9

EMPLOYEES AND INDEPENDENT CONTRACTORS

It’s always easier to do it yourself. You do a much better job.

—TAXMAMA’S MOTHER (OR YOURS?)

On your last job, you came to realize you did all the work but got paid only a fraction of what you’re worth. You quit and ranged out on your own. Now, with your own business, you get to keep all the money. You’re better off, it’s true; only now you have to do all the work yourself.

You may decide that you need help; if so, it’s time to hire your own staff. Excellent idea—many companies can grow to great heights with the right employees, and there are tax benefits to hiring employees. This chapter covers everything you need to know about categorizing employees, hiring family members, setting up payrolls, paying employee taxes, and much more.

Who Is an Employee?

Often, new small business owners are apt to think of people who work for them as temporaries or as freelancers. You may feel that since you haven’t had employees until now, you don’t want to go through the hassle of setting up a formal payroll until you absolutely must.

You’ve got my sympathy. But not the IRS’s.

Knowing the legal difference between an official employee and an independent contractor can be challenging. The following examples show just a small sampling of the wide range of possible employment situations:

•  Nancy comes to Jackie’s home to open mail, do filing, and pay bills. Nancy picks up a big stack of files and works on them at her own home. Is Nancy an employee?

•  Joe hires Dan as his webmaster and site developer. Joe is gearing up for a big marketing push, making it clear that Dan must devote all his time to the project. Dan agrees to work for Joe exclusively for 2016. Dan works from his home in another state. Is Dan an employee?

•  Perry is self-employed as a journalist. During the school yearbook season, Perry works for PhotoKiddie, snapping shots of schoolchildren for the yearbooks the company creates. Perry uses PhotoKiddie’s film, contracts, and forms and also collects all the payments, which are made out to PhotoKiddie. Is Perry an employee of PhotoKiddie?

•  You do work for your own corporation, but you have a full-time job. You’re only working on your own corporate matters 10 hours a week. Are you an employee of your own corporation?

All right, which of these people are considered legal employees, and how can you tell?

In actuality, the descriptions above don’t provide enough information to make a decision. To determine if someone counts as an employee, you must ask more questions about each person you pay. As the positions are described above, it could go either way. With more information, however, there is an answer.

The IRS used to use 20 common-law factors that determine a person’s employment status, and the factors don’t all carry the same weight. (IRS has refined those factors a bit. But the basic concepts have not changed.) Without having experience facing employment audits, you won’t know which factors matter. To make things more challenging, your state might have its own factors that don’t match up to the IRS’s. A tax professional whose practice specializes in small businesses and freelance work can evaluate the relative importance of each of the following factors for your business and industry.

The 20 Common-Law Factors the IRS Uses to Define Independent Contractors

1. Instructions are generally not given by the company that hires you.

2. Training is not essential and is not given by the company.

3. Your personal services are not required; you can assign the work to anyone.

4. The work you are performing is not essential to the company.

5. You set your own hours.

6. You have no continuing relationship with the company.

7. You control and hire your own assistants.

8. You are free to pursue other work.

9. Where you work is your choice.

10. You set your own work priorities.

11. No interim reports are required of you.

12. You work for more than one firm.

13. You pay your own business expenses.

14. You use your own tools and equipment.

15. You bear a risk of loss.

16. Your services are available to the general public (or industry).

17. You have a significant capital investment.

18. Right of discharge is limited by contract.

19. You are not compensated for incomplete work.

20. Timing of payment coincides with completion of the job, rather than in regular intervals.

Consider those 20 factors whenever you need to decide if someone you hire should be on payroll or not.

Or take a shortcut and look at the IRS’s three “Common Law Rules” at http://iTaxMama.com/IRS_Emp_v_IC:

1.  Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

2.  Financial: Are the business aspects of the worker’s job controlled by the payer (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)?

3.  Type of Relationship: Are there written contracts or employee type benefits (i.e., pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Do They Act Like a Business?

If you’re unsure how the IRS definition of contractors applies to your situation, consider this when looking at someone you want to treat as an independent contractor— people in business must look and act like a business. They must have all the licenses and certifications standard for their profession and their city, county, state, province, or other government division. They don’t need to have a business name, but if your contractor uses Susan Johnson Consulting instead of plain old Susan Johnson, she’d have to get a fictitious name filing, otherwise known as a DBA (doing business as).

People you consider freelancers who are working for you, on your premises, using your equipment, and following your instructions are typically employees. Did you give them a key? Or access to one, to get in when you’re away? That sounds like an employee relationship. If they feel like taking off, going down to the beach for the day, and sending a colleague to do the work, may they? If not and you require that only the person you hired do the work, on your schedule—you have an employer-employee relationship. Essentially, it means that you control the person’s work, hours, and staffing decisions. If people were in business for themselves, you couldn’t do that, could you?

Now, if your new hire does fit the definition of an independent contractor, what should you do to prove it to the IRS just in case the agency ever asks?

Protecting Yourself from Independent Contractor Claims

Whenever the IRS audits a business return that shows independent contractors, the first thing it checks is whether the 1099-MISCs are filed. (You’ll learn about them later in this chapter.) The second thing the examiner looks at is the worker’s job duties. If the IRS decides you have an employee, not an independent contractor, it will create a payroll and assess you for payroll taxes you should have paid, plus penalties and interest.

To legitimize your claim of the independent relationship, use a checklist when hiring new vendors who provide rent or services of any kind (Table 9.1). Simply hand the list to all new hires.

TABLE 9.1 Independent Contractor Hiring Checklist

Alert: If needy friends beg you to hire them without putting them on the payroll, be wary. The biggest cause of employer audits is a nonemployee who is let go (even voluntarily) or gets sick. Suddenly, people in this situation realize they can’t collect unemployment or disability insurance, but they file anyway—and turn you in. Yes, this could even be your best friend—someone who was really in need and begged you to hire him or her under the table. Here is a horror story from one of my clients.

Bennie the Barber. Bennie the Barber had a modest shop in Santa Monica that supported his family. Carlos came to him, begging for work. Bennie really couldn’t afford it, but Carlos kept calling and coming by, telling Bennie how desperate he was for work. Relenting, Bennie gave him the second chair and turned customers over to Carlos. Bennie cut his own income because Carlos didn’t bring in a single customer of his own. Then Carlos started coming in late. Some days, he just didn’t feel like coming in—no explanations. After two years of being treated rudely, Bennie finally got smart and let Carlos go.

