Payroll Taxes and Wage Rules for Small Employers: The Legal Basics

Hiring employees brings tax and wage obligations that differ from working with independent contractors. Mistakes can lead to back taxes, penalties and personal liability, so many owners use payroll services or professionals.

Setup steps

1. Obtain an employer identification number from the IRS.
2. Register with your state tax agency and unemployment insurance agency.
3. Have each employee complete Form W-4 and a federal employment eligibility form.
4. Set up payroll to withhold income tax, Social Security and Medicare taxes.
5. Deposit taxes on the schedule required and file the required returns.
6. Obtain workers' compensation insurance where required.

Payroll taxes

• Employees' share of Social Security and Medicare is withheld from wages.
• Employers pay a matching share and federal and state unemployment taxes.
• Income tax withholding depends on the employee's W-4 and state rules.
• Trust fund taxes withheld from employees must be held for the government, and failure to pay can lead to personal liability for responsible persons.

Wage and hour basics

• Federal and state minimum wage laws apply, and the higher rate controls.
• Non-exempt employees must be paid overtime, generally time and a half over 40 hours a week, and some states have daily overtime.
• Exempt status depends on both salary level and job duties, not job title.
• Tipped employee rules, meal and rest breaks, and pay frequency vary by state.

Employee or contractor?

Misclassifying employees as independent contractors can lead to back taxes, overtime liability and penalties. Use the tests for your state and the federal agencies. See our guide to the employee versus independent contractor test.

Recordkeeping

Keep payroll records, time records, tax filings and personnel files for the required periods, often at least three to four years. Accurate records protect you in audits and wage claims.

Common pitfalls

Paying cash off the books, treating salaried workers as automatically exempt, not paying for all hours worked, taking unauthorized deductions and missing payroll tax deposits are common mistakes that lead to penalties.

Getting help

Payroll providers, accountants and employment lawyers can set up compliant systems. Your state labor department and the IRS publish guidance and may offer small-business assistance. Check requirements before your first hire. See our guide to hiring your first employee.

Real-life scenarios

1. A new employer uses a payroll service to handle withholding and deposits.
2. An employer corrects a misclassified salaried employee and pays back overtime.
3. A business owner learns trust fund taxes can create personal liability and files on time.

Common mistakes to avoid

• Not registering with state agencies.
• Misclassifying workers.
• Missing tax deposits.
• Assuming salary means exempt.
• Poor recordkeeping.
• Making improper wage deductions.

Questions to ask a professional

• Which agencies must I register with?
• Is this worker an employee or contractor?
• Is this position exempt?
• What deposit schedule applies?
• Do I need workers' compensation insurance?

A practical action plan

1. Get an EIN and register with state agencies.
2. Set up payroll and collect forms.
3. Classify workers correctly.
4. Track hours and pay overtime when due.
5. Keep records and file on time.

Terms you may hear

• EIN: employer identification number.
• Withholding: taxes taken from wages.
• Exempt employee: not entitled to overtime.
• Trust fund taxes: employee taxes held for the government.
• Misclassification: treating an employee as a contractor.

Frequently asked questions