Hiring your first employee is a big step for any small business, but it involves more than just onboarding and payroll. It introduces a range of tax responsibilities that can impact your bottom line if not managed properly.
From federal withholding to employer-paid taxes and compliance rules, things can get complex fast. This guide breaks down what business owners need to know before and after they hire. We cover key tax obligations, common mistakes, and tips for staying compliant while managing costs.
Understanding the Basics of Hiring Employees
Employee vs. Independent Contractor: Why Classification Matters
Misclassifying workers can lead to costly penalties. Employees are subject to payroll taxes and protections, while independent contractors handle their taxes. The IRS assesses multiple criteria, such as behavioral control, financial control, and the nature of the relationship, to determine status. Getting this right ensures proper tax treatment and protects your business from audits and back taxes.
Legal Requirements Before Hiring
Before hiring, secure an Employer Identification Number (EIN) and register with state labor and tax agencies. Understand wage laws, anti-discrimination rules, and eligibility verification using Form I-9. Furthermore, comply with federal and state new hire reporting requirements. Handling these steps early keeps your business legally prepared.
Payroll Setup and Withholding Obligations
You must set up a payroll system to withhold and deposit federal, state, and local taxes. This includes income tax, Social Security, and Medicare. Accurate calculations and timely filings are essential. Whether using payroll software or a service, ensure you remain legally responsible for all payments and documentation.
Federal Tax Responsibilities
Federal Income Tax Withholding (Form W-4 and W-2)
Employees complete Form W-4 to determine withholding. Employers compute and subtract taxes from pay at the end of the year, then submit the totals on Form W-2. Additionally, forms need to be sent to the Social Security Administration. Errors can lead to penalties and tax problems for both parties.
Social Security and Medicare Taxes (FICA)
FICA taxes are divided between employers and employees, with each party contributing 6.2% for Social Security and 1.45% for Medicare. Employers must match these amounts. Funds support retirement and healthcare benefits. The frequency of payroll deposits is determined by the size of the payroll, with options for either monthly or semiweekly deposits available. Compliance ensures you avoid penalties.
Federal Unemployment Tax (FUTA)
Employers pay FUTA to fund unemployment benefits. The base rate is 6% on the first $7,000 in wages, but timely state payments may reduce it to 0.6%. Only employers contribute. To maintain credit eligibility, please ensure you are familiar with your deposit schedule.
Employer Matching Requirements
It is essential to ensure that you remit the full amount of FUTA taxes and provide matching contributions for FICA as mandated. These amounts are real costs and should be included in hiring budgets. The Electronic Federal Tax Payment System (EFTPS) serves as a mechanism for processing tax payments efficiently. Late or incorrect filings can trigger audits and fines.
State and Local Tax Requirements Before Hiring Employee
State Income Tax Withholding
Most states require withholding from wages. Certain states impose no income tax whatsoever, and there is considerable variation in tax rates and regulations across different jurisdictions. Register with your state’s tax agency, follow deposit schedules, and file reports accurately. Failing to withhold correctly can lead to enforcement actions.
State Unemployment Insurance (SUI)
Employers pay SUI taxes to fund jobless benefits. New employers get standard rates, which may change based on claims. Some states also withhold a small portion from employee wages. Adhere to the specified filing and payment guidelines to avoid incurring penalties.
Local Payroll and Employment Taxes
Cities and counties may impose additional taxes, based on either work location or residence. You may need to register with local tax authorities and manage multiple rates. Multi-state businesses or remote teams increase the complexity, requiring diligent tracking and systems.
New Hire Reporting Requirements
Federal law requires you to register new hires with your state. Reports must include basic employee info and be submitted within 20 days. This procedure helps enforce child support and prevent fraud. Penalties may be imposed for late reporting.
Additional Costs and Tax Considerations
Workers’ Compensation Insurance
Most states require workers’ compensation coverage. Rates depend on payroll size, industry, and claims history. There may be penalties or legal action for not having coverage. Include this cost in your hiring budget and shop for competitive policies to manage expenses.
