CHAPTER
9

Setting Up New Team Members

In This Chapter

• When to treat yourself as an employee
• Employees versus independent contractors
• Forms for new employees
• Paying hourly and salaried workers and owners
• Processing payroll

Not every business has employees. Sometimes a business is organized to simply own property or hold an ownership stake in other companies. Many businesses, though, have at least one employee.

In Chapter 2, we discussed different business structures. If you operate your business as a sole proprietorship, you are a de facto owner who, in some ways, is treated as if you’re an employee of your business. However, the other types of businesses may or may not have employees. As you’ll see in this chapter, you might be required to classify yourself as an employee. In Chapter 4, we discussed the concept of paying distributions to yourself; beyond that, the Internal Revenue Service (IRS) does require corporate officers to pay themselves a reasonable salary.

You also have to determine whether your “hires” are employees or independent contractors, file the correct paperwork to establish employment, meet the requirements for paying hourly wages and salaries, and choose a method for processing payroll. This chapter walks you through the essentials of all these employment issues.

Are You an Employee?

If you’re an officer in a corporation you own, you might be required to treat yourself as an employee. The IRS provides specific guidance to help with making this determination in Publication 15-A Employer’s Supplemental Tax Guide. In short, if you take an active role in the day-to-day operations of a corporation, at least a portion of your compensation must be paid to you in the form of payroll.

As noted in Chapter 4, owners of a corporation may elect to pay themselves distributions. However, distributions from a S corporation are often exempt from the payroll taxes (more on this in Chapter 12), so owners tend to want to minimize this tax. Dividends disbursed from a C corporation are taxable to the owner.

The IRS only provides vague guidance that owners must pay themselves a “reasonable salary.” We say vague guidance because the IRS reserves the right to make its own determination if you’ve been underpaying yourself. A tax professional can help you determine an appropriate pay level for your industry, or you might be able to find resource material online or at your local public library. You can be subject to additional taxes, as well as interest and penalties, if the IRS inspects your records and finds that you’ve been substantially underpaying yourself.

The Difference Between Employees and Independent Contractors

Now, should your team members be considered employees or vendors? Having employees triggers a number of payroll taxes (more on this in Chapter 12), some of which are borne solely by the business. As such, business owners sometimes try to classify new hires as contractors, which shifts the burden of those taxes to the contractor instead of the business. Further, employees are often entitled to benefits and reimbursements (see Chapter 11), whereas contractors are not.

The IRS lists three specific criteria for determining whether someone is an employee:

Behavioral control: Factors such as set work hours, specific work locations, required meetings, and whether or not work can be performed by a substitute without issue all contribute to whether a worker is considered an employee or independent contractor. The more control the employer has over the behavior of the worker, the more likely the worker is classified as an employee.

Financial control: Another primary determining factor is whether required equipment and supplies are provided to the worker, or if the worker is responsible for supplying them. The latter tends to suggest the worker is an independent contractor. Other factors include whether customers pay the worker directly, whether expenses are reimbursed, and the worker’s responsibility for economic loss or financial risk.

Relationship type: A primary test of employment is if the worker performs services for only your firm or provides services for yours and other firms as well. A worker who performer services for multiple companies is more likely to be classified as an independent contractor. Further tests include whether the worker is entitled to paid vacation, holidays, or sick pay—all of which equate to employee benefits—and whether the relationship can be terminated without liability or penalty, which is more likely to describe an independent contractor.

Keep in mind that as an employer, you really don’t have a choice regarding this classification unless there’s a very gray area. If these guidelines point to a clear definition of either an employee or an independent contractor, that’s the classification you must use.

However, if the lines between employee and independent contractor are fuzzy, consider other issues when making a decision as to how to classify workers. Aside from the obvious benefit of not having to withhold and pay payroll taxes if your workers are independent contractors, here are some additional issues to consider when determining classification of workers:

• Employees are subject to wage guidelines, including minimum wage and overtime laws.
• Employees must be covered by workers’ compensation insurance, paid for by the employer, as well as unemployment tax.
• Employees are entitled to benefits based on the company’s benefit structure.
• Employees have the right to vote to unionize.
• Employees are often subject to right-to-work laws that allow employers to terminate them without cause, whereas independent contractors are under contract and the employer might not have the right to choose which contractors are doing the work.
• Independent contractors decide how and when they’re going to do the job and what they’re going to charge.
• Independent contractors are not necessarily covered by workers’ compensation insurance, but that might not alleviate the employer’s liability if the worker is hurt on the job. Your workers’ compensation carrier might require you to report amounts paid to independent contractors, which will increase the premium you pay.
• Employees who are paid any amount of wages during a calendar year must be issued Form W-2 (see Chapter 18). Conversely, you must issue Form 1099 to report compensation paid to independent contractors in the amount of $600 or more per calendar year.

