Small business owners face a variety of challenges every day. In addition to the day-to-day operations of the business, the task of processing payroll for employees can often be overwhelming, and mistakes made can result in sizable financial penalties and fines. Here is some essential information that every employer should know when preparing for payroll processing.
1. Classifying Workers
Employers must identify which category each worker fits into based on the business relationship they have with that worker. Workers can be classified as an employee, an independent contractor, a statutory employee or a statutory nonemployee.
- Typically, a worker is classified as an employee when the employer maintains a continuous relationship with the worker, provides a workplace and tools with which to perform his or her job and has the right to terminate employment.. In this instance, the employer decides what work needs to be performed, and has the right to specify how it will be done. Payments to workers classified as employees require employers to withhold taxes and report wages subject to taxation; employers are also responsible for employment taxes such as unemployment, Social Security and Medicare.
- Payments to workers classified as independent contractors generally do not require any withholding and are reported annually using a Form 1099.
- Some workers who qualify as independent contractors can be treated as statutory employees for certain employment tax purposes if they are an agent or commissioned driver, a full-time life insurance salesperson, a home worker or a traveling or city salesperson.
- Independent contractors who are considered statutory nonemployees include direct sellers and licensed real estate agents and are treated as self-employed for tax purposes.
Employers may use IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax, to help them determine the classification of a worker. The completed form is submitted to the Internal Revenue Service (IRS) which will notify the employer of the decision. However, while awaiting the IRS’ determination, the employer must treat the worker as an employee, including withholding taxes and reporting wage and tax information.
The U.S. and individual state departments of labor, state unemployment agencies, workers’ compensation bureaus and the U.S. Citizenship and Immigration Services closely monitor the classification of workers. Misclassification of workers can result in costly penalties for the business, as well as the payment of back wages.
2. Tax Regulations for Family Members
Children under the age of 18 working for a parent who is a sole proprietor or a member of a 50/50 spousal partnership are not subject to Social Security, federal unemployment or Medicare taxes. At 18 these children become subject to Social Security and Medicare taxes, however they continue to be exempt from federal unemployment tax withholding until the age of 21.
An individual who works for his or her spouse in a sole proprietorship is not subject to federal unemployment taxes. They are, nevertheless, subject to Medicare and Social Security taxes.
3. Employee Hiring Records
Employers must make sure they fill out all of the required paperwork upon hiring a new employee.. Forms W-4 and I-9 need to be filled out and kept on file. Additionally, the employee’s Social Security number should be verified and new hire reporting requirements need to be met.
New hires must complete Form W-4 to determine how much tax should be withheld from their pay. In some states there is also a state equivalent of the W-4 form that the employee should complete. Both should be kept on file by the employer in the employee’s file and new forms should be completed each year.
The federal government requires that each employee complete Form I-9 and that it be kept on file by the employer at all times. Form I-9 verifies an employee’s eligibility to work in the United States. This form is required to be completed by all employees and is completed only after hiring to prevent discrimination. All Forms I-9 need to be kept in a file separate from the employee’s main employment records because, in the case of an audit, the auditor is to have access to only the Forms I-9 and no other personnel records. It is critical for employers to keep records of these forms for every employee since there are significant fines associated with not having them on file. It is also important to note that there are significant penalties that can be levied against businesses that employ persons who are not legally able to work in the United States.
Each employee’s Social Security number (SSN) should be verified to ensure that Social Security funds are being applied to the proper Social Security account. The Social Security Administration has created a free tool, the Social Security Number Verification Service, for employers to use for SSN verification purposes. You can learn more about using this service on the Social Security Administration’s website.
In October of 1996, a federal law was created that requires all employers to report new hires to their individual states, which then report the new hires to the National Directory of New Hires. While individual state requirements vary, most states require that new hires be reported within 10 to 20 days of the date of hire. To assist with this process, many states have an online tool available. Be sure to check with your individual state to ensure that you meet its reporting requirements. Links to each state’s department of labor website can be found on the U.S. Department of Labor’s website.
4. Fair Labor Standards Act (FLSA)
The Fair Labor Standards Act was enacted in 1938 and governs minimum wage, overtime, child labor, recordkeeping and equal pay laws. Currently, the federal minimum wage set through FLSA is $7.25 per hour and tipped employees’ minimum wage is set at $2.13 per hour. It is important to keep in mind that although this federal law may set a specific standard, like minimum wage or youth employment rules, individual state laws supersede those standards if they are to the benefit of the employee. It is always prudent to check with your individual state to ensure that you are in compliance in your state.
Although the FLSA does not cover vacation pay, sick pay, jury duty leave, holiday pay, breaks, pay frequency or hourly restrictions for individuals over the age of 16, most states have regulations that do.
All documents regarding an employee’s hire, reviews, disciplinary action, termination paperwork, etc. should be kept in a confidential file for each individual. How long it is necessary to retain those records varies depending on the government agency and the type of paperwork involved.
- The FLSA states that all employee payroll records be kept for three years after the date of the last entry. Details on FLSA's recordkeeping requirements are on the U.S Department of Labor website.
- The IRS requires that employee records be kept on file for four years and they levy stiff penalties if it is found that those records have not been kept.
- The Family and Medical Leave Act (FMLA) requires employers with over 50 employees to retain records regarding any employee leave under FMLA.
- State unemployment agencies require that records be retained for anywhere from four to seven years; be sure to check with your individual state to ensure compliance with your state’s law.
As there are usually significant fines and penalties assessed against employers who are not in compliance with federal and state employment laws, business owners should consult with their legal and/or accounting professional to ensure that they are in compliance with all laws.