The new employer's checklist for the first year of payroll and taxes

Nobody warns you about the day you become an employer. The work is piling up. You are doing the books at midnight. A good person walks in and says yes, I would take that job. You shake hands, you feel like an American success story, and then it hits you: you are no longer just a person with a business. You are an employer. And an employer, in this country, is something like a part-time unpaid deputy of the federal government, several state agencies and, in some towns, the county.

I say that with affection and a little bit of anger. Affection, because creating a job is the finest thing a person can do in the economy. Anger, because the paperwork that comes with that first hire is the reason a good many people never make one. That is a policy complaint and I will spend plenty of time on it in other posts. This one is about the practical side. The rules exist, the penalties are real, and a shop owner who knows the list in advance sleeps better than one who finds out by letter.

What follows is a checklist, grouped by the job to be done, with the reason for each item so that you know what you are doing and not just that you should do it. It is general information, not legal or tax advice, and the details vary by state, so use it as a map and then confirm each item with the IRS, your state agencies, or a payroll professional. A word on my format: I will keep the steps plain, because that is what a checklist is for.

Before the first day

Get an employer identification number (EIN). It is a nine-digit number the IRS assigns to your business, and it is the number every payroll form carries. You apply for free on the IRS website, or on paper with Form SS-4. Reason: you cannot file payroll returns or deposit payroll taxes without it. If you are a sole proprietor who has been using your own Social Security number, you still need an EIN as soon as you have employees.

Register with your state. Most states require a registration for withholding state income tax (where there is one) and a separate registration for the state unemployment insurance program. Reason: the state has its own claim on every paycheck, and the account numbers go on your quarterly reports. Start with the state tax agency and the state workforce agency.

Line up workers' compensation coverage. Nearly every state requires employers to carry it, and it pays for medical care and lost wages if an employee is hurt on the job. A few states have exceptions, such as small-employer thresholds, so check yours. Reason: an uninsured injury can sink a business, and in many states going without coverage is itself a violation.

Choose how you will run payroll. You can do it yourself with software, hire a payroll service, or hand it to an accountant. Reason: the work recurs every payday, and the penalties for late deposits are stiff. The cost of a service is often smaller than the cost of one mistake.

Check local licenses and registrations. Your city or county may require a business license or a registration tied to employees. Reason: the local rules are the ones most often overlooked, because no federal form mentions them.

On the first day of work

Complete Form I-9, Employment Eligibility Verification. The employee fills out Section 1 no later than the first day of work. You, the employer, examine the employee's documents and complete Section 2 within three business days of the start. Reason: federal immigration law requires you to verify that every new hire is authorized to work, and you keep the form on file. The form lists which documents are acceptable, and you may not demand specific ones. Some states also require or encourage E-Verify, so look at your state's rules.

Collect Form W-4, Employee's Withholding Certificate. The employee tells you how much federal income tax to withhold. Reason: you must withhold according to it. If an employee doesn't give you a W-4, the instructions tell you to treat the person as single with no adjustments. Also collect your state's withholding form if the state has an income tax.

Report the new hire to your state. Federal law requires employers to report new hires to a state directory, within 20 days of the hire date, and some states set a shorter deadline. Reason: the directory helps states enforce child-support orders and detect unemployment fraud. Most states let you do it online in a few minutes.

Post the required notices. Federal and state labor law posters must be displayed where employees can see them. Reason: employees must be told about their rights on minimum wage, overtime, safety and discrimination, and inspectors check for it.

Decide whether the job is exempt or nonexempt. Under the Fair Labor Standards Act, most hourly employees must be paid at least the minimum wage and overtime for hours beyond 40 in a week. Some salaried employees are exempt, but only if they meet both a salary test and a duties test. Reason: calling someone "salaried" does not by itself excuse you from overtime, and back-pay claims for overtime are among the most common employment disputes.

Every payday

Withhold and calculate the payroll taxes. From each paycheck you withhold federal income tax (from the W-4 and the IRS withholding tables in Publication 15-T), the employee's share of Social Security tax at 6.2 percent, and the employee's share of Medicare tax at 1.45 percent. You, the employer, owe a matching 6.2 percent and 1.45 percent on top. Together that is 7.65 percent from each side. Reason: these are known as the trust fund taxes, because you are holding the employee's money in trust for the government.

Deposit the taxes on schedule. You deposit the withheld income tax, the Social Security and Medicare taxes, and your own matching share, electronically. Your deposit schedule is monthly or semiweekly, based on how much tax you reported in a lookback period, and there is a next-day rule if you accumulate $100,000 or more in liability. New employers generally start on the monthly schedule. The IRS's Employer's Tax Guide, Publication 15 (known as Circular E), lays out the schedules. Reason: late or missing deposits bring penalties that start at 2 percent and climb to 15 percent, and the "trust fund recovery penalty" can make the people responsible for payroll personally liable for the withheld taxes, even if the business has failed. Do not use those dollars to cover rent.

Keep payroll records. Hold on to hours, wages, deposits and the forms. Reason: the IRS recommends keeping employment tax records for at least four years, and wage and hour disputes can reach back further.