BOTTOM LINE

Workers who feel they’ve been inappropriately classified as independent contractors can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS. This document requests information about the working relationship so the IRS can launch an investigation. However, employers may also elect to file Form SS-8 on a preemptive basis to avoid unexpected tax penalties for making an inappropriate determination regarding a worker.

New Hire Paperwork

Hiring a new employee can be an exciting time for your business, but it also can be a lot of paperwork. Although we can’t provide specific guidance for every situation, we can provide an overview of the types of rules and regulations with which you might be expected to comply.

As we noted in Chapter 2, your business must register for an employer identification number (EIN) with the IRS if you have any employees. You also will be required to register with one or more regulatory agencies within your state government and possibly your local government.

Federal Paperwork

Employers are required to hire only individuals who are legally entitled to work in the United States. This obviously includes all U.S. citizens, but also foreign citizens who have proper authorization, commonly referred to as a Green Card.

U.S. Citizenship and Immigration Services operates a system known as E-Verify employers can use to determine the eligibility of job applicants. Presently, E-Verify is optional for many employers, although participation can be mandatory for employers that perform work for the federal government. Further, certain states require either all or most employers to participate in the E-Verify system. Visit uscis.gov/e-verify to register for and utilize the E-Verify system.

RED FLAG

Many websites masquerade as free or paid services that will purportedly get you up to speed on complying with government regulations. As a general rule, federal government websites usually end in .gov. Tread carefully when seeking online guidance on federal and state regulations so you don’t inadvertently expose yourself or your employees to identify fraud or unnecessary fees.

Other than the E-Verify system, the federal government doesn’t require any formal notification that you’ve hired a new employee. However, you will want to request the following documents from every new hire:

Form I-9, Employment Eligibility Verification: Individuals use this form to verify they can legally work in the United States. It provides the information you need to provide to the aforementioned E-Verify system.

Form W-4, Employee’s Withholding Allowance Certificate: This form allows employees to either document, in limited cases, that they are exempt from federal income tax withholding, or document the number of exemptions they want to claim for withholding purposes. Each exemption reduces the basis for which an employee’s federal income tax withholding is calculated but does not affect Social Security or Medicare withholding. This form also documents an employee’s Social Security number, which you need to file Form W-2, Wage and Tax Statement, at the end of each calendar year when reporting each employee’s wages and state and federal withholding taxes.

ACCOUNTING HACK

To help new employees determine how many exemptions to claim, direct them to the online withholding calculator available at irs.gov/Individuals/IRS-Withholding-Calculator.

Beyond these two forms, the federal government won’t take any other initial interest when you first hire new employees.

State Paperwork

Your state takes interest in new hires from two perspectives:

New hire reporting: In 1996, Congress enacted the Personal Responsibility and Work Opportunity Reconciliation Act, which requires employers in all 50 states to report new hires, re-hires, and temporary employees. In part, this program helps enforce child-support compliance and helps detect citizens who attempt to collect public assistance or unemployment insurance and paychecks at the same time. An internet search with your state’s name and the phrase “new hire” helps you locate the official website for your state’s new-hire directory.

Federal law requires you to report new hires within 20 days of their hire date, but your state might set an even shorter timeframe. Check your state’s specific procedures and timeframe.

Withholding allowances: States with an income tax typically have their own version of the federal Form W-4. Most employees will want the same number of withholdings for both state and federal purposes, but you should provide the state form when applicable.

Local Paperwork

In certain situations, your new hires might have to register for a permit from your local municipality, which could mean city, county, or township. For instance, in Georgia, the city of Atlanta requires professionals in the medical, cosmetology, and athletic training fields to register for annual licenses.

Rules for Hourly and Salaried Employees

As an employer, you have a lot of latitude when it comes to how much you pay employees, but you do have to conform to the Federal Labor Standards Act (FLSA), which is administered by the U.S. Department of Labor. In short, the FLSA sets standards for minimum wages and overtime, which we discuss in a moment.

Employers often try to classify as many employees as salaried as possible because this fixes annual payroll costs. Some employees relish knowing what their paycheck will be each pay period, while others might want the opportunity to earn overtime pay.