What did Carlos do? You guessed it. He filed for disability. Carlos claimed he didn’t know why he wasn’t an employee. Carlos accused Bennie of cheating him. The state disability auditor was no dummy. But under the circumstances she had no choice. She audited Bennie. Digging deeply and looking at the whole situation, the auditor was sympathetic and limited her assessment for unpaid State of California payroll taxes to only one year. This consisted primarily of state disability costs and state unemployment costs. With penalties and interest, the bill was less than $1,000. It could have been double, without her sympathy. IRS charges for the employer’s share of FICA, Medicare, and federal unemployment taxes, plus penalties and interest, added another $2,500.

TaxMama Tip

Insist that all independent contractors provide all the information on the checklist in Table 9.1 before issuing the first check. Make this a part of all contracts. It’s easier to compel people to provide an address and identification number when they want their check than it is in January when you want to file 1099-MISCs—and they weren’t expecting to get one.

If you encounter a situation similar to Bennie the Barber’s case, there’s a way to reduce the IRS assessments when it decides your independent contractor is really an employee. You can use a safe harbor, which we’ll discuss in the next section.

Before moving on, though, there’s one very important thing you need to remember about independent contractors. Don’t call them employees when talking about them, describing them, or speaking to them. Especially, do not use the word employee during an audit. You’d be surprised how many people trip themselves up that way. It’s important that you change the word you use to think of these people. Get your mind around a new word, depending on what they do. Some options are consultant, expert, contractor, or advisor.

Also, they are not your associates or your partners—that’s a different relationship. How you think of the person will determine what you instinctively say. At least, if the terminology is common in your industry, the safe harbors covered next may help reduce the damages.

Safe Harbor Rules

Section 530 of the Revenue Act of 1978 provides a safe harbor with special leniency toward certain employers.¹ Barbers and beauty salons are among those protected by Section 530.

Congress decreed that you have a reasonable basis for treating your staff as independent contractors if you can pass a test. You pass the test if you relied on:

•  Judicial precedent, published rulings, technical advice, or letter ruling to the employer

•  A past IRS audit in which no assessment was made on account of improper treatment of workers (even if the audit was not related to employee issues)

•  A longstanding recognized practice of a significant segment of the industry in which the individual worked. (The IRS used to require the practice to span more than 10 years, before 1979, or more than 50 percent of the industry. The new law requires no fixed amount of time and no more than 25 percent of the industry.)

Earlier, we posed some situations. The PhotoKiddie example would fit the safe harbor rules. Why? When an industry (photographers) treats its freelance workers as contractors, it can get the penalty reduction.

When the IRS decides you should have had an employee, the agency charges you for both halves of the Social Security and Medicare taxes that should have been withheld from the worker’s wages. It also charges you for a certain amount of the withholding. Then the IRS adds various penalties and finally tops off the whole thing with interest on the combined total. The final balance due may be hefty enough to shut down your business.

When facing an employment tax audit, be sure to ask your tax pro to invoke the Section 530 safe harbor rules. You’ll be relieved of a substantial part of the Social Security taxes and IRS withholding you should have taken. Hopefully, you’ll never need this rule.

What Are 1099-MISCs?

You’re familiar with W-2s. Think of 1099-MISCs as the same thing—but for people who are not employees. Form 1099-MISC is also the IRS’s way of catching tax cheaters. Before the program started in 1980, there was a huge under-the-table economy. It’s still large, but getting smaller as enforcement improves. Using 1099-MISCs, the IRS can ensure that freelancers report all their income. Knowing you’ll be reporting their earnings to the IRS, freelancers have two choices:

1.  They can refuse to work for you, which has happened. If someone refuses to provide the requisite information, you’re better off knowing this when the project starts while you have time to find someone else. You don’t want to find out that this person may not be ethical after giving him or her access to sensitive information or clients.

2.  They can do as everyone else does—earn the money and pay taxes on it.

OK, there’s always a third option—where they collect the fees and don’t file. When they do that, the IRS sends out notices to companies that filed 1099-MISCs, insisting that the companies withhold 28 percent of all checks to those individuals as backup withholding. You’ll rarely face this issue. If it comes up for you, you’ll find instructions and explanations in IRS Publication 1281, A Guide to Backup Withholding on Missing and Incorrect Name/TINs—http://iTaxMama.com/IRS_1281.

Some states realized that waiting until 1099s are filed and processed means the tax evader can stay on the job before being caught until July or August of the following year. To shorten the time, many states are coming up with solutions. California created Form 542, which companies must file with the state as soon as they pay anyone $600 or more. Since this is working for California, expect other states to request it, too. Since the state garnishes the wages of “deadbeat dads or moms,” this is one way to help locate deadbeats when they keep switching jobs to avoid supporting their children.

Who Gets 1099s?

IRS instructions on the 1099 forms require you to send them out to people you’ve paid for services rendered in the course of your trade or business, as well as rents to unincorporated landlords. 1099s are issued to individuals and to LLCs who report their businesses on their personal income tax returns or on partnership returns. Generally, corporations are exempt, with the exception of legal and medical practices operating as a corporation. When your business pays these types of corporations, you must issue 1099s to them.

Note: If you are paying people for nonbusiness services, you don’t need to issue a 1099-MISC to them, unless you plan to (and are able to) take a deduction on your personal income tax return for their work. Of course, if they work for you regularly as household employees (think of daily housekeeper, or the gardener living in the carriage house), then you need to put them on payroll and file a Schedule H. But that’s a whole other issue.

When your own corporation pays you for your work, without putting you on payroll, the corporation should issue 1099s to you. However, the truth is—the corporation should really put you on payroll. Getting paid by your own corporation as a freelancer could generate an audit with costly results. Partnerships should not be doing that. They should report your compensation as “Guaranteed Payments.”

TaxMama Tip

Here’s a 1099 secret. Hardly anyone knows this, but if you need extra time to file those 1099s, you can get another 30 days using Form 8809. If you’re really in trouble and need still more time, you can get a second extension using the same form.

