Lesson 5 - Federal taxes when hiring employees or independent contractors
Small Business Tax Workshop
    References (Links)


    Hello and welcome to our video lesson on federal taxes when hiring employees or independent contractors.

    In this workshop we'll discuss your responsibilities as an employer or as one who pays others for services in the course of your trade or business.

    Whether you're handling this yourself or paying someone else to do it, you need to know this important information.

    It is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, withhold Medicare taxes when applicable, and pay unemployment tax on wages paid to an employee.

    You do not generally have to withhold or pay any taxes on payments to independent contractors unless you are not provided with a required taxpayer identification number or are instructed to withhold by the Internal Revenue Service. In this program, you'll learn about the differences between an employee and independent contractor; how to determine eligibility to work legally in the United States; the importance of the Form W-4 and the employer's responsibility regarding withholding; how to verify work names and Social Security numbers; the process for filing Form W-2; your obligations to notify employees about the Earned Income Tax Credit; the role of individual taxpayer identification numbers; and finally, the process for enrolling in and using the Filing Information Returns Electronically System, also known as FIRE. Before we begin, we'd like to remind you that much of the information we will be discussing here is available from IRS Publication 15 Employer's Tax Guide.

    Employment Taxes

    As an employer, you are responsible for withholding and for paying certain taxes from your employee's paychecks.

    These taxes are for their income taxes and employee share of FICA and that is Social Security and Medicare taxes as well as any applicable additional Medicare taxes.

    They are sometimes called trust fund taxes because you hold them on behalf of — or in trust for — your employees before you deposit them to the Treasury. In addition, you must pay the employer's matching share of FICA taxes and in most cases you will have to pay the Federal Unemployment Tax also known as FUTA tax.

    Generally, if you have properly requested taxpayer identification numbers and have not been advised by the IRS otherwise, you do not have to withhold or pay any taxes on payments for non employee compensation made to independent contractors.

    Worker classification - Employee or Independent Contractor

    The courts have considered many facts in deciding whether a worker is an employee or an independent contractor.

    These relevant facts fall into three main categories: behavioral control, financial control, and the relationship of the parties.

    In each case it is very important to consider all the facts as no single fact provides the answer.

    Behavioral Control

    The facts about behavioral control show whether there is a right to direct or to control how the worker performs the specific task for which he or she is hired.

    A worker is considered an employee when the business has the right to direct and control the worker.

    The business does not have to direct or control the way work is done as long as the employer has the right to direct and to control the work.

    So as an employer ask yourself: does my business have the right to direct and control how the worker does the work I hired them to do? Not just the end result, but am I telling the worker what they need to do to achieve those end results?

    Can I tell the worker when and where to do the work?

    Can I determine what tools or equipment the workers should use or where to purchase supplies and services?

    Can I control whether the worker can hire assistants?

    Can I control what work a specific individual must do and the order in which that work must be done?

    Do I train the worker? Generally, if you have the right to control what will be done and how it will be done the worker is an employee.

    OK. So that's behavioral control.

    Financial Control

    Financial control is another important category you must consider.

    Ask yourself who directs or controls the economic aspects of the work, or more importantly, who can direct and control the business aspects of the work? As an employer with employees, you would direct or control the business aspect of the work.

    Independent contractors however are in business for themselves.

    They usually offer their services to the public or other businesses and may have a significant financial investment in their business or equipment.

    Independent contractors are more likely to have out-of-pocket business expenses and can have their own profits or losses as compared to an employee who has an established salary with no opportunity to make a profit or suffer a loss in connection with the services they provide.

    Relationship with worker

    When considering this final category think about the relationship you intend to have with your worker.

    If you provide employee benefits such as: health insurance, a pension plan, or paid vacation or sick days, this generally indicates an employer — employee relationship.

    Also consider the importance of the workers services.

    If the worker provides services that are a key aspect of your regular business activity it is more likely that the worker is an employee.

