Lesson 6 - What you need to know about federal taxes when hiring employees or contractors
Hi, I'm Janene. I've just started my own real estate company, and I have six people working for me. Some of them work in the office, performing administrative duties, and some of them are real estate agents. I've been classifying everyone as an employee, but based on some of the reading I've been doing I'm not sure that's right anymore. I also thought I was doing what I was supposed to be doing regarding my federal tax obligations as a business owner with employees but again, now I'm not so sure. Can you help me help myself-and my workers?
Janene, we have exactly the information you're looking for. Welcome, everyone, to What You Need to Know about Federal Taxes when Hiring Employees or Independent Contractors. In this lesson, we'll discuss Janene's- and 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 like Janene is, or paying someone else to do it, you need to know your responsibilities.
In this lesson... you'll learn about the differences between an employee and an 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 purpose of the state new hire registry; 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 in this lesson is available from IRS Publication 15, Employer's Tax Guide.
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 their FICA; that is, Social Security and Medicare taxes. I've heard these referred to as trust taxes? What does that mean? They are sometimes called trust taxes because you hold them on behalf of, or in trust for, your employees before you deposit them to the Treasury. In addition, you have to pay the employers' matching share of FICA taxes and in most cases... you will have to pay the federal unemployment tax, also known as FUTA tax.
In most cases, however, you do not have to withhold or pay any taxes on payments made to independent contractors.
Worker classification - Employee v. Independent Contractor
But how do I know if the person working for me should be classified as an employee or as an independent contractor?
Good question, Janene. 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.
What is meant by behavioral control?
The facts about behavioral control show whether there is a right to direct or to control how the worker does the work. A worker is an employee when the business has the right to direct and to control the worker. The business does not have to actually direct or to control the way the 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 to control how the worker does the work I hired them to do? Do I direct when and where to do the work? Do I determine what tools or equipment to use, or where to purchase supplies and services? Do I control hiring? Do 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. Okay, so that's behavioral control.
What about financial control?
Financial control is another important factor you must consider. Again, ask yourself: Who directs or controls the business aspect 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 and may have a significant financial investment in their business. They may also have their own tools and equipment. Independent contractors are more likely to have out-of-pocket business expenses and can have profits or losses.
Relationship with the worker
And the final area- my relationship with the worker?
When considering this final area, 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 worker's 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 does not automatically make the worker an independent contractor. Deciding the worker's employment status up front is important for you and for the worker. If you misclassify workers as independent contractors and you have no reasonable basis for doing so, you may be liable for their employment taxes and have to pay all the employee's taxes.
I can see why this is so important, but what if I'm still not sure whether a worker should be classified as an employee or as an independent contractor?
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 will 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 lesson. Please choose one of the following: You have only employees working for your business. You have only contractors working for your business. You have both employees and contractors working for your business.
Employer responsibilities if you have employees
Now we're going to go into detail about your responsibilities if you have employees. There seem to be a lot of responsibilities- what are they exactly? Janene, you have numerous responsibilities as a business owner with employees.
In this part of the lesson, we are going to cover... eligibility to work legally in the United States, Form W 4, Social Security number verification, the state new hire registry, Form W 2, the Earned Income Tax Credit, and Individual Taxpayer Identification Numbers.
Determining eligibility of employees to work legally in U.S.
Let's start with how to determine the eligibility of your employees to work legally in the United States. 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 US citizen; a national, or legal permanent resident; or must have been granted authorization to work in the US. US 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 US 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 US passport or a driver's license and a birth certificate.
Where can I find Form I 9, and what are my responsibilities about reviewing and accepting the form from my employees?
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 the 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 three years after the date of hire or one year after employment ends, whichever is later. For more information, we encourage you to view the lesson "Hiring People Who Live in the U.S. but Who aren't U.S. Citizens."
Alright, I understand about Form I 9, but what about Form W 4?
Each employee must complete a Form W 4: Employee's Withholding Allowance Certificate. Use the employee's gross wages and the information on the Form W 4 to calculate the amount to withhold. This information includes the employee's marital status, the number of withholding allowances claimed, the employee's desire to have additional tax withheld, and an employee's claim to exemption from withholding, if applicable. If an employee does not give you a signed W 4, withhold tax at the single rate with no withholding allowances. 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. Employees claiming exemption from withholding must submit a new W 4 each year by February 15th to re-establish their exempt status.
Verification of employees' SSNs
Now, let's turn our attention towards verification of employees' Social Security numbers. Another responsibility you have as an employer is that you are required to get and to verify each of your employee's Social Security numbers.
How do I do that?
The Social Security Administration offers employers three methods to verify employee Social Security numbers.
First, 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 thousand names and numbers and receive results the next business day. To explore these options further and to become a registered user, visit www.ssa.gov/employer and click on the Verify SSNs Online link. Second, in an emergency situation, employers can call the employer 800 number at 1.800.772.6270 and, once your user authentication is complete, an agent will provide the name and Social Security number verification over the phone. Third, you can submit your request on paper to your local Social Security Administration office.