Looking at the boxes on the 1099-MISC form, even without reading the tax code or the instructions, you can readily get an idea of who gets 1099s. Let’s review only the boxes that are apt to affect your business.

•  Box 1: Rents. This is for payments to your landlord. Also, use it for equipment leases from private parties. If you pay for storage and the company is a partnership, it gets one, too. If your business pays you rent, you get one.

•  Box 2: Royalties. This applies if you have a graphic artist, you’re licensing technology, you have a coauthor or ghostwriter, or you’re a publisher. If you are licensing something to your entity, issue this to yourself.

•  Box 3: Other income. Be generous with this. If you’re paying someone for something that clearly is not self-employment, use this box instead of Box 7. Anytime you’re not sure how to categorize payments to people and have no one to ask, use Box 3. Leave it up to them to decide how to report it on their own tax returns.

•  Box 4: Federal income tax withheld. Some of your vendors may want withholding (rarely). Usually you will withhold taxes when the IRS garnishes their incomes. You may hear from the IRS if people give you a phony Social Security number on the Form W-9 they give you or, if they are in arrears on their tax payments. When you do hear from the IRS, it’s bad news. You must withhold 28 percent from all monies you pay these folks—or pay it yourself. So don’t be softhearted. Incidentally, having the company take withholding from their compensation is a convenient way for partners or LLC members to avoid making quarterly estimated tax payments (more on this in Chapter 11). When you do withhold, be sure to issue the 1099s early so recipients can file their tax returns on time.

•  Box 6: Medical and healthcare payments. When individuals are not your employees—when they are independent contractors—if your company has paid their medical or healthcare, this is self-employment income to them. They will report this on their Schedule Cs.

•  Box 7: Nonemployee compensation. All remuneration to anyone performing a service to your business gets reported here, including your tax pro, consultants, freelancers, web designers, outside services, virtual assistants, trainers, advertising agency, public relations firm, landlord, and equipment rentals. Attorney fees go into Box 14.

•  Box 9: Payer made direct sales of $5,000 or more of consumer products to a buyer (recipient) for resale. This is for network marketers and MLM participants. The company you represent will report the gross sales you’ve made. Remember, the IRS knows you also use the products. So when receiving a 1099 in this case, be sure to deduct your personal usage of the purchases.

•  Boxes 16 and 17: State income tax withheld and State/Payer’s state number. When you have withheld money for state taxes, remember to fill this in. See the notes for Box 4 for instances where this might be necessary.

The other boxes won’t affect the average small business. If they do, you need to have an accountant on staff to help you.

To the recipient, it’s very important that you get the boxes right. Income reported in Box 1 and Box 2 is not subject to self-employment taxes. Taxpayers pay self-employment taxes on all income in Box 7. When they don’t, the IRS sends them nasty letters (we’ll discuss this in Chapter 13). Box 3 is a gray area. Generally the income in that box is not self-employment taxable—but it could be. The IRS’s computers won’t be looking for a match on Schedule SE for amounts in Box 3.

When Are 1099s Issued?

1099-MISC forms must be issued when paying $600 per year or more to anyone for services rendered or rents. The forms must be distributed to payees by January 31. Due to the PATH Act of 2015, we have tighter rules. When the 1099-MISC includes nonemployee compensation in Box 7, you must also file it with the IRS by that date. On all other 1099-MISCs, you have until the last day of February to file them with the IRS. Folks filing the forms electronically have until March 31 to file. (Forms may be filed on the following Monday when the due date falls on a weekend.)

I recommend that you mail out all the forms as early as possible in January. Then hold off filing them until the last minute, giving you time to get the address corrections back from the post office or the payees. During this time, you’ll probably hear from people if their earnings records are different from your records. This will give you the time to reconcile the amounts before you send in the final 1099s.

When you find errors, naturally, you may send in corrected 1099s, but those attract attention. Try to get it right the first time.

Oh, and if you’re holding them until the end of February, don’t forget to mail them in or to file electronically.

Payroll and Payroll Taxes

To avoid complications and painful audits, once you start using regular help, go ahead and put them on payroll. In the short run, this may cost you a little more than using contractors. In the long run, though, you’ll be better off. Depending on the form your business takes, you may even end up putting yourself, your spouse, or your children on payroll.

Payroll Across Entities

Before we get into the mechanics of payrolls, you’ll need to know whether or not you’re required to be paid wages. Let’s look at a quick outline of personal and family compensation for the different forms of businesses you learned about in Chapter 3.

•  Sole proprietorships. The owner may never be on payroll. The spouse and children may be—if they perform services for the company and are not owners of the company. Watch out for community property states with laws that say each spouse owns whatever the other spouse owns. You can overcome community property rules with contracts. Be careful; make sure you have a solid marriage. Otherwise, in the event of a divorce, one spouse will have signed away valuable ownership rights just to gain some short-term tax benefits.

•  Partnerships, LLPs, and LLCs taxed as partnerships. The rules are the same as for sole proprietorships. However, partners may receive “guaranteed payments.” These are specific allocations, such as a monthly stipend. Partners may receive different amounts, based on the time or resources they contribute to the business. Be sure to allocate reasonable guaranteed payments to working partners. If you don’t, as explained in Chapter 3, the IRS will assign a compensation level to you.

•  Corporations and LLCs taxed as corporations. The shareholders and officers must be on the payroll, and reasonable compensation must be paid based on profits, time devoted to the business, and industry standards. Family members may be hired. Children’s payroll is fully taxed. Officers are entitled to receive benefits like any employee. When it comes to profit-sharing and retirement plans, there are special rules to avoid discriminating in favor of highly compensated employees. Those rules won’t affect you if you have no employees outside your family. If you have employees outside your family, this is where your advisory board will become really helpful. We won’t be covering the details in this book—that’s advanced tax planning. I just wanted you to be aware of the issue.

•  S corporations. Working shareholders must receive wages. The IRS is running an audit campaign to catch omissions in this area. People who own more than 2 percent of the company are excluded from benefits. Legislation has been proposed to require 100 percent of profits to be treated as wages for S corporations where the income is generated primarily from the services of three or fewer shareholders. Although this legislation did not pass, it’s wise to show reasonable, market-level salaries for the owners. And no, taking the compensation in the form of fees instead of wages will not allow the shareholders to escape IRS penalties for lack of payroll. (This is an area of discussion with the IRS and tax professionals lately. The IRS has come down solidly on this issue.)

