, employers must MATCH social security and Medicare. The calculators above do not calculate tax on tips. If your employees are paid tips, please review:
Use the following forms to pay taxes to the government (usually a monthly requirement for new businesses):
EFTPS Deposit for Federal Payroll Taxes
Paying Yourself (and Uncle Sam)
Please go to Government Requirements and under Taxes and Required Forms, select "Paying Yourself " and your business entity.
Paying Independent Contractors
Pay independent contractors using the same systems as you do for other vendors. Do not ask for time-sheets or pay them with your regular employees.
Contract for Services
A contract is not required to hire an independent contractor. However, it is useful to clearly establish responsibilities so that both parties realize that the person being hired is not an employee and has different rights than employees have.
Where to get a contract for services agreement?
You can obtain a contract for services online, in an independent contractor how-to book, from your attorney, or from the library. You can also create your own custom agreement by visiting your county law library and requesting the legal forms book for your state.
You can also use the sample contractor agreement available through the SME Toolkit (a service of The World Bank)
What the contract typically says
The contract establishes the worker as an independent contractor, who has the right to hire assistants, choose how to do the work, and cannot be terminated at will. It should state that the contractor is responsible for taxes and that the hiring firm will not provide workers compensation insurance or other benefits associated with employees. It outlines how long the hiring firm will have to pay invoices after receipt.
The contract should also describe the services to be performed and the compensation (preferably the total amount, not an hourly rate).
Doesn't guarantee independent contractor status
A signed contract does not guarantee that the IRS or other agency will determine that the worker is an independent contractor. Here are some reasons why sometimes courts have ignored signed contracts:
What to do
What should NOT be in the contract
Do not put restrictions that indicate an employer-employee relationship. Specifically, do not give the hiring firm the right to "terminate at will", control who does the work, the working hours, etc.
Questions? Contact a business attorney.
Before we begin the forms, here is basic information about employer requirements. The state and federal governments impose 6 employee-related taxes and require workers compensation insurance from either private insurers or a state affiliated agency. Some of the taxes are paid for by employees. Others are paid by employers. Some are shared.
Employees pay through withholdings
| Tax | Tax Rate | Maximum |
|---|---|---|
| Federal income tax (FIT) | 10-35% | -- |
| 1/2 social security (FICA) | 6.2% | $6,621.60 |
| 1/2 Medicare | 1.45% | -- |
| State income tax | --- |
Employers pay
| Tax | Tax Rate | Maximum |
|---|---|---|
| Workers compensation insurance | varies | -- |
| 1/2 social security (FICA) | 6.2% | $6,621.60 |
| 1/2 Medicare | 1.45% | -- |
| Federal unemployment (FUTA) | 0.8% | $56.00 |
Prepaid workers compensation
State law requires that employers either prepay their workers compensation premium or provide the insurance carrier a deposit. The amount of this prepayment varies by the type of business, but can range from $100 to $1000+ depending on the type of business you are in.
Tax deadlines
Employers are responsible for withholding the proper amount of employee-paid taxes and depositing them and the employer-paid taxes in a timely manner. This kit shows you when each tax is due, how to pay it, and the reporting requirements. The taxing agencies have substantial penalties for late deposits or late report filing. These penalties are not described. Suffice it to say that they do not waive penalties due to ignorance and are very serious about their deadlines. They do not want employers to mis-use taxes meant to benefit employees.
Personally liable for taxes
Business owners are personally liable for employment taxes. This means that if you declare bankruptcy or close down a business, you will still be personally liable for employment taxes owed - even if you formed a corporation or limited liability company.
Required employee records
Unemployment records must be retained in Arizona for a minimum period of four years. This information generally includes: name; social security number; dates of hire, rehire and termination; wages by period; Payroll pay periods and pay dates; date and circumstances of termination.
Employees who are discharged, fired, laid off or have a leave of absence must be given their final pay within 3 working days. Employees who voluntarily quit must be given their final pay by the next regular payday.
