Section 12.1 Employees, Payroll Taxes and the Importance of Hiring a Payroll Service to Do Payroll & Prepare & File Payroll Tax Returns
If your company will have employees, it must: (i) calculate and withhold the proper federal and state income tax and FICA amounts from employees’ wages, (ii) calculate and pay correct FICA and FUTA amounts to the federal government, (iii) calculate and pay state unemployment tax to the state government, (iv) calculate and pay before the due dates federal and state payroll tax deposits, and (v) prepare and file all federal and state payroll tax returns before the due dates, including, IRS forms W-2s and 1099s. As a person who has been an owner of a law firm with employees for over 20 years, I know that complying with payroll tax laws is a nightmare unless you have an experienced and reputable service do it for you. If you do not get payroll under control, it can be a very expensive disaster.
I recommend that all LLCs I form that have employees hire an experienced and reputable payroll service to handle all payroll tax responsibilities. The small cost per employee for a good payroll service is well worth it when you consider what the services include. A good payroll service helps you remain compliant and alleviates much of the administrative burden that comes with payroll processing, tax filing and time and attendance tracking.
Take a look at what a payroll service can do for your company::
- A solution that allows you to enter your payroll data via phone, fax or the internet virtually anytime, anywhere.
- Your payroll is expertly calculated.
- Professionally produced paychecks delivered and ready for payday.
- Easy-to-use reports that provide you a complete overview of your payroll processing.
- Tax Filing –The service should calculate, file, deposit, and reconcile all your payroll taxes. It should respond to inquiries from taxing agencies regarding the deposits and returns it files for your company.
- Time and Labor Management – Utilize the internet to automate your time and attendance system and ensure your pay policies are applied fairly and consistently. Employees’ hours are transferred directly to payroll, saving you the time it takes to manually tabulate them. Plus math and keying errors can be eliminated, which significantly increases your payroll accuracy.
- New Hire Reporting – The service should automatically report all new hires to the proper agencies, helping to keep you in compliance with these regulations.
- State Unemployment Management – The service should complete and file all claims and appeals within the statutory time limits.
- Payroll processing, including deductions and withholdings for all relevant tax jurisdictions
- Tax Filing and Compliance
- Direct deposit, Check fraud protection, Check signing, stuffing and delivery by bonded courier
- Check Signing and Stuffing
- Overnight Delivery of your payroll
- Electronic Payroll Reports and Data Export
- All year-end W-2 and 1099 reporting and document preparation
- Flexible payroll reporting options including phone, internet or fax
- Automated calculation, depositing, filing and reconciling of all payroll taxes!!
- New Hire Reporting, State Unemployment Insurance Management
Section 12.2 The General Rule for Employees & Independent Contractors
Before engaging a “contract” worker or independent contractor, the company should consult with a tax professional for advice on whether the prospective worker or contractor will, in fact, be considered to be an independent contractor by the Internal Revenue Service rather than an employee. Incorrectly classifying a person as an independent contractor when he or she is actually an employee can result in substantial IRS interest charges and underpayment penalties. One of the IRS’ highest priorities is investigating and collecting payroll taxes so a mistake in classifying a worker can be a very expensive problem.
The general rule is that an individual is an independent contractor if (the person for whom the services are performed) has the right to control or direct only the result of the work, and not what will be done and how it will be done or method of accomplishing the result. Under common-law rules, anyone who performs services for you is your employee if you have the right to control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed. If you have an employer-employee relationship, it makes no difference how it is labeled. The substance of the relationship, not the label, governs the worker’s status. Nor does it matter whether the individual is employed full time or part time.
For employment tax purposes, no distinction is made between classes of employees. Superintendents, managers, and other supervisory personnel are all employees. A manager of a limited liability company is generally an employee; however, a manager who performs no services or only minor services and neither receives nor is entitled to receive any pay, is not considered an employee of the company.
The company generally has to withhold and pay income, social security, and Medicare taxes on wages that it pays to common-law employees.
Section 12.3 The Importance of Properly Classifying Employees & Independent Contractors
Before you can determine how to treat payments the company makes for services to people, you must first know the business relationship that exists between the company and the person performing the services. The person performing the services may be:
- An independent contractor
- A common-law employee
- A statutory employee
- A statutory nonemployee
In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.
It is critical that the company as the employer, correctly determine if individuals providing services are employees or independent contractors. Generally, the company must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. The company, as a general rule, does not have to withhold or pay any taxes on payments to independent contractors. Caution: If the company incorrectly classifies an employee as an independent contractor, it can be held liable for employment taxes for that worker, plus a penalty.
Section 12.4 Who is an Independent Contractor?
A general rule is that the company, as the payer, has the right to control or direct only the result of the work done by an independent contractor, and not the means and methods of accomplishing the result.
Example: Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies, that she obtained through advertisements. Vera is an independent contractor.
Section 12.5 How to Report Payments Made to Independent Contractors
The company may be required to file information returns to report certain types of payments made to independent contractors during the year. For example, it must file Form 1099-MISC, Miscellaneous Income, to report payments of $600 or more to persons not treated as employees (e.g. independent contractors) for services performed for the company.
Section 12.6 Common-Law Employees
Under common-law rules, anyone who performs services for the company is its employee if the company can control what will be done and how it will be done. This is so even when the company gives the employee freedom of action. What matters is that the company has the right to control the details of how the services are performed.