•  On the issue of what is “adequate compensation.” The following two sites, introduced in Chapter 3, can provide definitive reports to use to back up your decisions for wages or guaranteed payments:

º  http://www.rcreports.com/

º  http://www.reasonablecompensation.com

With these points in mind, let’s start with the very touchy issue of hiring family members.

Hiring Family Members

Your e-mail is likely full of messages from scamsters wanting to sell you tax-cutting kits. One of the tax loopholes they push most aggressively is the practice of hiring family members. The IRS has shut down a number of operations whose primary focus is encouraging people to take fraudulent deductions for home and family expenses, including The Tax People and Tax Toolbox. The IRS has filed civil and criminal charges against tax professionals promoting this practice fraudulently.

Does that mean you should completely avoid hiring your spouse and children? Nonsense! There would be no Rothschild dynasty, or Ford Motor Company, or Disney, or Wal-Mart, or Harry and David, or any number of great companies if people had been afraid to build family businesses. To the contrary, many founders nurture dreams of having their children take over the family business. Some of today’s major corporations started out as family businesses. Many publicly traded companies still have significant family leadership and ownership.²

So please, don’t let fear of the IRS prevent you from establishing your own dynasty. Besides, so much good comes from getting your family involved—and some of the benefits have nothing to do with taxes.

Intangible Benefits of Hiring Family

•  Your spouse and children understand the time requirements and pressures you face. This reduces familial conflict.

•  You see your children more often. You don’t just see them rushing out in the morning or wolfing down dinner on the way out to the library or to meet friends.

•  You have things to talk about together, rather than the vacuous, “So how was your day?”

•  Being in the same office or business location, you’re apt to overhear your children’s conversations with their friends and be more tuned in to the good and bad things in their lives. (Avoid deliberate eavesdropping, though.)

•  Working with you, your family members have less time to get into the kind of trouble that comes from boredom or from too much time and money.

•  Your children actually earn their “allowances.” This is so important in eliminating that attitude of entitlement. You see other people’s children growing up rude and demanding, without consideration for their parents. Your children won’t act this way if they work for their spending money.

•  When you are your family’s employer, you know how much money your children have available to spend. If they suddenly come home with something unreasonably expensive, you won’t fall for “I got a bonus at work.” You’ll know it’s a warning sign.

•  Your family knows the details of your business and where the important files and documents are. If anything happens to you, they can carry on.

•  Each of your family members develops marketable skills. If your business fails, your spouse and kids will be able to get jobs and earn decent money. When your children head off to college, they’ll be able to score higher- paying jobs because of their skills and experience.

•  Maintaining all the records and time sheets needed to prove your family members are working in the business develops discipline, organization skills, and reporting skills—all of which will be important in the business world.

•  Finally, growing up together in the business, your children may become passionate about getting an education they can bring back home to enhance the family’s business.

Oddly enough, doing everything right, doing things just the way the IRS demands, could be the glue that holds your family together. After all, your family can join the group of top 500 family businesses worldwide. Some of the most recently established businesses are the wealthiest.

See, it is in your best interest to avoid the temptation to take shortcuts and to pay your family members from the business without their earning the money. Think about the kind of message you will be sending them if you cheat. You would be telling them it’s all right to lie; to operate outside the rules; to avoid your responsibility to your community; to shrug off authority. Teaching them to lie or cheat will tell your children they may behave that way toward you, too. Children do not see the difference.

Sure, we could get into long arguments about what your tax money pays for and how often it’s wasted. And it is wasted! The bottom line: your taxes do go toward maintaining a measure of sanity, safety, comfort, and predictability in a community of millions of passionate individualists.

Tax Benefits of Hiring Family

In Chapter 10 you’ll learn all about the healthcare, insurance, and retirement benefits available to small business owners and their families. Right now, we’re going to cover the payroll tax and compensation benefits available to you.

Special Tax Benefits of Hiring Your Child(ren) for Proprietorships and Partnerships

•  Wages paid to your children are fully deductible to your business. Allowances are not. You can give your children more money than you give them now—but have them earn it. All of it will be deductible to you.

•  If you are a sole proprietorship or partnership, the wages you pay your children who are under 18 are not subject to Social Security, Medicare, or federal unemployment taxes. Most states also waive payroll taxes—but not all, so be sure to check with your state’s payroll tax authority. The website http://www.taxadmin.org/state-tax-forms has more information. On wages of $7,000, this strategy would save you nearly $1,100 (15.3 percent) worth of your self-employment taxes and $2,100 (30 percent) of federal and state income taxes. You’ve just cut nearly $3,200 off your tax bill.

•  If you had hired a nonchild employee, you’d be paying half the Social Security and Medicare, all the federal and state unemployment taxes, workers’ compensation insurance, holidays, sick days, and, possibly, benefits. Those additional expenses would add more than $1,000 to your business overhead. Paying your child, you’re just converting money you’d give to your child anyway into a deduction. Even when you spend twice as much on your child as before (through allowances), the government pays for nearly half the money you give him or her.

Tax Benefits of Hiring Family in General

•  For jobs requiring the use of cars, you may pay your spouse, your child, or yourself a mileage allowance or auto expenses. Be sure to get a mileage report and a copy of auto expenses to support your checks. The U.S. Tax Court just issued a ruling in support of the IRS’s position. The IRS determined that payments that Continental Express, Inc.,³ made to its drivers were subject to the meals and entertainment rules. Continental Express didn’t require substantiation of the expenses from its drivers. That ruling cut the company’s deduction by 50 percent. Expect this same logic to be applied to other businesses. Warnings aside, paying your child $100 per month for deliveries and errands cuts your taxes by about $550 per year (15.3 percent self- employment taxes, 30 percent federal and state taxes). If your child submits expense reports, he or she doesn’t report this income at all. You don’t have to pay your spouse or child’s auto upkeep from your own pocket.

