Hiring employees comes with tax responsibilities and also tax benefits. As a sole proprietor or small business, you need to know what to do and when before you hire your first employee.
There are several concepts related to taxes to understand when you hire employees as a sole proprietor or small business.
- Registering with the federal and state governments
- Collecting information from employees
- The difference between employees and independent contractors
- Payroll taxes
You may also want to talk to a human resources specialist or employment lawyer about things like hiring best practices, workers compensation, and labor laws.
Registering Your Business
Before you can hire employees, you need to register your business with the IRS and often your state government.
The first step is getting an Employer Identification Number (EIN) from the IRS. You’ll use this number on your payroll tax returns and the W-2s you give your employees. It’s like a Social Security Number except for businesses that helps the IRS identify businesses and who paid employees.
You may already have an EIN if you formed a corporation or LLC. Many sole proprietors don’t have an EIN, because they don’t need one unless they hire employees. Partnerships also sometimes forget they need an EIN.
Get an EIN
There are two ways to get an EIN.
- Go directly to the IRS and get one for free.
- Use an online EIN service for added convenience and help setting up and running your business.
Register with Your State
Almost all states will use your federal EIN to identify you for state taxes. Check with your state, since some do use their own state Employer Identification Number (EIN) or state Employer Account Number (EAN).
You may also need to file a form with your state. For example, Florida businesses need to file a Form DR-1 Business Tax Application. You’ll usually need to already have your EIN to complete this step.
Collecting Information From Employees
When you hire a new employee, there are several steps and forms to complete.
I-9 Employment Verification Form
Form I-9 is a U.S. Citizenship and Immigration Services Form to help you verify that an employee is eligible to work in the United States. It lists documents you need to check to verify their eligibility such as a passport, driver’s license, or Social Security card.
You don’t need to file the I-9, but you do need to keep it in your files in case a government agency audits whether your employees are eligible to work. There are potential penalties for not taking reasonable steps to verify an employee, so many employers participate in the USCIS E-Verify System.
IRS Form W-4 is how you collect your employee’s tax information. It gives you what you need to calculate their tax withholding and create their W-2 at the end of the year.
Current employees may need to provide an updated Form W-4 if they need to change their tax withholding because of a change in their overall tax situation.
If you hire independent contractors, you’ll collect a Form W-9 instead of a W-4.
State Tax Withholding Forms
Some states have their own tax withholding forms similar to the federal W-4. Others go by the IRS form.
Other Payroll Deductions
You may also need to have employees to fill out other forms to set up payroll deductions like health insurance or 401(k) contributions.
Employees vs. Independent Contractors
This is the part where many business owners start thinking it would be easier to just 1099 their workers. The IRS has very specific rules for when someone is an employee versus an independent contractor.
Generally, when you control someone’s work and set their schedule, they’re an employee. An independent contractor is essentially an outside business performing a specific service that isn’t a key aspect of your business.
There are different sets of rules for when someone is an employee versus independent contractor including:
- Federal tax laws
- Federal labor laws
- State tax laws
- State labor laws
- Workers compensation
It’s possible for a worker to be an independent contractor in some circumstances but an employee in others. Since employee versus independent contractor classification affects workers’ rights and benefits, there are big penalties if you get it wrong. Talk to an employment lawyer if you have questions about how to classify your workers.
When you pay employees, you need to
- Pay certain payroll taxes as the employer
- Withhold a portion of employees’ paychecks for taxes
- Pay the taxes to the IRS and your state
- File payroll tax returns
Taxes the Employer Pays
There are several taxes you pay as the employer. They are a percent of the employee’s wages but not deducted from the employee’s earnings.
- Social Security Tax: 6.2% on up to $147,000 in wages
- Medicare Tax: 1.45% with no cap
- Federal Unemployment Tax Act: 0.6% on up to $7,000 in wages
- State Unemployment Tax Act: Varies by state, usually around 3% on $5,000 to $10,000 in wages
- Workers Compensation Insurance: Varies by state, job type, and your safety history, usually around 1%
Special Rules for Owners
Owners are never employees in sole proprietorships, partnerships, or LLCs that aren’t taxed as corporations. They don’t receive wages subject to payroll taxes or get a W-2.
Owners who are paid wages through a corporation, including S-corporations, do get a W-2 and are subject to payroll taxes. Unemployment taxes generally don’t apply to owner payroll.