Identity theft... how to destroy documents
The federal government requires employers to restrict access to personal information that might lead to identity theft. Specifically, any information that can be reported by a consumer reporting agency, such as social security numbers, addresses, and telephone numbers, must be kept confidential. That means that the files (either paper or electronic) should not be available for other employees to see.
This information must be destroyed before discarding it. If it is on a computer, it must be deleted before discarding or donating the computer. If it is on paper, it must be shredded before discarding. Failure to do this may subject you to fines or liability for identity theft.
Other requirements
In addition to payroll taxes, employers have many other responsibilities. While all are required, their priorities will depend on the business you are in. For example, if you are starting a construction business, the safety requirements are critical, and should be done before hiring employees. They are less critical to a consulting business. Because of that, we have put most of these requirements in the "Filling in the Gaps" section of this kit. Please review them and if any are critical to your business, do them before hiring employees.
Part-time, on-call, exempt, hourly
Employee classifications are often used to to distinguish which employees receive certain benefits. For example, a company may develop a policy that only full-time workers and part-time workers over 30 hours receive vacation benefits. Companies have this flexibility in most areas, except:
More about overtime
Click here for more information about overtime rules.
"Contractors"
Please review Are you an Employer? for information about independent contractor requirements.
Payroll calculator https://www.paycheckcity.com/calculator/salary/
Each employee must complete a W-4 to declare the number of withholding allowances and to authorize federal income tax withholdings.
Forms to use
W-4 Employees Allowance Certificate
How often?
Required for each employee
When you use W-4
Prior to an employee's first pay date. W-4s remain in effect until an employee submits a new form to reflect a change in marital status or withholding allowances. Employees who claim they are exempt from taxes have to submit these forms annually.
How to complete W-4
Each employee should complete the Personal Allowance Worksheet on the front page. The two worksheets on the back side of Form W-4 are only used if the employee:
More allowances? Less tax withholding
Each federal allowance represents $3,900 in tax withholdings. If an employee regularly receives IRS refunds over $3,900 or has to pay more than $3,900, they should consider adjusting their allowances.
Questions?
Call the IRS information hotline at (800) 829-4933.
The Homeland Security Office requires this form for all employees, regardless of nationality.
You can only ask for this information AFTER you have decided to hire the worker - otherwise it could be considered discrimination.
Forms to use
Do not discriminate
An I-9 form is required for ALL new hires. As long as the worker can show you the documents discussed below, it is illegal to discriminate in hiring or firing practices. This form is not required for independent contractors or for workers employed by other employers (such as a temporary employment agency).
How often
Required for each new employee
When you use this form
Upon hiring each employee. If you are hiring someone to work for less than three business days, this form MUST be completed with the required documents shown to you prior to beginning work. If the person will work for more than three business days, this form can be completed within three days of hire.
IF under 18:
You cannot choose which documents the worker must show you. Photocopies are not acceptable, except if it is a certified copy of a birth certificate. If you do not believe a form is valid, you may ask for another document from the list. You can also call for assistance at your nearest Immigration Field Office or the Office of Business Liaison (see phone number below).
How to complete
Where to send the form
Keep them, in case the U.S. Citizenship and Immigration Service or U.S. Labor Department audits your business.
Remote hires
If you cannot personally see the documents to verify their authenticity, the INS recommends that employers use an agent (a notary public, accountant, attorney or other). Faxed or mailed documents do not satisfy I-9 requirements.
No docs? No Job
Employers should not continue to employ someone who cannot present documentation that meets INS requirements.
How long to keep forms
You must keep I-9 forms until the later of: the employee's termination date plus one year or the employee's third year after hiring.
Additional Information
You can find complete information about I-9 requirements by visiting http://www.uscis.gov/I-9Central
What to do
Contact your insurance broker to determine your choices for workers compensation coverage. Because of the complexity of the workers' compensation system, most insurance carriers will not give quotes over the phone but will require that you complete a questionnaire so that they can determine your rates based on your exact industry and job classifications.
Time deadlines
Upon hiring your first employee.