•  The money you pay your spouse and child doesn’t need to go into their pockets. Arrange to set up IRAs, Roth IRAs, MyRAs, or other retirement plans, to save $3,000 to $5,000 of those wages each year. They will get a deduction for the contribution to a regular IRA—but not the Roth IRA or MyRa. Your child may end up paying no tax at all on that money, and your personal taxes are reduced. Chapter 10 describes the types of plans available.

•  Chapter 10 also explains how medical expenses may be deducted by small businesses. This could convert $5,000 to $10,000 of unusable deductions into business deductions.

The financial and emotional rewards of hiring family members are substantial. Only don’t push it. If they resist, don’t force the issue relentlessly. You’ll only take a good thing and turn it into something nasty. Knowing that you’re doing it for their own good won’t make them resent you less. Know when not to push. Just leave the door open for whenever they’re ready to join you.

Better yet, sucker them into it. Just ask for a little help with some minor thing. Be sure to thank them and praise them. Once they get used to doing that, add one more little thing. As they do the small things automatically, and well . . . gradually add a few more tasks. Pretty soon, they’ll be working by your side. Shhh, don’t tell them I told you.

Now it’s time to work on the payroll.

Paying Payroll

First of all, whenever you hire someone, have the person fill out two forms before he or she starts working. The first is Form W-4, Employee’s Withholding Allowance Certificate. You’ve seen W-4s before—get a new one filled out by each employee every January. The second form is the I-9, which you can access at https://www.uscis.gov/sites/default/files/files/form/i-9.pdf. It’s important that all of your employees fill out this form for the benefit of the immigration department (currently known as U.S. Citizenship and Immigration Services—USCIS, now a part of Homeland Security), even if they are citizens. Make a copy of each identification document used by the employee to substantiate his or her right to work. Keep it with the signed I-9 in the person’s permanent employee file.

Compensation Methods

You may pay your employees in a variety of ways. Each one is acceptable, as long as you’re consistent, using the same method for all people in the same position. If you pay people doing the same job at different rates, or using different methods, it won’t be the IRS you’ll have to face. Most likely it will be the wrath of the employee, in front of a labor judge. So if you’re going to discriminate in favor of friends or family members, give them a higher title or additional duties to justify the higher pay rate.

Note: Be sure to look up the latest rules relating to hiring employees on the U.S. Department of Labor’s website, http://webapps.dol.gov/elaws/flsa.htm. Look up minimum wage rules, overtime rules, and so on. Also, check with your state to see if it has specific rules and rules for your industry.

These are common compensation methods:

•  Hourly. Your employees keep a time sheet or punch a time card. Multiply their hours worked by their hourly pay rate. If they work overtime, multiply the pay rate by 1.5 to get the overtime rate. For example, if the base hourly rate is $10, overtime is paid at $15 (10 × 1.5). A weekly payroll for 50 hours of work including 10 hours of overtime would look like this:

Base pay:         40 hours × $10 = $400

Overtime pay:  10 hours × $15 = $150

Total wages:     $550

•  Salary. Your employee gets paid the same amount each pay period, regardless of the hours worked. For instance, Nancy gets $50,000 per year, paid every 2 weeks. (Note: That does not mean twice a month. Twice a month is 24 pay periods.) Divide 52 weeks by 2 weeks, and the result is 26 pay periods. Now divide $50,000 by 26 weeks. That gives Nancy $1,923 per pay period. Often, people who are paid salaries get no overtime.

Note: There are new overtime compensation rules that apply to employees that have traditionally been classified as exempt. Read this overview carefully, or consult with a human resources expert for guidance specific to your business—https://www.dol.gov/whd/overtime_pay.htm.

•  Commission. Employees are paid on a percentage of their sales or unit’s revenues. Often, to equalize the compensation, they are paid some fixed rate against commission. That means they get a base pay of, let’s say, $1,000 per month, before they earn commissions. That $1,000 per month should be treated as wages, with all the usual withholding. When they earn the commissions, their advance payments get deducted from their commission checks. For example, Josey had her first big sale at the end of December. It netted her a commission of $25,000. She had been with the company since June and had received $8,000 in advances. When she gets paid her commission in December, her employer will deduct the $8,000 from her net check, before taxes are taken out—since she has already paid taxes on the first $8,000. The payroll taxes will be computed on the remaining $17,000 ($25,000 − $8,000).

•  Bonus. Regardless of the other compensation methods, there is nothing to prevent you from giving your employees bonuses at any time you choose. Bonuses may be rewards for individuals or teams hitting targets or goals. They may simply be split among all employees because you had a great month. Even small bonuses, given to everyone to celebrate, can really boost morale and build team spirit. The bonus is fully taxable, just like payroll—and is part of their payroll. Bonuses should be reported on the W-2.

•  Employee gifts. Except for minor gifts worth $25 or less for the whole year, the value of a gift is fully taxable. Include the value of all gifts in the employee’s wages.

•  Employee achievement awards. When the award is part of a written plan with defined targets, you may give an employee an award worth up to $1,600, without including it in the employee’s income. Unfortunately, the award must be a thing, not money. There are very specific rules about who qualifies. Read Chapter 2 of IRS Publication 15-A (at https://www.irs.gov/publications/p15a/) for more details.

Payroll Taxes

Along with a payroll come payroll taxes. When you cut the check to the IRS at the end of each payroll period, it looks like you’re paying the IRS a ton of money. Actually, your payroll taxes are lower than you think. Most of the money you’re sending to the IRS is the employees’ own money, deducted from their paychecks. The only things the employer pays are:

Add in your state unemployment taxes and other minor local taxes as well as mandatory workers’ compensation, and you’re paying about 10 percent of the employees’ wages.

Note: While the percentages haven’t changed in decades, the limits on Social Security wages increase each year. See the “What’s New” section of IRS Publication 15 (https://www.irs.gov/publications/p15a/) for the new Social Security limits each year.

Preparing Payroll: Checks, Journals, Reports

You have several options when it comes to the accounting involved with pay- roll. You can do it the old-fashioned way, by hand, on paper, on columnar pads, or by using journals. You can do it by hand using preprinted manual systems. One-Write is a very popular manual system. You also can use software that either integrates into your accounting system or stands alone, like QuickBooks. Or you can do the really smart thing—turn it all over to a professional!