Hourly Workers

As of this writing, the federal government requires that every employee age 16 and over be paid at least $7.25 per hour. If an employee works 40 hours a week for 52 weeks, this translates to an annual pay of $15,080. Some cities and states mandate higher minimum wages, so be sure to check your local statutes. You’re required to use the state minimum if it’s higher than its federal counterpart.

Federal law also requires hourly employees be paid time and a half ($10.88 per hour for minimum wage employees) for any hours beyond 40 in a 7-day period.

There’s no state or federal requirement to extend paid vacation to hourly workers, as you learn in Chapter 11. However, some states, cities, and counties have enacted legislation that requires paid sick time for certain workers.

Although there’s no federal requirement to do so, some employers offer time-and-a-half or even double-time pay to employees who work on holidays. Doing so can make it easier to staff a business that operates on holidays and can yield goodwill with employees.

Some businesses try to skirt certain employment regulations by limiting certain workers to less than 30 hours per week. Such part-time workers usually aren’t entitled to most of the employee benefits we discuss in Chapter 11. Although the cost savings might appear enticing, you’ll likely experience higher employee turnover—and incur the costs related to hiring and training new employees often. Also, customer service could suffer if your employees don’t feel invested in your company.

Salaried Workers

The FLSA governs both hourly and salaried employees. Salaried employees—often referred to as exempt employees, meaning the employee is not eligible for overtime pay—are expected to complete their job responsibilities each week even if those tasks require more than 40 hours of time. Salaried employees are typically part of a company’s management or professional staff.

Exempt employees must earn at least $455 per week ($23,660 a year), although some states require an even higher minimum. At the time of this writing, new federal guidelines are being proposed to raise the $455 limit so be sure to check the current guidelines.

Salaries provide a fixed cost for employers, but unfair expectations with regard to job responsibilities can send salaried employees running for the door. As we discuss in Chapter 11, your business might offer paid vacation time or sick leave. Depending on the arrangement you strike with your employees, even salaried employees can have their pay docked when they take sick or vacation time that exceeds company policies.

RED FLAG

Employee wages are serious business, and you might be surprised at the levels of government that have enforcement power over employee wages. Federal minimum wage changes require an act of Congress, which means the rate doesn’t change very often. The current rate of $7.25 an hour took effect on July 24, 2009. However, state and local governments are authorized to set minimum wage levels that are higher than the federal level, and these can and do change more frequently. Disgruntled employees often have multiple governmental agencies that are interested in correcting unfair or illegal wage practices so keep your pay practices on the right side of the requirements.

Paying Owners

Technically, an owner of a corporation is within his or her right to decide to work for free and just take a share of the profits in the form of a dividend when the corporation is successful. However, the IRS frowns on this behavior and believes that if a corporation is functioning, someone must be doing some work on its behalf and, therefore, employment occurs. Yet beware of the nuances: sole proprietors (and partners in a partnership) normally aren’t considered employees and do not receive a W-2. Owners of entities treated as corporations can be employees.

Some studies seem to indicate that a reasonable rule to apply is a 60/40 rule, wherein 60 percent of the distribution to a working owner is treated as salary, subject to payroll taxes, and the remaining 40 percent is treated as dividend. This percentage can, and should, change when an owner goes into semiretirement, the business has a reason to accumulate capital, or a number of other business-based circumstances occur.

The 60/40 rule is a starting point for determining the portion of employment of a business owner and by no means is written in stone. Your own calculation of what constitutes a reasonable salary should be well documented so you can support the logic of it should the IRS contest your determination.

BOTTOM LINE

We’ve focused this discussion on taxable corporations and have not addressed salary rules for owners of other types of entities. There’s more flexibility in determining a salary/dividend/draw split in S corporations, LLCs, partnerships, and other types of business entities. No matter what type of entity you choose, discuss your plans for ownership withdrawals with your tax adviser.

Payroll Processing Options

At this point, you might be realizing that the simple act of paying someone can mean a great deal of complexity. Fortunately, you do have options.

You could outsource payroll processing to a third party, or your accounting software might allow you to electronically calculate payroll and related taxes. But both of these options require some level of financial outlay.

If you’re on a tight budget or have very minimal payroll processing needs, you can manually calculate the payroll tax amounts due. Let’s look at the ins and outs of each of these processing methods.

Third-Party Providers

Many businesses enlist the services of a national fee-based payroll provider, such as ADP (adp.com), Ceridian (ceridian.com), or Paychex (paychex.com). These companies specialize in making payroll simple by providing the following options:

• Employees can be paid by direct deposit.
• Payroll taxes can be automatically remitted to the designated tax authorities.
• Periodic tax reporting, such the items discussed in Chapter 18, can be filed automatically.