Your local office will provide you with formatting and submission instructions. Some offices even accept faxed listings. When you do 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.
State Hire Registry
In addition to getting and verifying personnel information for payroll purposes, what else do I have to do?
Once your employees provide that information, and you've verified it, you must also send information on new employees to your state's new hire registry. The state matches records from the new hire registry against child support records at the state and national levels to locate parents who owe child support. The information to send includes your business name and address; your EIN; and the name, address, and Social Security number of the new hire. Because most of this information is on a completed Form W 4, many states accept a copy of the Form W 4 with employer information added. Quarterly wage reports and unemployment claims are also required. To find the specific requirements in your state, go to your state's Website.
Form W-2, Wage and Tax Statement
So far, we've covered Form I 9, Form W 4, verifying Social Security numbers, and the state new hire registry. What's next?
Next, Janene, we're going to talk about Form W 2. As an employer, you must complete a Form W 2: Wage and Tax Statement, for each of your employees every year. The Form W 2 shows the amount of compensation paid to employees and the amount of tax withheld for the year. The Social Security Administration also uses this form to update the employee's lifelong earning history and then, from that earning history, calculate the employee's benefits.
Penalty for non-matches
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 Forms W 2 and W 3 for more information on penalties. So, as you can see, it is important that an 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
But how can I be sure that my new employee provided the correct information?
First, keep your payroll records up to date. 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 it isn't required. Second, 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 keeping 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
When do I have to issue Form W 2s?
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.
Filing Forms W-2 Electronically
It would be a big help if I could file these electronically. Can I do that?
You sure can, Janene. In fact, the Social Security Administration has two electronic filing methods. Companies filing 2 hundred and 50 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 March 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 Filing Handbook link.
In the second method, called W 2 Online, you can complete up to 50 Form W 2s at the Social Security Administration's Website 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 Filing Handbook link at www.ssa.gov/employer.
Both online options require registration with the Business Services Online, or BSO, Website at www.ssa.gov/bso. From the BSO Website, select Register and complete the information. You will be assigned a User ID 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 may still send the Form W 2s by mail along with your Form W 3s. If you file by paper, you'll need to file a whole month earlier, by February 28th.
That covers the major areas of responsibilities to employees, but there are two more topics we need to discuss: The Earned Income Tax Credit and Individual Taxpayer Identification Numbers.
Earned Income Tax Credit (EITC)
What responsibilities do I have towards my employees regarding the Earned Income Tax Credit?
The Earned Income Tax Credit, or EITC, is a refundable tax credit for people who work but who do not earn high incomes. 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. 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 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 Taxpayer Identification Numbers (ITIN)
And, finally, what is an ITIN?
The IRS issues Individual Taxpayer Identification Numbers, or ITINs, to individuals who are required to have a US 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' Form W 2s. They do not provide eligibility for Social Security benefits or the Earned Income Tax Credit. An ITIN is a nine digit number that always begins with the number 9 and has a 7 or an 8 in the fourth digit.
Now we're going to look at your responsibilities regarding independent contractors. For independent contractors, you file Form 1099 Miscellaneous with the IRS. Make sure you give a copy to the independent contractor by January 31st. If you choose to file Form 1099 with the IRS by paper, the deadline is February 28th. As with Form W 2s, though, if you have 2 hundred 50 or more Form 1099s, you must file electronically. The deadline for filing electronically is March 31st. You don't need a transmittal form and filing electronically allows you up to ten days from transmission to stop processing. This means you have an opportunity to make corrections to your final transmission before the due date.
Filing Information Returns Electronically Using FIRE
How do I file electronically?
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 complete Form 4419, Application for Filing Information Returns Electronically, and mail or fax that form to the IRS at least 30 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 to you. When you receive your Transmitter Control Code, you may create a User ID, password, and Personal Identification Number, or PIN, right away.
For more specific information on using the FIRE system, see IRS Publication 3609, Filing Information Returns Electronically for business e-filers. Although the FIRE system is easy to use, you still must use the pre-approved software. You can develop your own software by following the specifications in IRS Publication 1220, Specifications for Filing Forms 1097 BTC, 1098, 1099, 3921, 3922, 5498, 8935, and W 2G Electronically. To find a vendor who sells pre-approved software or for a transmission service provider, see IRS Publication 1582, Information Returns Vendor List. The IRS does not endorse or approve products and services offered by these vendors; the publication is simply for your convenience.
Filing Forms 1099 with your state
If I use the FIRE system, would I also need to separately file Form 1099 with my state?
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 to see if your state participates in the combined federal state filing program.
This has been a lot of information, and I think I finally understand what I'm supposed to be doing for myself and for my workers. But I'd still appreciate a review.
No problem, Janene. First, we talked about differences between an employee and an independent contractor. And remember, there are three areas 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 mentioned the state new hire registry and its purpose. 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 lesson 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. Remember, if you have questions or need more information, you can consult IRS Publication 15, Employer's 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.