Payroll record keeping is fraught with danger. There are so many little things that go wrong all the time, due to errors on your part, program glitches, or tax law changes you didn’t get. Messing up on payroll tax forms unleashes a gusher of notices. Your time is worth more than that. Worse, most really small businesses end up with huge IRS payroll tax debt because they don’t do their payroll reporting properly and don’t pay their payroll tax deposits.

Make all the problems go away. Turn over your payroll processing to a tax professional or a professional payroll service. It will cost $50 to $100 per month for a small company, but it’s really worth it. A good payroll processing house will make your life so easy. Once you set up your employees, all you have to do is call in with their hours or enter the hours online. All the major companies have toll-free customer service centers.

They prepare your payroll, cut payroll checks on your account, file all the tax returns, issue the W-2s, and—for a small extra fee—arrange to make your tax agency payments directly from your account. This will give you proof your payments were made on time. If they make an error, the payroll services must pay any penalties incurred, not you. (But if you don’t have funds in your bank account on payroll day—that’s your error, not theirs.) The best thing about payroll services is that if the IRS sends correspondence, they will handle all the responses. You don’t need to be bothered. If you’re the kind of person who cringes every time you see one of those white envelopes with the IRS eagle . . . a payroll service is for you.

Here are the top two companies in the industry:

•  Intuit’s QuickBooks Payroll. If you request the Complete Payroll Service, you can get additional services, including background checks before hiring, integration into QuickBooks, cafeteria plans, and retirement plans. Reach the company at http://iTaxMama.com/Intuit_Payroll.

•  Paychex. Though geared toward companies with 50 employees or more, it will still work with mom-and-pop businesses. The service reps are a joy to work with. Check out the company at http://www.paychex.com/.

For more options, visit the IRS’s list of payroll providers, available at http://iTaxMama.com/IRS_Payroll.

Tips on Using Payroll Service Bureaus

•  Be sure to get yourself assigned to a local personal account manager. He or she will be a big help to you anytime there is a problem or you have a question.

•  Give your tax preparers online access so they can look up information and print out forms and reports when working on your business return, without ever bothering you.

•  Some payroll services, or your bank, will enable you to offer direct deposit to your employees’ bank accounts, so you never have to cut checks or mail them.

•  You will be able to offer employee benefits economically, even if you’re a small company.

Alert: Set up an IRS EFTPS (electronic federal tax payment system; see https://www.eftps.gov/eftps/) account and a similar state account, if available, so your payroll tax deposits can go directly from your own bank account to the IRS and your state (see Chapter 1). That way, your payroll service will not be holding your funds. Unfortunately, there have been instances of payroll companies going bankrupt while holding client funds—or worse—absconding with your funds.⁵ You don’t want that to happen.

Regardless of who prepares your payroll, it pays for you to get educated about it. The IRS provides detailed information on its Employment Taxes for Small Business website, available at http://iTaxMama.com/IRS_Employment_Tax.

The IRS, SCORE, and your state government frequently offer free workshops on how to handle payroll and employee issues. Take advantage of the free information. It’s important that you understand what your responsibilities are and how things work. It also will help you catch errors or oversights on the part of your staff, service bureau, or tax preparer. It’s important that you know what forms must be filed and when.

Reporting Payroll

Payroll tax returns are filed quarterly and annually. Table 9.2 provides the due dates and lists the specific forms that are due. For the final quarter of the year, you must file both the quarterly reports and the annual summaries, for both the IRS and state, along with the W-2s and 1099s. These days, as much as possible, the IRS wants to see payroll tax forms filed electronically. That’s another benefit of payroll services.

TABLE 9.2 Quarterly Payroll Tax Return Due Dates

When the last day of the month falls on a weekend or holiday, the forms and payments are due on the following business day.

Form 941 is the quarterly report. You can also find this form on the IRS’s website at https://www.irs.gov/pub/irs-pdf/f941.pdf.

On Form 941, do you see that box on line 4, where it says if no wages or compensation are subject to Social Security or Medicare tax? If you’ve hired your children who are under age 18 and they are your only employees, check that box. That alerts the IRS that you didn’t omit the Social Security and Medicare wages by accident. Remember, your children’s wages are not subject to those taxes. If you have other employees who are subject to Social Security and Medicare, leave that box empty. You will be using lines 6a–6e to enter your children’s and other exempt payroll. Be prepared to get a flurry of mail from the IRS. It usually takes the agency three letters before it accepts your explanation about having hired your child. But keep replying to the letters. In time, you will get the IRS to accept it—and next quarter the letters will start again.

You must send in your payroll tax payments within three business days after each payroll. (Some people have more time, but it’s a good habit to get into.) When you file the returns at the end of the quarter, you should owe no more than $2,500. If you do owe more than that, you will be required to establish that EFTPS account I mentioned. The IRS has phased out the Form 8109 vouchers in that thin yellow book the IRS used to send you when you got your employer identification number.

Form 941-V is the payment coupon for Form 941. If you are making payment by check, fill in the coupon and send the check with it. Be sure to include FYTIN (form number, year, and taxpayer ID number). You must deposit all payroll taxes electronically or you will face a 10 percent penalty. If the balance due is more than $2,500, pay it online via the EFTPS.

There are special rules for marijuana and associated businesses that cannot get bank accounts.

Form 940 is the annual unemployment tax return. The final tax rate only ends up being 0.6 percent if you file the return on time and pay your state unemployment taxes on time. (See this chapter’s footnote 4, for states in default of their FUTA obligations.) If you default on the state tax, you end up paying 6.2 percent for federal unemployment. So make sure you always pay the state unemployment taxes first.

W-2s must be mailed out to employees by January 31st. No payment goes with these forms. They must also be mailed to the Social Security Administration by January 31st (https://www.ssa.gov/employer/filingDeadlines.htm). Due to the millions of dollars of fraudulent tax refunds, Congress changed the filing date in the PATH Act of 2015.

Form W-3 is the summary of all the W-2s. Be sure all the boxes on the W-2s add up to the totals on the W-3. Included on the W-2 is the information about employee benefits, which we’ll discuss in the next section.