    Determining worker status

    It's important to remember that just signing a contract which states the worker is an independent contractor does not automatically make the worker an independent contractor.

    Remember as I said before all the categories of control must be considered and no single fact determines whether the worker is an employee or independent contractor.

    Deciding the worker's employment status up front is important for you and the worker.

    If you misclassify workers as independent contractors and have no reasonable basis for doing so, you may be liable for employment taxes in an event where the IRS challenges their classification.

    If you're still uncertain about a worker's employment status the IRS can help.

    You can send in Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, and the IRS may be able to send you and the worker a determination letter.

    You can find Form SS-8 at www.irs.gov.

    Determining the status of a worker is just the first step in understanding your federal tax responsibilities.

    Before we continue though, we have a question for you.

    And your answer will help us customize this segment.

    Employer responsibilities if you have employees

    Now we're going to go into detail about your responsibilities if you have employees.

    We are going to cover eligibility: to work legally in the United States, Form W-4, Social Security number verification, Form W-2, the Earned Income Tax Credit, and Individual Taxpayer Identification Numbers.

    Determining eligibility of employees to work legally in the U.S.

    As an employer you are responsible for determining that employees are legally eligible to work in the United States. To work in the United States, the employee must be a U.S. citizen, a national, or lawful permanent resident, or must have been granted authorization to work in the U.S.  U.S.

    Citizenship and Immigration Services or USCIS requires that all employers and employees complete Form I-9 Employment Eligibility Verification.

    While citizens and nationals of the U.S.

    are automatically eligible for employment, they too must present proof of identity and employment eligibility by completing Form I-9.

    As an employer you complete the employer section of the form.

    This certifies that you have reviewed original documents establishing the identity and employment eligibility of the employee.

    Form I-9 lists several documents or combinations of documents that the employee can show you to satisfy this requirement.

    For example, an employee may provide a U.S.

    passport or a driver's license and a birth certificate.

    You can find Form I-9 as well as more information at the USCIS’s website: www.uscis.gov/i-9.

    The employee has three business days from the date employment begins to show you that required documentation or a receipt for a replacement document, if documents are lost stolen or destroyed.

    While you can terminate the employment of any employee who does not submit a completed Form I-9 and the required documentation you must apply this rule to all of your employees.

    Employers are not responsible for the authenticity of documents.

    However if a document does not appear genuine do not accept it.

    You do not need to file the I-9 with USCIS but you must keep the I-9 for 3 years after the date of hire or 1 year after employment ends whichever is later.

    For more information we encourage you to view the video workshop in this series: Hiring People Who Live in the US but Who Aren't U.S. Citizens.

    Form W-4

    Each employee must complete a form W-4 Employee's Withholding Allowance Certificate.

    Additional information on completing this form is located in the instructions for Form W-4.

    Use the employee's gross wages and the information on the Form W-4 to calculate the amount to withhold.

    If an employee does not give you a signed W-4, withhold tax at the single rate with no adjustments.

    If an employee claims to be exempt from withholding, that exemption only applies to income tax not to Social Security or to Medicare taxes, that is the FICA taxes.

    Employee's claiming exemption from withholding must submit a new W-4 each year by February 15th to re-establish their exempt status.

    Verification of employee SSNs

    Another responsibility you have as an employer is that you are required to get each of your employees Social Security numbers to enter them on Form W-2.

    You should ask the employee to show you his or her social security card, and although not required you can keep a copy of the card for your files.

    To verify a worker's Social Security number, the Social Security Administration web site offers some help.

    You can use the Social Security number verification service to verify up to 10 names and Social Security numbers instantly or upload batch files of up to 250,000 names and numbers and receive results the very next business day.

    To explore these options further and to become a registered user, visit www.ssa.gov.

    When you use the SSN verification the Social Security Administration will only tell you if the name and Social Security number match.

    They will not tell you the correct Social Security number.

    If the name and the number do not match, it's up to you to get the correct name or Social Security number from your employee.

