Payroll for a first employee

In short

A friend of mine ran a bakery for six years alone, and the day she hired her first helper she felt proud and a little sick to her stomach. If you are about to do the same, you have every right to feel both. Before the first paycheck, get an Employer Identification Number from the IRS, which is free on the IRS website. Have your new hire fill out Form W 4 for federal withholding and Form I 9 to show they may work in the United States. Learn your state's rules too, because your state may want its own registration, tax account, and workers' compensation cover. Set aside the tax money the moment you pay wages, and do not treat it as yours. Pick a payroll schedule and stick to it. You can do this, and the steps are smaller than they look.

The whole of it

What it is

I once watched a neighbor shake hands with a young man on his porch and call it a job. It was a kind gesture, but it left out a great deal. Payroll is the set of jobs you take on once someone works for you and you owe them wages. You figure out what they earned. You hold back their share of taxes. You add your own share of taxes. You send that money to the right agencies on time. You keep records.

You are, in a sense, the middleman between your worker and the government. That is a lot of trust, and the law treats it seriously. The money you hold back from a paycheck is not yours to borrow. It belongs to the government from the moment you withhold it.

There is a question that comes first, and it is worth a minute. Is this person an employee, or a contractor who runs their own business? The IRS looks at how much control you have over the work and how it gets done. If you set the hours, supply the tools, and direct the work, that person is likely an employee. The IRS explains the tests in Publication 15 A, Employer's Supplemental Tax Guide. Getting this wrong can be costly, so read it before you decide.

How it works

If you are holding a signed offer letter and wondering what comes next, here is the road as I understand it. It runs in a sensible order.

First, get your EIN. It works like a Social Security number for your business, and the IRS gives it out free. Second, check with your state. Most states want you to register for a state withholding account and a state unemployment insurance account. Many also require workers' compensation insurance, which pays for injuries on the job. Your state labor department can tell you which apply to you.

Third, have your employee complete Form W 4, Employee's Withholding Certificate. This tells you how much federal income tax to hold back. Fourth, complete Form I 9, Employment Eligibility Verification, within three business days after the person starts. You look at their documents and keep the form on file. You do not send it to the government. Fifth, report the new hire to your state, since states keep a directory of new hires.

Then comes the pay itself. Each payday you take the gross pay, which is the full wage before anything comes out. You subtract federal income tax, based on the W 4. You subtract the employee's share of Social Security and Medicare tax, which together are called FICA. You subtract any state or local taxes. What remains is the net pay, and that is the check your employee takes home.

Now for your side. You also owe an employer share of Social Security and Medicare, matching what you took from the worker. You may owe federal unemployment tax, called FUTA, and state unemployment tax too. These come from your pocket, not the employee's. Budget for them before you set the wage.

Last, deposit and report. You send the withheld taxes and your own share to the IRS on a schedule the IRS assigns. You report them on Form 941, Employer's Quarterly Federal Tax Return. After the year ends, you give your employee a Form W 2 and file copies with the Social Security Administration.

The numbers, and where to find yours

Every year some of these figures change, so I will not pin one on a page and leave it to go stale. The Social Security tax rate is the current figure, which the official source publishes each year for both you and your employee. The Medicare tax rate is the current figure, which the official source publishes each year each. Social Security tax only applies up to a yearly wage cap, which is the current figure, which the official source publishes each year. Above that cap, no more Social Security tax is due on that worker's pay. Your federal unemployment tax rate is the current figure, which the official source publishes each year, and it applies to a limited amount of each worker's wages, set at the current figure, which the official source publishes each year. Many employers get a credit against FUTA when they pay state unemployment tax on time.

Where do you find the real figures? Publication 15, called the Employer's Tax Guide, lists them each year. It also holds the withholding tables. State rates live with your state workforce or revenue agency. Your state assigns your unemployment tax rate, and a new business often starts with a standard new employer rate. Read your own notice, since it will not match your neighbor's.

A worked example

Let me tell you about a woman named Marisol, who runs a small landscaping company. She hired her first employee, Devon, at a salary of 52,000 dollars a year, paid every two weeks. That makes 26 paychecks.

Marisol divides the salary by the number of paychecks. 52,000 divided by 26 equals 2,000 dollars gross pay per check. That is Devon's wage before any tax comes out.

Next she works out the Social Security and Medicare hold back. To keep the math plain, suppose the Social Security rate is 6.2 percent and the Medicare rate is 1.45 percent, which are the rates the IRS has published in recent years. Always confirm the current rates in Publication 15 before you run real payroll. Social Security is 2,000 times 0.062, which is 124.00 dollars. Medicare is 2,000 times 0.0145, which is 29.00 dollars. Together that is 153.00 dollars from Devon's check for FICA.

Federal income tax comes from the W 4 and the tables in Publication 15. Say the tables call for 160.00 dollars on this check. State tax, say 60.00 dollars. Marisol adds up what came out: 153.00 plus 160.00 plus 60.00 equals 373.00 dollars. Devon's net pay is 2,000 minus 373, which is 1,627.00 dollars.

Now Marisol's own cost. She matches the FICA, so she owes another 153.00 dollars. Her true cost for this one paycheck is 2,000 plus 153, which is 2,153.00 dollars, and that is before unemployment taxes and insurance. Over 26 checks, her share of FICA alone is 153 times 26, which is 3,978.00 dollars. Marisol did not see that number coming, and it changed how she priced her jobs.

She then deposits 373.00 plus 153.00, plus her matching 153.00, to the right agencies on schedule. That totals 679.00 dollars for the pay period, split between federal and state as the rules direct.

Where it goes wrong

I have seen good people trip on the same few stones. The biggest is spending the withheld tax money. A slow month comes, cash is tight, and that tax cash looks tempting. It is not yours. The IRS can hold owners personally responsible for withheld taxes that go unpaid, and that is a painful place to stand.

Another stone is mixing up employees and contractors. Calling someone a contractor does not make them one. What counts is the real working relationship. The IRS and your state each have their own tests, so check both.

Late deposits and late filings bring penalties and interest. So does skipping paperwork. A missing I 9 can cost you in an audit. Forgetting workers' compensation can be worse, since a single injury without cover can sink a small shop.

Some owners also forget that state rules differ. Overtime, minimum wage, pay stubs, and final paychecks all follow state and federal wage law. The Department of Labor's Wage and Hour Division explains the federal side. Keep your records in one tidy place. It saves you later.

Finally, many people try to do it all by hand and burn out. Payroll software or a payroll service costs money, and it also removes a whole pile of arithmetic. Weigh that cost against your hours. Only you can say which fits.

Questions to answer before you leave this page

Have you decided whether your new hire is truly an employee or a contractor, and can you explain why? Do you have your EIN, and have you checked what your state wants for withholding, unemployment insurance, and workers' compensation? Have you priced the full cost of the job, including your share of FICA and unemployment taxes, so the wage you offer fits your budget? Where will you keep the withheld tax money so it stays untouched until the deposit is due? Who will file your quarterly and yearly forms, and will you do it yourself or hire help? And when did you last read the current Publication 15 for this year's figures?