Payroll, Employee Taxes & Contractor Management

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Introduction: Payroll Is Your Largest Legal Liability

Most entrepreneurs get payroll wrong.

They hire employee, pay them cash, don’t file paperwork.

Seems simple. But it’s illegal and creates massive liability:

  • Unpaid employment taxes (penalties can exceed 100% of taxes owed)
  • Wage & hour lawsuits (employees can sue for unpaid overtime)
  • Workers’ compensation violations
  • IRS audit (if cash payments discovered)

Proper payroll setup is non-negotiable.

Part 1: Employee vs. Contractor – The Critical Distinction

The Test (IRS Common Law Test)

Is person an employee or contractor?

IRS uses “Common Law Test”:

  1. Control Test: Do you control what, how, and when work is done?
    • Employee: You control everything
    • Contractor: They control method, schedule
  2. Financial Test: Do you pay for tools, training, expenses?
    • Employee: Company pays
    • Contractor: They pay their own
  3. Relationship Test: Is this ongoing, permanent relationship?
    • Employee: Ongoing, indefinite
    • Contractor: Short-term, project-based

Real Example: Employee vs. Contractor

Scenario 1 (Employee):

  • Person works in your office
  • You provide computer, phone, software
  • You determine hours (9-5 M-F)
  • You assign projects
  • You supervise daily work
  • Relationship is indefinite

Result: EMPLOYEE (must be on payroll)

Scenario 2 (Contractor):

  • Person works from their home office
  • Uses their own equipment
  • Works 20 hours/week on their own schedule
  • You give end goal, they determine approach
  • You review completed work
  • Project ends in 6 months

Result: CONTRACTOR (1099, no payroll)

Misclassification Risk:

If you classify employee as contractor, penalties include:

  • Back payroll taxes
  • 15.3% penalty (employer + employee)
  • Potential 50% of unpaid taxes penalty
  • Interest on all amounts

Example: $100,000 paid to misclassified employee

  • Payroll taxes owed: $15,300
  • Penalty: $7,650
  • Interest: $2,000+
  • Total liability: $25,000+

Never take this risk. Classify correctly.

Part 2: Payroll Setup Step by Step

Step 1: Get EIN

If you don’t have EIN:

  • IRS.gov, Form SS-4
  • 10 minutes, free
  • Needed to hire anyone

Step 2: Choose Payroll System

Options:

  • ADP: Traditional, full-service, $50-150/month
  • Gusto: Modern, easy, $40-120/month
  • Paychex: Business-focused, $20-100/month
  • Square Payroll: Good for retail, integrated
  • Wave Payroll: Free for basics

Recommendation: Gusto or Square for small businesses. They handle everything (payroll, taxes, filings).

Step 3: Register for State Payroll Taxes

Contact state labor department, register for unemployment insurance, income tax withholding.

Step 4: Set Up First Paycheck

Run payroll through chosen system.

System calculates:

  • Gross pay
  • Federal income tax withholding
  • Social Security withholding (6.2%)
  • Medicare withholding (1.45%)
  • State income tax withholding
  • Net pay

Example: $5,000 gross pay

  • Federal income tax: -$600
  • Social Security: -$310
  • Medicare: -$73
  • State income tax: -$200
  • Net pay: $3,817

Employer also pays:

  • Employer Social Security: $310 (6.2%)
  • Employer Medicare: $73 (1.45%)
  • Federal unemployment: $48
  • State unemployment: $35
  • Total employer cost: $5,466 (vs $5,000 gross)

Step 5: Pay Payroll Taxes

Monthly or quarterly (depending on business size), payroll system reminds you.

You pay federal withholdings, employer taxes to IRS.

System files paperwork automatically (if you use Gusto, etc.)

Part 3: 1099 Contractor Management

What Is 1099?

1099 is form sent to contractor (and IRS) reporting amount paid.

Contractor reports this as self-employment income.

Contractor Payment Process:

  1. Hire contractor for project ($10,000)
  2. Contractor completes work
  3. Send invoice (or you pay agreed amount)
  4. Pay contractor (check, ACH, PayPal)
  5. At year-end, send 1099-NEC form showing $10,000 paid
  6. File copy with IRS

1099 Requirements:

  • Need contractor’s name, address, tax ID (SSN or EIN)
  • Pay threshold: If paid $600+ in year, must send 1099-NEC
  • Send by January 31 of following year
  • File with IRS by February 28

Contractor Red Flags:

If contractor:

  • Is actually doing employee-type work
  • You control their schedule/methods
  • They work exclusively for you
  • You provide tools/office space

These are misclassification risks. Reclassify as employee.

Part 4: Common Payroll Mistakes

Mistake 1: Not Filing Payroll Taxes on Time

Late payroll tax filing can result in 50-100% penalty.

Set automatic reminders. Mark payroll tax deadlines in calendar.

Gusto/ADP handle this if you use them properly.

Mistake 2: Misclassifying Employees as Contractors

Biggest mistake. Results in $15,000-50,000+ penalties.

Use IRS Common Law Test. When in doubt, classify as employee.

Mistake 3: Not Having Payroll Records

If audited, must show:

  • Hours worked
  • Gross pay
  • Deductions
  • Taxes paid
  • Filings submitted

Keep detailed records for 3-4 years minimum.

Mistake 4: Paying Cash to Avoid Payroll Taxes

Illegal. Results in penalties plus criminal charges possible.

Never do this.

Mistake 5: Not Providing Paystubs

Law requires providing paycheck stub with gross, deductions, net.

Gusto/ADP provide automatically.

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