    E-Verify is the Social Security Administration's program that verifies a name matches a Social Security number (SSN.)

    With that said a person in the United States may have a valid SSN but not be authorized to work in the United States.

    E-Verify is a web based system that allows enrolled employers to confirm the eligibility of their employees to work in the United States.

    E-Verify employers verify the identity and employment eligibility of newly hired employees by electronically matching information provided by employees on the Form I-9 Employment Eligibility Verification, against records available to the Social Security Administration (SSA) and the Department of Homeland Security (DHS).

    E-Verify can be accessed that www.e-verify.gov.

    Form W-2 Wage and Tax Statement

    As an employer you must complete a Form W-2 Wage and Tax Statement for each of your employees at the end of each year.

    The Form W-2 shows the amount of compensation paid to employees and the amount of taxes withheld for the year, among other things.

    The Social Security Administration also uses this form to update an employee’s lifelong earning history and then from that earning history calculate the employees benefits.

    Because this information is so important, you can be assessed a penalty for W-2 names and Social Security numbers that do not match.

    See instructions for Form W-2 and W-3 for more information on penalties.

    So as you can see it is important that employee’s name and Social Security number as shown on Form W-4 match your payroll records and Form W-2.

    Ensuring new employees provide correct information

    When you hire new employees always verify the name and Social Security number.

    Ask them to show you their Social Security card if it's available.

    It's okay for you to photocopy the Social Security card but as I said before it isn't required.

    Keep your payroll records up to date.

    This applies to both new and existing employees.

    Remind employees to report any name change due to marriage, adoption, divorce, or other circumstances, first to the Social Security Administration and then to you.

    Make sure employees know that notifying their employer of a name change is not enough.

    They must complete Form SS 5, Application for a Social Security Card to have the change made on their Social Security record.

    Form SS 5 and additional information are available at www.ssa.gov.

    Document the steps you take

    Documenting the steps you take to obtain and correct any name and Social Security number mismatches may help you avoid costly penalties down the line.

    One of those steps is getting the Form W-4 which also shows an employee's name and Social Security number and keep it in your files.

    If you relied on the information provided by your employee on their Form W-4 to prepare their Form W-2, the IRS may waive the penalties.

    The law does allow a waiver of penalties where an employer had reasonable cause for including incorrect information on Form W-2.

    Issuing Forms W-2

    All employers must issue Form W-2s to report wages and withholdings to their employees by January 31st.

    If your employee leaves before the end of the year, you can give them their Form W-2 at any time after they leave, as long as it is before January 31st.

    If any employee asks for their Form W-2, you have 30 days after their last pay date or 30 days after they leave whichever is later.

    You can file Form W-2 electronically.

    The Social Security Administration has two electronic filing methods.

    Companies filing 250 or more Form W-2s must file electronically, and electronic copies of the Form W-2s must be sent to the Social Security Administration by January 31st.

    In the first method you upload a wage report.

    If you use software that matches the required format you can upload your files to the Social Security Administration.

    Software specifications and more information can be found at www.ssa.gov/employer.

    Click on the electronic W-2/W-2C filing handbook link. In the second method, called Forms W-2/ W-3 Online, you can complete up to 50 Form W-2s at the Social Security Administration's Web site and print copies suitable for distribution to your employees.

    In this method no software is required.

    A Form W-3, Transmittal of Income and Tax Statements, is created for each W-2 online report, even if the multiple reports are for the same EIN.

    Again more information can be found at the Electronic W-2/W-3C Filing Handbook link at www.ssa.gov/employer.

    Both online options require registration with the Business Services Online or BSO web site at www.ssa.gov/bso.

    From the BSO web site select Register and complete the information. You will be assigned a user I.D.

    immediately and you choose your own password.

    Third party preparers need to register only once and not for every client they represent.

    Of course if you choose not to use the electronic system you still send the Form W-2s by mail along with your Form W-3s.