Employer-Paid Benefits and Their Tax Treatment
Offering health or retirement benefits can lower tax liability if structured properly. Many benefits are tax-deductible and reduce payroll taxes. But rules are strict. Some perks are taxable. Maintain clear documentation and follow IRS guidelines for benefit taxation.
Impacts on Business Deductions
Wages, payroll taxes, and benefits are typically deductible. But deductions require accurate classification, reporting, and documentation. Improper practices can disqualify deductions. Work with a tax advisor to ensure your payroll expenses meet IRS standards.
Budgeting for Hidden Payroll Costs
Beyond salaries, payroll includes software fees, training, onboarding time, insurance increases, and compliance materials. These hidden costs add up. Create a comprehensive budget for each employee to prevent surprises and maintain a stable cash flow.
Tax Credits and Incentives for Employers
Work Opportunity Tax Credit (WOTC)
WOTC rewards hiring individuals from certain groups, like veterans or the long-term unemployed. Credits range up to $9,600 per employee. Submit Form 8850 within 28 days of hiring. Keep records to ensure your qualification and legally reduce your tax bill.
Small Business Health Care Tax Credit for Hiring Employees
If you provide insurance through the SHOP Marketplace, you may qualify for a credit of up to 50% of premiums. Businesses must have fewer than 25 employees and meet average wage thresholds. The two-year credit may cover benefit expenditures.
State and Local Hiring Incentives
States and cities may offer hiring credits, training reimbursements, or wage subsidies. These often require applications before hiring. Programs may target certain industries, wage levels, or geographic areas. Research local options to maximize your return on hiring.
Compliance and Documentation for Credits
To claim any credit, you need detailed records on eligibility, hours worked, and wages. Missed deadlines or incomplete forms can disqualify your claim. Use payroll systems or advisors to track requirements and file accurately.
Common Tax Mistakes When Hiring Employees
Misclassification Risks and Penalties
Incorrectly classifying workers as independent contractors may result in significant back taxes and penalties. The IRS uses control tests to determine status. Please review each role carefully and consider consulting an advisor if you are unsure. Mistakes here are among the most costly and common. Mistakes are among the most prevalent and costly in this area.
File Failure Penalties or Deposit Taxes
Missing tax deadlines for deposits or filings results in penalties. Please ensure you are acquainted with your deposit schedule and confirm that all filings have been completed. Payroll software helps, but it does not eliminate your responsibility. Set calendar alerts and review reports regularly.
Not Keeping Adequate Payroll Records
Incomplete payroll records can disqualify deductions and trigger audits. Keep records of wages, hours, withholdings, benefits, and filings for at least four years. Digital tools help, but human oversight is still needed to ensure accuracy.
Ignoring State and Local Tax Obligations When Hiring Employee
Each state and locality has its own rules. Failing to register or file properly can cause compliance issues. Multi-state teams and remote workers add complexity. Understand where each employee lives and works, and update systems accordingly.
How to Stay Compliant and Reduce Risk
Use of Payroll Services or Software
Payroll software helps automate tax calculations, withholdings, and filings. Many payroll platforms also automatically update to reflect changing tax rules. Choose a system that fits your business size. While automation is helpful, please ensure that taxes are submitted and filed promptly.
Scheduling Regular Tax Reviews
Review payroll records, deposits, and filings quarterly. This helps catch errors early and adjust for new regulations. As your team grows or expands into new areas, reviews become even more essential. Partner with a tax advisor for extra oversight.
Partnering with a Small Business Tax Advisor
Tax advisors help you understand requirements, optimize tax credits, and avoid costly errors. They are especially valuable when expanding into new states or adding complex benefits. An ongoing relationship provides year-round support and peace of mind.
Final Thoughts When Hiring
Hiring employees comes with important tax and compliance responsibilities. Every decision, from classification and payroll taxes to deductions and credits, has a significant impact on your business. Staying organized, using reliable tools, and consulting a tax professional will keep you compliant and efficient.
Schedule a consultation with JoQuin Associates today to guarantee that your employment business is consistent with the most recent tax laws and industry standards.