Every quarter

File Form 941, Employer's Quarterly Federal Tax Return. It reports wages paid, tax withheld and your matching shares. It is due by the last day of the month after the quarter ends: April 30, July 31, October 31 and January 31. Reason: the IRS reconciles it against your deposits and the W-2s you file later. The IRS lets some very small employers file once a year on Form 944 if it notifies them to do so.

File your state quarterly wage report and pay state unemployment contributions. Reason: the state uses these reports to determine your employees' eligibility for benefits and to set your contribution rate.

Every January

Send the W-2. Form W-2, Wage and Tax Statement, goes to each employee, and a copy goes to the Social Security Administration, by January 31. Reason: the employee needs it to file a return, and the SSA uses it to credit earnings to the worker's Social Security record.

File Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return. It is due January 31. The federal unemployment tax is a separate tax paid by the employer alone, and the statutory rate is 6.0 percent on the first $7,000 paid to each employee. Employers who pay their state unemployment taxes on time get a credit of up to 5.4 percent, so the effective federal rate is usually 0.6 percent. Reason: this tax funds the federal part of the unemployment system. In a state that has borrowed from the federal government and not repaid, the credit can be reduced, and the effective rate goes up.

File Form 1099-NEC for contractors. If you paid an independent contractor above the reporting threshold during the year, you report it on Form 1099-NEC by January 31. Reason: this ties directly to the next item, since a contractor is not paid through payroll.

The employee-or-contractor test

This is the item that trips up more small businesses than any other, and it deserves a section of its own. Treating someone as an independent contractor lets you skip withholding, matching taxes and workers' compensation. That is why some owners are tempted to do it, and why agencies watch for it.

The IRS uses a common-law test that looks at three categories of evidence:

1. Behavioral control. Do you control what the worker does and how? Instructions, training and set schedules point toward an employee.
2. Financial control. Does the worker have unreimbursed expenses, invest in equipment, offer services to the market, and have a chance of profit or loss? Those point toward a contractor.
3. Relationship of the parties. Are there written contracts, benefits, and a permanent relationship? An open-ended arrangement points toward an employee.

No single factor decides it. The Department of Labor uses its own "economic reality" approach under the Fair Labor Standards Act, and states apply their own tests, some of them stricter than the federal one. A contract that says "independent contractor" does not settle the question; the facts do. If you cannot tell, the IRS accepts Form SS-8 to request a determination, and an accountant or employment lawyer is worth the fee. The cost of getting it wrong includes back payroll taxes, penalties and interest, and unpaid overtime.

Worked example: what one hire really costs

Here is the arithmetic on a hypothetical first hire so you can see the shape of it. Suppose an employee earns $52,000 a year, paid every two weeks. That is 26 paychecks of $2,000 each ($52,000 divided by 26 equals $2,000).

• Employer's share of Social Security and Medicare, per paycheck: 7.65 percent of $2,000 is $153. Over the year it is 7.65 percent of $52,000, which is $3,978.
• Employee's matching share, withheld from the check: another $153 per paycheck. So each pay period you deposit $306 for those two taxes alone, plus the federal income tax withheld.
• Federal unemployment tax: 0.6 percent of the first $7,000 is $42 for the year, assuming you get the full credit.
• Employer's federal payroll tax cost for the year: $3,978 plus $42, or $4,020. That is before state unemployment tax, workers' compensation premiums and any benefits, which vary widely.

So a $52,000 job costs a bit over $56,000 before the state items and benefits. The worker never sees that gap on the paycheck, which is the subject of why your raise feels smaller than the number your boss pays out. The employee's side of the same ledger is shown in a paycheck worksheet that shows where every dollar of your pay goes.

What to do when the rules get in the way

I said I would not preach, and I will keep that promise: the rules above are the law, and following them is not optional. A man who skips the I-9 or pockets withheld taxes is not being a rebel. He is being reckless with other people's money and his own business.

But a citizen can also push for simpler rules, and many have. You are allowed to comment when an agency proposes a new reporting requirement, and how a small business owner can fight a federal rule before it is final shows how. You are allowed to ask why the compliance burden falls hardest on the smallest firms, which is the argument in Regulation protects us, so why count the cost? Because someone pays it. And you can ask your state legislator which of these registrations could be combined into one. Several states have created a single online portal for new businesses for this reason.

Meanwhile, help is available. The Small Business Administration funds local Small Business Development Centers and works with the volunteer mentors of SCORE, and both give free or low-cost guidance to new employers. The IRS publishes the Employer's Tax Guide and a separate guide for small businesses at no charge. Use them.

The bottom line

• Get your EIN, register with the state tax and unemployment agencies, and arrange workers' compensation before the first day of work, not after.
• On day one, complete the I-9 on time (employee on the first day, employer within three business days), collect the W-4, and report the hire to your state within the deadline.
• Make every payroll tax deposit on schedule. The withheld money belongs to the government and to the employee, and you can be held personally liable for it.
• Calendar the dates: Form 941 each quarter, and the W-2, Form 940 and any 1099-NEC by January 31.
• Treat the employee-versus-contractor question as a legal test, not a preference, and ask a professional when you are unsure.