    The due dates for filing forms W-2 is January 31st whether you file using paper forms or electronically.

    Earned Income Tax Credit (EITC)

    The Earned Income Tax Credit or EITC or EIC, is a refundable tax credit for people who work but who do not earn high incomes. Notice 1015, “Have you told your employees about the Earned Income Tax Credit?” provides information on your responsibilities for notifying your employees.

    As an employer you may be required to notify an employee that they may be able to claim a tax refund because of the Earned Income Tax Credit and you must also notify employees who have no income tax withheld that they may be eligible for EITC.

    This does not include employees that claimed exemption from withholding.

    We also encourage you to notify employees when their income is below the maximum income threshold allowed for claiming EITC that they may be eligible for the credit.

    This is because eligible employees may get a refund of the EITC that is more than the tax that they owe.

    You may use Notice 797, Possible Federal Tax Refund Due to the Earned Income Credit, to meet the notification requirement.

    You can find a printable copy of Notice 797 on www.irs.gov.

    IRS Publication 15 lists other ways you can meet the notification requirement.

    Individual Tax Identification Number (ITIN)

    The IRS issues Individual Taxpayer Identification Numbers or ITINs to individuals who are required to have a U.S.

    taxpayer identification number but who do not have and are not eligible to get a Social Security number from the Social Security Administration.

    ITINs are not valid for employment and should not be used on workers Forms W-2s.

    They do not provide eligibility for Social Security benefits or the Earned Income Tax Credit.

    An ITIN is a nine digit number beginning with the number “9” formatted like an SSN.

    Independent Contractors/Filing Proper Forms

    Now we're going to look at your responsibilities regarding independent contractors.

    For independent contractors you may need to file Form 1099 Miscellaneous with the IRS.

    If you are required to file a Form 1099 make sure you give a copy to the independent contractor by January 31 of the year following the payment.

    The IRS Electronic System for filing Form 1099 is called Filing Information Returns Electronically or FIRE for short. To use the FIRE system, you must first create an account.

    You will create a user I.D., password, and Personal Identification Number or PIN.

    After you create an account or log into your existing account, in order to use the FIRE system to transmit information returns electronically, you must complete Form 4419 Application for Filing Information Returns Electronically, and submit this electronically within the FIRE system at least 45 days before the due date of the returns for current year processing.

    After the application is approved, the IRS will assign a transmitter control code also called TCC to you.

    Although the FIRE system is easy to use, you still must use the pre-approved software.

    To find software providers perform an Internet search with the keywords “Form 1099 Software Providers.” You can also develop your own software by following the specifications in IRS Publication 1220 Specifications for Electronic Filing of Forms 1097, 1098, 1099, 3921, 3922, 5498, and W-2G.

    Many states have entered into an agreement with the IRS to accept FIRE files, which means you may not need to file additionally with your state.

    If you're in a participating state and you want to participate, you must send the IRS a test file.

    See IRS Publication 1220 for more information on the FIRE system and see if your state participates in the combined federal state filing program.


    Let's do a quick review.

    We talked about differences between an employee and an independent contractor.

    And remember there are three general categories to consider: behavioral control, financial control, and the relationship of the parties.

    Then we discussed verifying work authorization.

    Next we discussed Form W-4s and the employer's responsibility regarding withholding as well as verifying employees' names and Social Security numbers.

    After that, we also discussed Form W-2s and the process for filing them.

    We briefly mentioned the Earned Income Tax Credit and Individual Taxpayer Identification Numbers.

    And finally we looked at filing Form 1099s using the FIRE system.

    I hope you found this information helpful.

    As you are probably aware of by now, there are many employer responsibilities involved in meeting your tax obligations and there's always more to learn.

    Keep in mind if you have questions or need more information you can consult IRS Publication 15 Employers Tax Guide or contact the business and specialty tax line at 1-800-829-4933.

    Thank you for joining us. Best wishes on your business.

    Please choose whether you have employees, contractors or both working for your business: