Are Your Workers Subject to Payroll Taxation?

Payroll taxes involve a variety of difficult issues for the small business owner, which center around determining who is a taxable employee, what compensation is taxable, which payroll taxes apply, and when and how to make the tax payments.

Payroll tax responsibilities are something that every employer must deal with. Generally, employers are required to withhold taxes from employees' pay and deposit the withheld amounts with the appropriate tax agencies. You will also have to pay certain taxes based on the amounts that you pay your workers.

The taxes that you're required to withhold, together with those that you're directly required to pay, comprise your payroll taxes. They may include federal, state, and perhaps local income taxes, Social Security and Medicare taxes, federal and state unemployment taxes, and, in some states, disability insurance taxes.

Keep in mind, regardless of whether you employ others, you can also expect to owe some payroll-type taxes on income that you receive from your business.

The key to controlling your payroll tax obligations involves the following considerations:

which workers are taxable employees

what type of compensation is taxable

which payroll taxes apply

the payroll tax returns and payments that must be filed and paid

whether self-employment taxes apply to your business income

Who Are Your Taxable Workers?

Before you can calculate your payroll tax liabilities, you must first determine which of the people who work for you, if any, are "employees" for whom you must withhold and pay taxes.

Each federal and state law imposing a payroll tax has its own definition of the types of workers to which the tax applies. However, as a practical matter, the basic governing standard under all of these laws is whether the individual who performs services for you is properly characterized as an employee, as opposed to an independent contractor, under so-called "common law rules."

In general, these common law rules say that your workers must be treated as employees if you have the right to direct and control the way they do their work, rather than merely the results of the work. However, consider the following:

Distinguishing common-law employees from contractors can be difficult, since every working relationship must be judged on its own particular facts. There are a number of tools that can help you, including the IRS's 20-factor test, the IRS safe-haven rules, and the opportunity to get an IRS ruling on the issue.

Some independent contractors are taxable as employees, if they perform certain types of duties.

Some employees may be treated as nontaxable contractors, namely, real estate agents and direct sellers.

Part-time and temporary workers. If your workers are properly classified as being employees, the fact that they may work for you only on a part-time or temporary basis or that they may be minors generally won't relieve you from the obligation to withhold and pay taxes on their wages. Again, the key issue is whether the workers are common-law employees, and that determination is unaffected by the number of hours the workers put in or by their age.

You take on a significant risk if you improperly treat an employee as an independent contractor.

The risk is that the IRS and your state tax authorities will hit you with penalties that at a minimum make you personally liable for paying, with interest, both the taxes you should have paid and the taxes you should have withheld. So, if you have any doubts as to the proper classification of a worker, consult your accountant or other tax professional. Or, request an IRS determination of the worker's correct classification.

Special Payroll Tax Obligations Apply When Hiring Family

Your payroll tax obligations as an employer differ from the norm if you hire your family members to work in your business. One of the advantages of hiring family is that you may realize some savings in payroll tax dollars.

Family members fall into a separate category. Some family members are not subject to certain payroll taxes even if they are your employees.

Is there a specific exception from income tax withholding for wages you pay to family members? There isn't a specific exemption, so if family members are common-law employees of your business, you'll generally have to withhold income taxes from the wages you pay them.

However, you may be relieved from FICA taxes and federal and state unemployment taxes in some situations if you don't run your business through a corporation:

Children: For a child who works as an employee of your business, you're relieved from withholding and paying FICA taxes until the child reaches 18 and from paying FUTA taxes until the child reaches age 21.
Spouse and parents: You don't have to pay FUTA taxes with respect to a spouse or parent who works as an employee of your business. However, you do have to withhold and pay FICA taxes for those relatives.
Siblings and other relatives: You don't receive any payroll tax breaks for hiring your siblings or other relatives. You have the same payroll tax obligations for these family members as you have for employees who are not related to you.

If you operate your business through a corporation, the payroll tax breaks associated with hiring family members are not available. This is because your corporation, and not you, will be considered the employer.

For similar reasons, most of the tax breaks won't be available if you operate your business through a partnership. However, if you and your spouse are the only partners of the partnership, you do retain the tax breaks associated with hiring your children. This rule holds true for limited liability companies (LLCs) as well, since in the eyes of the IRS, an LLC is treated as a partnership.