Approximate cost
Insurance rates are charged on each $100 of payroll. Although carriers are allowed to determine their own rate, the rates are monitored by the State. Determining rates is very complex and depends on your industry as well as the job types.
Up-front costs
Most businesses must pay a deposit premium The deposit amount is based on the estimated annual premium and the payment schedule. It is common to prepay the entire first year. Often the deposit can be increased to reflect extra risks such as a new business, hazardous activities, etc. Future premium payments may be monthly, quarterly, semi-annually or annually.
Corporate officers, partners and business owners
Corporate officers and partners may be eligible for exclusion from workers' compensation coverage when certain conditions are met. Sole proprietor business owners are automatically excluded unless they specifically request to be covered.
To get a quote, your carrier must know
Warning: Do not simply request workers comp coverage for your independent contractors. The IRS may consider that to be evidence that you are inconsistently treating these workers as both employees and independent contractors, which will invalidate their independent contractor status. Please consult with a labor attorney before taking any action.
Multiple classifications for one employee possible
After your carrier has discussed the classifications chosen for your business, be sure to ask for a list of similar classifications and their rates. In some industries, it is possible for one employee to work in several job classifications. Employers can save in premiums by keeping payroll records that clearly distinguish the type of work done.
Annual audit
Most workers comp carriers will audit your payroll annually and make premium adjustments. The amounts that you pay during the policy year are based on an estimated annual premium. At the expiration of the policy, an audit will be done and a final premium will be determined, resulting in a refund or a bill for additional premium due.
Can you avoid getting coverage?
Workers compensation was developed to protect both your employees and employers. Through this system employees generally cannot sue employers for injuries, but must obtain benefits and any other compensation through the workers compensation system.
Hiring employees is an important, but serious step for any business. Regardless of a business' size, employers must comply with a vast number of state and federal laws, or face significant fines. Small businesses are particularly vulnerable to fines because many don't know the laws or keep appropriate records.
Key areas:
Here are some areas of frequent labor disputes.
At will employment and termination
At-will employment means that the employer and employee have a right to terminate their relationship at any time with or without cause. This is invalidated if the employer implies that employees are protected by a higher standard. Avoid making statements (written or oral) regarding job security, anything that implies an employment contract or anything that implies that the employee can only be terminated for specific causes. This is an area of extensive lawsuits.
Should you use employment contracts?
In general, no. Employment contracts invalidate at-will employment - so you can only fire someone (or an employee can only quit) if it complies with the contract. If you have an employment contract and one party violates it, the other party can seek financial compensation. With that said, employment contracts are sometimes used if the hiring firm wants a key employee to commit to being with the company for a specific period of time, or if a key employee wants the hiring firm to commit to compensation if (s)he is dismissed within a certain period of time. If you want to use an employment contract, it is critical that both parties work with attorneys to protect their interests.
Please note that if you use an employment contract, the person is still your employee, not an independent contractor.
Can you hire workers as independent contractors?
Only if the person is truly in business for him/herself - and you have no RIGHT to control the worker or the work. They can
Click here for more information about independent contractors.
Employee records
Unemployment records must be retained in Arizona for a minimum period of four years. This information generally includes: name; social security number; dates of hire, rehire and termination; wages by period; Payroll pay periods and pay dates; date and circumstances of termination.
If you use independent contractors, do not keep their files with employee records, or use any of the same forms, because they are vendors, not employees.
Pay upon Termination
Fired employees must receive final pay within 3 working days and voluntarily terminated employees must be paid by the next regular payday.
Fair employment
Don't discriminate in age (40+), race, sex, religion, national origin, physical or mental disability (including AIDS), or pregnancy. Provide equal opportunity. Pay equal pay for equal work. Do not retaliate. Do not sexually harass.
Rest and meal breaks
In Arizona there is no provision covering required rest or meal periods.
Local employee protection laws?
Contact your city to learn about any local employee protection laws affecting private business. Some cities have restrictions regarding computer terminals and some prohibit businesses from discriminating against employees due to their appearance. Some require you to pay sick leave.
