Your Business Payroll Guide to Employee Tax Classification

Are you a small business owner concerned about improperly classifying your employees? You don’t want to risk an audit, you need to be sure to get the right tax classification for everyone working for you. 

Don’t worry if you don’t know anything about payroll taxes or what your tax liability may be, we’ve got you covered. Keep reading to learn all about what you’re responsible for and how to know the right classification for each person working for you. 

The Right Tax Classification of an Employee

When it comes to employment law and your tax responsibilities, you can’t afford to get it wrong. Employee law is clear, you need to know whether or not each person working for you is a  W-2 employee vs a 1099 employee. At the end of the year, you need to know what to send to everyone who did anything for you throughout the year. 

The difference between independent contractor vs employee is whether or not you withhold their taxes from their paycheck or they’re responsible for their own tax liabilities. There are three different factors the government uses to determine whether or not someone on your payroll is a contractor or an employee. These three factors are: 

  1. Behavioral control
  2. Financial control
  3. Type of relationship

There are some distinct differences between each of these tests to see who qualifies to be a contractor or an employee. First, contractors work with several other businesses at the same time. And salaried employees generally only have one employer and are considered W-2 employees. 

Contractors and Freelancers

Anyone who is an independent contractor or freelancer offers their services to several different business owners. They are considered self-employed and are responsible for paying their own FICA taxes. Many people might think about accountants or graphic designers when they think of contractors, but doctors and dentists are also considered self-employed contractors. 

In terms of the first test for behavioral control, will you give detailed training for how to do the job or are you hiring a professional to complete a project without much micromanaging? Additionally, will you evaluate their performance regularly or expect them to do their job correctly since you’ve hired an expert?

Answering these tests will tell you if you’ve hired an employee or a contractor.

Exempt Employees

Exempt employees are those people working for you who are paid by the hour and are restricted by the Fair Labor Standards Act guidelines for fair pay practices. They must be paid at least minimum wage per hour and any work over the usual 40-hour workweek must be fairly compensated with overtime pay. 

How and when you pay your workers also determines if they’re an employee or not. Will you be paying them by the hour on a regular pay schedule? Then they’re probably an employee. Can the person work elsewhere and would they expect their expenses to be reimbursed?

An employee can’t work elsewhere and can expect their expenses to be reimbursed, while a contractor claims their expenses on their taxes. 

Non-Exempt Employees

Non-exempt employees are paid a salary based on the work they complete rather than the hours they work. If they work less than forty hours in a given week they are still paid their same salary. And likewise, if they work more they are not compensated for their extra hours.

Additionally, if you provide benefits to your workers, then they’re an employee and not a contractor. All of these different tests will show you whether or not your workers are employees or contractors. 

3 Different Payroll Taxes

As a small business owner, it’s vitally important that you’re aware of the taxes you’re responsible for withholding and paying for your W-2 employees. There are three main types of taxes you’re responsible for when it comes to your exempt and non-exempt employees. 

Income Tax Withholdings

You must withhold taxes from wages for anyone who receives a W-2 from you at the end of the year. This includes even employees who aren’t paid an hourly wage such as a salesperson who is paid solely on commission. Whenever you pay each employee you must show their income tax withholdings that are sent to the IRS on their behalf. 

FICA Taxes (Social Security and Medicare)

FICA taxes are also withheld from the employees’ paychecks and sent to the IRS on behalf of the employee. These taxes include a 6.2% Social Security tax and a 1.45% Medicare tax. These numbers are contingent on the employee’s income and you should consult with your CPA to ensure you’re withholding the correct amount

Unemployment Taxes

This is a tax paid by the employer to the state and federal governments to cover the expenses of providing unemployment compensation to anyone who is unfairly let go due to no fault of their own. The amount you will need to pay is commensurate with your employee’s wages but doesn’t come from their wages. You pay this as the business owner. 

Your Payroll Concerns Solved

Appropriate classification of your employees is important for your business to ensure that you stay on the right side of the law. You can’t afford an audit, even if you win, it will still cost you more time and money than you need to spend. 

Be sure that you choose the right tax classification so that your employees can trust that they won’t have a large tax bill at the end of the year and you won’t have to risk the IRS calling. 

If you’re ready to learn how our payroll services can ensure you’re properly classifying everyone working for you, then reach out to us today. We help business owners like you every day and we’re here to help you too. 

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