Tax Implications of How You Set Up Your Payroll


The IRS is currently involved in a massive project that involves agents auditing businesses to determine if they are correctly following the rules of hiring of independent contractors, and business owners should take note and review their hiring practices.

Many employers are under the impression that the theory of “consenting adults” applies when it comes to the tax ramifications of hiring these workers. In other words, if a worker agrees to be classified as an independent contractor and even signs an agreement with this label, that the employer is safe to treat the person as such. This is not the case.

The IRS has a set of rules and regulations governing classification of workers, which can be viewed on its website at Employee or Independent Contractor. The agency is bearing down to reclassify in hopes of generating additional revenue in the form of payroll taxes.

It’s important to also understand that temporary help or workers on a probation period are considered employees if they fall within the guidelines outlined by the IRS. The temporary nature of their employment is not a factor to deeming them independent contractors.

Here are a few things you need to know to get started with payroll processing to stay out of hot water with the IRS:

EIN: You must have an Employer Identification Number (EIN) in order to process payroll. Complete IRS Form SS-4. If you already have an EIN, use that number. If you are a sole proprietor that had been operating previously under your Social Security number, you must apply for an EIN by completing Form SS-4. Then go to and under “Tools” on the home page you will see the selection, “Apply for EIN online.” Simply click through, follow the directions and you will have an EIN in no time at all. You can also call in an application to get an EIN.

Form W4: Each new hire (or converted independent contractor) must complete IRS Form W4. This is a simple form to complete. Provide a copy of it to your payroll processing company and keep a copy in your employee’s personnel file. The W4 provides the information needed to determine how much withholding should be taken on each paycheck. It also provides the employee’s name, address, and social security number for preparation of payroll tax returns and year end Form W2.

Form I-9: Since 1986, employers are required to have new hires complete Form I-9. This form is used to regulate the hiring of workers who are allowed to legally work in this country. Form I-9 is produced by the Department of Immigration. Each new hire--whether a U.S. citizen or not--must complete the form and provide proof of identity. If the worker is an immigrant, he or she must provide proof of legal status in this country. The form is not submitted to any government entity; you should store the Form I-9 and photocopies of ID and citizenship papers in your employee’s personnel file. If your business is audited by the Department of Immigration and you have the completed forms for each employee, you will be in compliance.

Check in with your insurance agent about OSHA requirements and worker’s compensation insurance.

As far as payroll processing is concerned, that job is usually best left to the professionals. There are so many rules and regulations plus it’s paperwork intensive. You have better things to do with your time. Contact your bank. They often provide the service to business account holders at a nominal fee or find a professional payroll processing service.

However, if you have an on-staff bookkeeper who has experience in processing payroll you may find that it will go smoothly enough working it in-house. Many accounting programs, such as QuickBooks have built-in payroll modules that do everything from processing pay checks to preparing quarterly payroll tax returns and year end W2s.

The IRS provides small business with a plethora of information regarding tax administration at all levels. For help with payroll, check out Employment Taxes.