Shoulda Had a Payroll—But Didn’t

Reading all of this, it may have dawned on you that you should have been running a payroll all along. Now, you’re afraid that you’re going to face some horrendous penalties for not putting your employees on payroll. Right? Well, I have good news for you. The IRS has a permanent amnesty program that will give you a huge break—and help you avoid audits. It only works if you have been issuing 1099-MISCs to your workers who should have been employees. It’s called the Voluntary Classification Settlement Program (VCSP). If the IRS accepts you into the program, you will pay about one-tenth of one year’s payroll taxes. It’s a really good deal. The bad news? The IRS didn’t coordinate this with the states. So when you come in out of the cold, so to speak, you may still face state audits and penalties.

Employee Benefits

Companies may offer their employees an array of benefits. Owners can only participate if they are incorporated. On the other hand, S corporation shareholders who own 2 percent or more of the company are excluded from most benefits.

Two of the common benefits employees receive are sick pay and vacations. Were you aware that these benefits are not a legal requirement in all states—particularly for small companies? Paying for these for employees is more of a custom than law. Check with your own state’s labor commission to learn the standards in your state.

You can offer some fringe benefit plans for employees that they pay for themselves—and would gladly. When it comes to medical and insurance plans, even if you don’t pay the premiums, your employees could get some terrific tax savings. You pay a small administrative fee, offset by the tax savings from the plan, and for your employees it’s like a small raise. They save nearly 38 percent of the amount of money they spend anyway, on things such as medical insurance, medical costs, or dependent care (7.65 percent Social Security and Medicare, 25 percent federal tax, 5 percent state tax). For the average family paying $17,000 in medical premiums, that’s over $500 per month into the family’s pockets, perhaps double if it has dependent care. As the employer, you save about 12 percent of the cost of those premiums because the employer’s taxes and workers’ compensation insurance fees don’t apply to that money either. That savings will more than cover your administrative costs for the plan.

Plans Where Employees’ Money Is Spent

Here are two popular fringe benefit plans employees pay for:

•  Premium-only plans (POPs). The employees pay their medical insurance premiums. Premiums are deducted from their wages before taxes are computed.

•  Flexible spending accounts (FSAs). These accounts let your staff deduct their medical, dental, optical, and therapy costs, up to $2,550 per employer for each spouse. Dependent care expenses (child or eldercare) are limited to $5,000 per year, but may increase with inflation. Employers, or your payroll service, set up limits on the medical spending. The FAQs page on the HealthCare.gov site (http://iTaxMama.com/FSA) provides a comprehensive set of answers to most FSA questions.

Plans Where Your Money Is Spent

Setting up employee plans for small companies has been complicated and expensive. Now that the payroll services are offering complete administration packages, even a small employer can offer these benefits. It only costs a few extra dollars per employee per month for the administration.

•  Group term life insurance. Employee benefits up to $50,000 are free to the employee. The premiums for coverage exceeding $50,000 are added back to their wages. Have the insurance expert on your advisory team help you find the right plan.

•  Education benefits. You may reimburse employees for up to $5,250 per year. It’s tax-free to them and a full deduction to you.

•  Employee death benefits. Employee death benefits may be paid to the employee’s family to help out with the funeral and other related costs. It would be a deduction to the employer. And it would be income to the employee if the benefit is based on the employee’s past service or other economic benefit due to the employee.

•  Meals and lodging. Some companies set up a cafeteria offering free meals to all employees to save time off from work or to ensure they get some nutritious meals. When you offer it to all employees, the company may deduct 100 percent of the costs without charging the employees. (These meals are not limited to a 50 percent deduction.) I’d be careful about this if you’re working from home and it’s just you and your family. Lodging is a bit more interesting. When your employee (such as an apartment manager) must live on the premises for the benefit of the employer, so he or she is available full-time, the lodging is free, without tax consequences to the employee.

Companies providing fringe benefits to qualified employees may deduct the costs of the benefits and administration. You’ll want to think carefully about setting up these plans, because once you start, employees expect them. To keep employees for the long term, you need to be generous. But it’s worth it to keep terrific employees. Be sure to build the costs of the perquisites into your product or service costs. On the other hand, many of these benefits reduce your tax and insurance costs, and you can use that savings to pay for the benefits.

There are a variety of retirement plans and profit-sharing plans you can offer your employees. Chapter 10 describes most of them as they apply to business owners and related parties. The spreadsheets in Tables 10.1 and 10.2 in Chapter 10 will give you an overview of each plan, with the limits, setup dates, and funding dates as well as the pros and cons of each plan.

Employee Ownership and Stock Options

Whether for tax planning or retention, employee ownership is an appealing option. Since the IPO craze of the 1990s, highly skilled employees are starting to expect a share of the equity and growth of a company.

Using stock is an excellent lure to hire an employee whose price you couldn’t otherwise afford. Giving up stock, you can offer a salary you can presently afford, with a promise of riches as the company grows. The right highly talented employee, who isn’t also highly strung, will make the difference between growing slowly or explosively. Which is better, giving up 5 percent of a company worth $10 million or owning 100 percent of a company worth $250,000? That’s the kind of difference the right employee(s) can make.

You can also use employee stock ownership plans (ESOPs)⁶ to avoid paying taxes. When you turn over 100 percent of the company’s stock to an ESOP, the ESOP pays no taxes on the company’s profits. It does mean giving up stock to each employee as he or she becomes eligible, and so you will own less of the company. But you will also own a share of the ESOP. However, with all the tax money available to the company for growth, what you’ve given up may earn you a greater reward— allowing you to build a bigger company.

Companies such as JetBlue and United Airlines have substantial employee ownership. You don’t have to be a large company to do this. Kinko’s started out quite small and was entirely employee-owned. With great employee training and participation, the company grew dramatically. In February 2004, Federal Express paid $2.4 billion for the company. You can just bet those Kinko’s employees’ retirement plans look healthy. All the profit is sitting in their ESOP accounts, ready to be drawn whenever they want to retire.

You can also offer stock options.⁷ The rules on when the options are taxable, when the employee can exercise them, and what taxes get paid when are very complex. I prefer to leave all that in the hands of the tax and labor attorneys. If you want to study this in depth, you’ll find a feast at the National Center for Employee Ownership’s website at http://www.nceo.org.

