Employee classification ultimately affects how you issue payroll. Each team member will be paid differently depending on whether they are a full-time or part-time employee, independent contractor, their relationship to the business, and what they’ve chosen to have withheld from their paycheck.
Additionally, the employer must ensure they are covering necessary taxes, health insurance premiums, 401k match, and other benefits for their payroll.
Here’s how employee classification impacts payroll.
Payroll Laws and Regulations
Before moving on to talk about how employee classification affects your payroll, you may be surprised to know that payroll does have legal obligations.
Employers that violate the payroll laws specified by the IRS or any other government institute may face penalties.
Here are just a few of the payroll laws that employers should be aware of are:
- Fair Labor Standards Act (FLSA)
- Federal Insurance Contributions Act (FICA)
- Federal Unemployment Tax Act (FUTA)
- Equal Pay Act (EPA)
- Davis-Bacon Act
How to Issue a Payroll: the Basics
Payroll represents the sum of the total monetary and non-monetary incentives that an employee gets. These typically fall into the following three categories:
1. Compensation
This includes the compensation that the employer and the employee or contractor have agreed upon in the contract. The pay could be on an hourly or monthly basis.
Note: this compensation amount and what you withhold will vary depending on whether your team is on hourly pay or salary (and therefore subject to overtime), part-time or full-time, and independent contractor or employee.
2. Benefits
Deducted from the paycheck are the employee’s share of any benefits the employer provides (the employer will typically contribute as well). These paycheck deductions typically cover 401(k) contribution and health insurance premiums (including dental or vision).
3. Withholding Taxes
Depending on the jurisdiction, taxes may be municipal, state, or federal in nature. All employers, however, are obligated to contribute to Social Security and Medicare for employees (though independent contractors will cover these taxes themselves).
Employers typically withhold:
- Social Security
- Medicare
- State Withholding
- Federal Withholding
The amounts and percentages will be impacted by what the employee claims and asks to have withheld on their W4 form.
Employer Obligations
The classification of your employee will impact payroll, but it will also impact what you must pay as well. Employers pay federal unemployment taxes. For the 2023 tax year, the federal tax rates are as follows:
- Social Security: 6.2% of an employee’s gross wages, up to $132,900 for each employee
- Medicare: 1.45% of gross wages with no earning limit
- Federal Unemployment Tax: 6% of gross wages, up to $7,000 for each employee
An employer will also cover a portion of the employee’s health insurance premiums, and sometimes offer 401(k) match.
How Employee Classification Affects Payroll
In the previous section, we outlined the basics. But, each member of your team will have different benefits and tax withholdings based on their classification.
For example, a full-time employee be eligible for all benefits of the company and rely on the employer to set aside a portion of their paycheck for taxes and pay that on their behalf, while an independent contractor typically won’t be eligible for benefits and will pay all taxes on their own.
Below, we dig in further.
Full-Time Employees
A typical full-time employee works within an organization at least 40 hours a week, and is either paid salary or hourly.
Compensation
Compensation for a full-time employee will be calculated either by dividing their yearly salary over the pay periods, or by multiplying their hours by their hourly rate (including time and a half for any overtime).
Benefits Deductions on Payroll:
For full-time employees, you will typically deduct the below from the paycheck:
- Social Security
- Medicare
- 401k Contributions
- Health insurance premiums
These amounts will be determined by the forms your employee provides, including W4, 401k documents, and health insurance plan selections.
Withholding Taxes on Payroll:
Following are the taxes you may need to withhold on your full-time employee on your payroll:
- Social Security and Medicare taxes
- Federal income tax
- State and local income tax
- Federal and state unemployment
This is determined by the employee’s tax forms. Of course, consulting with a CPA when setting up (and, even better, managing ongoing payroll) can help ensure this is done accurately.
Tax Form to Submit for Full-Time Employees
Following are the forms that you have to use to report these taxes:
- For Social Security and Medicare, an employer uses SSA-1099. The taxes are paid by both the employer and the employee, paying 6.25% and 1.45% for social security and medicare respectively.
- For federal income tax, use the employee’s Form W-4 and Employee’s Withholding Certificate.
- For state and local income tax, fill out the state Form W-4.
- For federal and state unemployment, use form-940.