To determine whether an individual is an employee or independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In an employee-independent contractor determination, all information that provides evidence of the degree of control and degree of independence must be considered. Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties. For more information on this topic, see IRS Publication 15-A, Employer’s Supplemental Tax Guide.
Example: Donna Lee is a salesperson employed on a full-time basis by Bob Blue, LLC, an auto dealer. She works 6 days a week, and is on duty in Bob Blue’s showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager’s approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob Blue. The company also pays for Donna’s health insurance and group-term life insurance. Donna is an employee of Bob Blue, LLC.
Section 12.7 Common-Law Rules – Factors Considered by the IRS
To determine whether an individual is an employee or an independent contractor under the common law, you must examine the relationship of the worker and the business. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered. Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties. These facts are discussed below.
Behavioral Control. Facts that show whether the company has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
Instructions that the Company Gives to the Worker. An employee is generally subject to the business’ instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work.
- When and where to do the work.
- What tools or equipment to use.
- What workers to hire or to assist with the work.
- Where to purchase supplies and services.
- What work must be performed by a specified individual.
- What order or sequence to follow.
The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.
Training that the Company Gives to the Worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Financial Control. Facts that show whether the company has a right to control the business aspects of the worker’s job include:
- The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.
- The extent of the worker’s investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
- The extent to which the worker makes his or her services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
- How the company pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
- The extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss.
Type of Relationship. Facts that show the type of relationship between the parties include:
- Written contracts describing the relationship the parties intended to create.
- Whether or not the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
- The permanency of the relationship. If the company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence of an intent to create an employer-employee relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of the company’s regular business activity, it is more likely that the company will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
Section 12.8 Statutory Employees
If workers are independent contractors under the common law rules, the workers may nevertheless be treated as employees by statute (a statutory employee) for certain employment tax purposes if they fall within any one of the following four categories and meet the three conditions described under Social security and Medicare taxes , below.
- A driver who distributes beverages (other than milk) or meat, vegetable, fruit, or bakery products; or who picks up and delivers laundry or dry cleaning, if the driver is your agent or is paid on commission.
- A full-time life insurance sales agent whose principal business activity is selling life insurance or annuity contracts, or both, primarily for one life insurance company.
- An individual who works at home on materials or goods that you supply and that must be returned to you or to a person you name, if you also furnish specifications for the work to be done.
- A full-time traveling or city salesperson who works on your behalf and turns in orders to you from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer s business operation. The work performed for you must be the salesperson s principal business activity. Refer to the Salesperson section located in Publication 15-A, Employer s Supplemental Tax Guide for additional information.
Section 12.9 Social Security and Medicare Taxes for Statutory Employees
Withhold social security and Medicare taxes from the wages of statutory employees if all three of the following conditions apply:
- The service contract states or implies that substantially all the services are to be performed personally by them.
- They do not have a substantial investment in the equipment and property used to perform the services (other than an investment in transportation facilities).
- The services are performed on a continuing basis for the same payer.
Section 12.10 Statutory Nonemployees
There are three categories of statutory nonemployees: direct sellers, licensed real estate agents, and certain companion sitters. Direct sellers and licensed real estate agents are treated as self-employed for all federal tax purposes, including income and employment taxes, if:
- Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and
- Their services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.
Direct Sellers. Direct sellers include persons falling within any of the following three groups:
- Persons engaged in selling (or soliciting the sale of) consumer products in the home or place of business other than in a permanent retail establishment.
- Persons engaged in selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis prescribed by regulations, for resale in the home or at a place of business other than in a permanent retail establishment.
- Persons engaged in the trade or business of delivering or distributing newspapers or shopping news (including any services directly related to such delivery or distribution).
Direct selling includes activities of individuals who attempt to increase direct sales activities of their direct sellers and who earn income based on the productivity of their direct sellers. Such activities include providing motivation and encouragement; imparting skills, knowledge, or experience; and recruiting. Refer to information on Direct Sellers located in Publication 15-A, Employer’s Supplemental Tax Guide.
Licensed Real Estate Agents. This category includes individuals engaged in appraisal activities for real estate sales if they earn income based on sales or other output.
Companion Sitters. Companion sitters are individuals who furnish personal attendance, companionship, or household care services to children or to individuals who are elderly or disabled. A person engaged in the trade or business of putting the sitters in touch with individuals who wish to employ them (that is, a companion sitting placement service) will not be treated as the employer of the sitters if that person does not receive or pay the salary or wages of the sitters and is compensated by the sitters or the persons who employ them on a fee basis. Companion sitters who are not employees of a companion sitting placement service are generally treated as self-employed for all federal tax purposes.
Section 12.11 Misclassification of Employees
If the company classifies an employee as an independent contractor without a reasonable basis for doing so, the company may be held liable for employment taxes for that worker. The economic cost of a mistake can be substantial, especially if the mistake applies to many employees.
Section 12.12 What to Do If You Are Unsure About a Worker’s Status
Because a mistake classifying a worker as an independent contractor when the worker is actually an employee can be so costly, we recommend that you consult with a tax advisor who has experience in this area before engaging the services of the worker. If you want the IRS to determine whether or not a worker is an employee, file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.
Section 12.13 Where to Get More Information on This Topic
For more information about employees and independent contractors, see the following resources:
- Publication 15E, a general discussion of taxable wages.