Summing Up Employees

Overall, you and your family can gain great benefits by having eligible family members go on the payroll. The trick is to pay wages only for valuable services performed on behalf of the business. Do what the IRS asks of you—your family will be closer knit, and your business will grow in leaps and bounds.

Just as the benefits are good for your family, think of how treating your employees well affects them. Seeing you extend yourself to provide them with ways to make their money go further will increase their loyalty to you.

At tax educational seminars I often hear the presenters speak about how to devise retirement and benefit plans that cut out the employees. Isn’t that the silliest thing you’ve ever heard? Why would you not want to give your employees benefits? Cost? Sure, cost is a factor. But think of the cost of hiring, training, and teaching a new employee because you didn’t value the previous employee enough. Cheap labor is not cheap! New hires make mistakes—sometimes mistakes big enough to cost you important clients.

So as you prosper, see to it that your employees do, too. Get some good planning with the help of the employee benefit specialist on your advisory team—and you’ll ensure being able to retire in style.

Employee and Independent Contractor Resources

IRS Forms and Publications

•  Form I-9, Employment Eligibility Verification. https://www.uscis.gov/sites/default/files/files/form/i-9.pdf.

•  Form SS-8, Determination of Worker Status. https://www.irs.gov/pub/irs-pdf/fss8.pdf.

•  Form W-4, Employee’s Withholding Allowance Certificate. https://www.irs.gov/pub/irs-pdf/fw4.pdf.

•  Form W-9, Request for Taxpayer Identification Number and Certification. https://www.irs.gov/pub/irs-pdf/fw9.pdf.

•  Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return and Form 940-V Payment Voucher. https://www.irs.gov/pub/irs-pdf/f940.pdf.

•  Form 941, Employer’s Quarterly Federal Tax Return and Form 941-V Payment Voucher. https://www.irs.gov/pub/irs-pdf/f941.pdf.

•  Form 1099-MISC. https://www.irs.gov/pub/irs-pdf/i1099msc.pdf.

•  Form 8809, Application for Extension of Time to File Information Returns. http://iTaxMama.com/IRS_Form8809.

•  IRS Employee vs. Independent Contractor rules. http://iTaxMama.com/IRS_Emp_v_IC.

•  IRS Employment Tax Issues. http://iTaxMama.com/IRS_Employment_Tax.

•  Section 530, Safe Harbor Information. http://iTaxMama.com/IRS_530. See the article “Section 530: Its History and Application in Light of the Federal Definition of the Employer-Employee Relationship for Federal Tax Purposes” (February 2009) by the National Association of Tax Reporting and Professional Management.

•  IRS EFTPS (electronic federal tax payment system). https://www.eftps.gov/eftps/. Set it up for your payroll tax deposits.

•  IRS Voluntary Classification Settlement Program (VCSP). http://iTaxMama.com/IRS_VCSP.

•  TaxMama’s free 2012 webinar on the VCSP. http://iTaxMama.com/TM_VCSP.

Other Resources

•  U.S. Department of Labor’s website. http://webapps.dol.gov/elaws/flsa.htm.

•  Links to state tax agencies. http://www.taxadmin.org/state-tax-forms.

•  Intuit’s Complete Payroll. http://iTaxMama.com/Intuit_Payroll.

•  Paychex. http://www.paychex.com/.

•  IRS’s list of payroll providers. http://iTaxMama.com/IRS_Payroll.

•  New! Final Rule: Overtime. https://www.dol.gov/whd/overtime/final2016/. Defining and Delimiting the Exemptions for Executive, Administrative, Professional, Outside Sales and Computer Employees under the Fair Labor Standards Act.

•  FUTA Credit Adjustment. http://iTaxMama.com/FUTA_State_Penalty. If your state gets behind on paying their share of the unemployment fund, your federal unemployment rate might go up. Look up your state here.

•  Service Corps of Retired Executives (SCORE). https://www.score.org/.

•  The Global Family Business Index. http://familybusinessindex.com/. Lists the top 500 family-owned businesses in the world—dating back to 1610. This is a fun chart to explore!

•  Family Business Magazine. http://www.familybusinessmagazine.com. An excellent collection of articles, resources, and information for small family businesses intending to become major businesses.

•  MyRA. https://myra.gov/. A new form of Roth IRA that allows you to make micro-deposits to your account, and grows tax-free. Deposits may be made via payroll withholding, automated direct deposit, or you can mail in your deposit.

•  National Center for Employee Ownership. http://www.nceo.org/. A private, nonprofit membership and research organization providing unbiased information on employee stock ownership plans, broadly granted employee stock options and related programs, and ownership culture.

•  What is “adequate compensation”? These two sites can provide definitive reports to use to back up your decisions for wages or guaranteed payments:

º  http://www.rcreports.com/

º  http://www.reasonablecompensation.com/

•  TaxMama’s Quick Look-Ups. http://iTaxMama.com/TM_QuickLookUp. You will find all kinds of useful reference materials, webinars you can replay, e-books, and more.

•  Your Business Bible. http://www.yourbusinessbible.com. Look for worksheets, printable checklists, and other goodies and resources.

1  Full text, plus amendments, of Section 530 of the Revenue Act of 1978 can be found at http://iTaxMama.com/IRS_530. (Note: This is not Code Section 530 of the Internal Revenue code.)

2  The Global Family Business Index lists the top 500 family-owned businesses in the world—dating back to 1610—http://familybusinessindex.com—this is a fun chart to explore!

3  Boyd v. Commissioner, 122 T.C. No. 18 (4/24/04)—an S corporation’s shareholders were not entitled to a 100 percent deduction for the portion of the per diem allowance paid to drivers for nonmeal expenses, including mileage. It all boils down to establishing clear accountability.

4  Note: If your state gets behind on paying its share of the unemployment fund, your federal unemployment rate might go up. Look up your state here—http://iTaxMama.com/FUTA_State_Penalty.

5  See the IRS’s resource on Employment Tax Fraud Investigation—https://www.irs.gov/uac/examples-of-employment-tax-fraud-investigations-fiscal-year-2016 (change the year to see the most current investigations).

6  The National Center for Employee Ownership (NCEO) has an extensive ESOP resource section, available at http://www.nceo.org/main/publications.php.

7  NCEO also provides an extensive stock options resource at https://www.nceo.org/articles/employee-stock-options-factsheet.