It is important to note that Part-Time Employee goes through the same steps and has to submit almost the same taxes except 401k and health insurance (unless provided by the employer, which is becoming more common)
Independent Contractor
Independent contractors are not classified as employees, and retain full autonomy in how they perform the assigned tasks. These workers are not given employee benefits in a company and are responsible for all portions of their taxes.
Employers are not even required to withhold taxes on behalf of independent contractors. These are not payroll employees, they are paid on a contract basis.
Benefits Deductions on Payroll
An independent contractor is not liable to get any direct benefits from the company, so the employers don’t need to make their deductions on the payroll.
However, in some cases, the independent contractor may ask for the benefits that the company provides. In such cases, the employer may need to deduct a portion of his salary.
Withholding Taxes on Payroll:
A contractor is responsible for paying his own taxes, including federal income tax and self-employment tax. A company will not withhold taxes from their pay until he asks for benefits from the company.
Tax Form to Submit for Independent Contractor
- Form W9 must be filled by independent contractors so that their Tax Identification Number is verified by the company and the IRS.
- The company should fill out form 1099 and send it to the IRS when they are paying the independent contractor
Owner’s Children
According to federal law, if you own a business, you can hire your children who are younger than 16 in your business. If you plan to have your children work at your company to take advantage of this tax benefit, we highly recommend speaking with a CPA to be sure you are following the regulations correctly.
Benefits Deductions on Payroll
Your children are liable to opt for the retirement plan. There is no age limit to claim these plans.
However, you can not contribute more than 100% of your income. For example, if your child gets $1500 then his contribution limit is $1500.
Withholding Taxes on Payroll:
The IRS states that if the work is legitimate (that does not involve hard labor), you can pay your child an amount of $12,000 per year tax-free (2019). This implies that there is NO federal tax on your children’s income who are working in your business.
Furthermore, many states in the U.S. also exempt unemployment taxes (FUTA) for the owner’s children. If your children work in a sole proprietorship, partnership, or LLC owned by you, they may also be exempted from employment taxes (FICA).
Tax Form to Submit for Owner’s Children
Since most of the earnings of your children are tax-free while working in your company, you may not submit a lot of taxes.
However, for documentation purposes, it is helpful to fill out our federal W-4 and state W-4 forms.
Volunteers
Volunteers are the people in your organization who you hire to do required work without giving them many incentives as compared to normal full-time employees.
Benefits Deductions on Payroll
As mentioned before, volunteers are not full-time employees, so they may not be eligible for all the benefits that a normal employee has.
However, for non-profits, volunteers may be classified as employees, so they may get fringe benefits.
Withholding Taxes on Payroll:
If you decide to take on volunteers in your organization in exchange for some experience, you may still need their records to process different exchanges you made with them.
These exchanges may include:
- Gifts
- Rewards
- Any cash reimbursement
You may need to report these exchanges to the IRS and make a deduction on the volunteers’ payroll.
Tax Form to Submit for Volunteers
For exempt organizations, they may report their volunteers using Form 990.
Can a Payroll Vary in Each Company?
Since different companies provide different benefits listed for their employees, the payroll really varies a lot.
The benefits that you may need to consider on your payroll if you are providing to your employees.
- Overtime pay
- Benefits
- Reimbursements
- Tips, commissions, bonuses
Moreover, as mentioned in beginning, you can calculate your payroll based on four steps:
- Step 1: Employee classification.
- Step 2: Deducting federal and state income tax on the employee’s income.
- Step 3: Deduct benefits (normally includes employee+employer contribution).
- Step 4: Deducting Social Welfare and Medicare taxes.
The Importance of Consulting with a CPA
Payroll, taxes, and correct employee classification is important to avoid any IRS penalties, ensure your team is paid properly and accurately, and managing your business’ financials. It’s critical to, at the very least, consult with a CPA as you are making these decisions. Having the appropriate guidance on what to withhold when and why, what paperwork you need, and what your own burden will be can mean you are fully prepared for the financial obligations of paying your team.
What Happens if You Misclassify Employees on Payroll?
If you observe all the taxable implications for the different classifications (full-time, contract), you will notice that each classification goes through different rules and regulations.
For example, if you mistakenly classify a contractual person as a full-time employee, you are required to provide extra benefits to the person for who he is not liable.
Moreover, a contractual person is liable to pay taxes himself, so you may waste extra time and money that you are NOT obliged to.
Furthermore, misclassifying a person may result in the IRS penalties as well.