When using these services, you report the hours worked by hourly employees, and the payroll provider automatically calculates the amounts due.

Of course, you also pay a fee for the payroll provider’s services. These vary depending on the frequency of your payroll (weekly, biweekly, semimonthly, or monthly) and the number of employees you have. All national providers offer websites where you can set up new employees and administer pay rates and withholding requests. Some even offer apps you can use on mobile devices. They also can directly provide or connect you with resources for time clock options if needed.

You have many other options for payroll processing beyond national providers. Your bank may offer payroll processing, as do cloud-based payroll services such as Kronos (kronos.com), SurePayroll (surepayroll.com), and ZenPayroll (zenpayroll.com). Pricing varies, but typically, assuming some level of responsibility through a cloud-based provider gives you the best of both worlds, meaning reduced costs and reduced paperwork.

Payroll service providers such as these provide summary reports you can use to post your payroll expense to your books. Many businesses use journal entries to post payroll expenses, as we covered in Chapter 7, but you also can record a check, as we discussed in Chapter 6. In this case, the check would be made payable to the payroll provider and include all the salaries, wages, and related payroll taxes.

Accounting Software Options

Most desktop and cloud-based accounting software programs offer built-in payroll features.

However, the software vendors generally consider this a bonus feature that requires an additional fee. For desktop-based accounting programs, such as QuickBooks and Sage 50, you must purchase a separate payroll subscription each year—in addition to your software license—that unlocks the payroll features of your accounting software. Some programs only streamline payroll calculations (that is, the subscription enables you to calculate payroll taxes for any jurisdiction in the United States). Others enable you to electronically file your payroll tax returns. Some provide reports that allow you to determine your tax liability for a given time period, but usually you’ll need to remit the taxes yourself, as we discuss in Chapter 18.

If you choose to process payroll within your accounting software, the first step is to enable the payroll feature, typically via the Help or Payroll menu. If you’re using a desktop-based accounting program, you’ll be prompted to periodically download tax updates that implement the latest payroll tax calculations. These updates are transparent within cloud-based accounting programs.

Within the accounting software, you’ll set up each employee individually. For instance, in the desktop version of QuickBooks, you’ll find an Employees menu at the top of the screen, along with Employee Center and Payroll Center commands.

QuickBooks desktop centralizes all employee and payroll activities in the Employee Center.

Conversely, Sage 50 Accounting takes a more distributed approach. You need to choose Maintain and then Employees/Sales Reps to set up a new employee. A Payroll command on that same menu provides access to payroll configuration options. You initiate paychecks from the Tasks menu by choosing one of two Payroll Entry options.

Sage 50 offers a decentralized approach to maintaining employees and processing payroll.

Your accounting software provides fields for you to specify both demographic and financial information about your employees. You’ll utilize the employee’s I-9 and W-4 forms for much of the data for these screens.

Different accounting software asks for new employee information in slightly different formats.

After you complete the employee setup, your accounting software automates most of the calculations related to payroll.

Manual Calculations

Although many aspects of payroll processing can be automated, you still can perform all the calculations by hand if you prefer. The IRS offers Publication 15, commonly referred to as Circular E, that contains guidance on calculating payroll tax withholding, including tax tables you can use.

RED FLAG

Due to the complexities and vagaries of payroll processing, you might quickly abandon manual calculations unless you have a situation in which most calculations related to employee paychecks are relatively constant. Another downside of manually preparing the withholding is that rates different from the standard tables in Circular E may be required for supplemental pay or bonuses.

Many businesses outsource as much of the payroll process as possible, which is certainly understandable given the complexities. Outsourcing also reduces the potential exposure of missing a payroll tax remittance or reporting deadline. Fortunately, if try handling payroll on your own and decide it’s too much, you can send it out. What’s important is that you ensure you have mechanisms in place so you accurately and timely comply with the federal, state, and local payroll regulations that apply to your business.

The Least You Need to Know

• If your business is a corporation, you might need to treat yourself as an employee and pay yourself a reasonable salary in addition to any draws you take.
• The IRS provides rules that can help you determine if a worker is an employee or an independent contractor.
• Every new employee is required to fill out employment forms, and employers are required to report new employee information to the government.
• You must comply with pay laws and regulations for both hourly and salaried employees.
• As an owner, you might need to use a method such as the 60/40 rule as a starting point to determine how much to pay yourself in salary (60 percent) versus draws (40 percent). The actual amounts of reasonable compensation vary among regions of the country and other economic factors.
• You can use a payroll service or employ the payroll features in your accounting software to complete this task.