Special Rules for Family Members
If you hire a family member or work for a family member, there are special rules at the federal level. This is often known as a family management company. State rules may vary.
- If your spouse is your employee in a sole proprietorship, income, Social Security, and Medicare but not unemployment taxes apply.
- If a child is the employee of their parents in a sole proprietorship or partnership only owned by the parents
- and they are under 18, they aren’t subject to Social Security or Medicare taxes
- and they are under 21, they aren’t subject to unemployment taxes
- If a child is the employee of their parents in a corporation, even if the parents are the sole owners, the usual payroll taxes apply
- If a parent is the employee of a child in a sole proprietorship, income, Social Security, and Medicare but not unemployment taxes apply.
Check with your state for workers compensation requirements.
Taxes the Employer Withholds for the Employee
The employer also deducts taxes that the employee is responsible for paying.
- Social Security Tax: 6.2% on up to $147,000 in wages
- Medicare Tax: 1.45% with no cap
- Federal Income Tax: Calculated according to their W-4
- State Income Tax: Calculated according to their state withholding form or W-4
Making Payroll Tax Payments
For federal payroll taxes, you generally need to make electronic tax deposits either monthly or semi-weekly. Deposit monthly if your payroll tax deposits in the previous four quarters were $50,000 or less. If they were more, deposit semi-weekly. There are large penalties if you don’t pay payroll taxes on time.
Each state has its own rules and schedule for state payroll taxes.
Payroll Tax Returns
There are several payroll tax returns you may need to file.
- Form 941 quarterly payroll tax return
- Form 944 annual payroll tax return
- Form 943 for agricultural payroll taxes not filed on 941 or 943
- Form 940 annual FUTA tax return
- Form 945 annual return for tax withheld from nonpayroll payments
- Forms W-2 and W-3 to report employee wages and taxes withheld for the year
- Form 8027 annual information return of tip income and allocated tips for large food and beverage establishment
You may need to file similar payroll tax returns with your state. Each state has its own forms, rules, and schedule.
Frequently Asked Questions
Can a sole proprietorship have employees?
Yes, a sole proprietorship can have employees. A proprietor means an owner, so sole proprietor means single owner. You can have an unlimited number of employees and still be a sole proprietorship.
Do you have to be an LLC or corporation to have employees?
No, any type of business can have employees as long as you have an EIN and follow the payroll tax requirements.
Can you have an LLC without employees?
Yes, you can have an LLC with one or more owners but no employees. This is common where the owner(s) want the LLC for legal protections but don’t have hiring employees in their plans.
What does a sole proprietor need to do to hire employees?
1) Get an EIN. 2) Understand the payroll tax requirements. 3) You’ll probably want to use a payroll tax service to make things easy.
Do you need a business license to have employees?
Business licenses are usually a state legal requirement that govern what type of work you’re allowed to do. You or your employees may need a license to do certain activities, but hiring employees alone usually doesn’t require a business license.
Are LLC members considered employees?
LLC members are generally considered owners not employees.
How do you pay yourself in a sole proprietorship?
Normally, you can just transfer money to your personal bank account. If you’re an employee of your corporation, you may want to have your payroll tax service pay you, since you’ll need to withhold payroll taxes on yourself.
Can you be a CEO of a sole proprietorship?
CEO is a business title that has no official meaning and doesn’t affect your taxes. However, CEO usually refers to someone in charge of a large business with many employees.
Can you pay yourself wages if you’re self-employed?
It’s a good idea to pay yourself a regular amount if you’re self-employed. However, unless you’re a corporation, you can’t officially take wages that go on a W-2 and are subject to payroll taxes.
Can a husband and wife be a sole proprietorship?
A husband and wife generally need to file a partnership tax return unless they elect to be treated as a qualified joint venture or live in a community property state. If only one spouse is the owner while the other is an employee, special payroll tax rules apply to the other’s wages.
Does a sole proprietor deduct wages on Schedule C?
Report wages on line 26 of Form Schedule C.
Can a single-member LLC hire employees?
Yes, registering as a single-member LLC only limits the number of owners. You can generally have employees.
Can a single-member LLC hire independent contractors?
Yes, for the same reason as above. Single-member only means one owner. You can still hire independent contractors and be a single-member LLC.