Monthly Archives: October 2012

Hiring Your First Employee & Payroll Taxes

So, in this post we discussed the trials and tribulations of finding the perfect employee for your company.  Now we’ll take a look at the tax implications so you keep yourself out of hot water with the regulators, or said another way, what ever employer should know BEFORE they hire their first employee.

Eligibility to Work in the United States.  Every employer must verify that each new employee is legally eligible to work in the United States. You don’t want to run into problems later so have the employees you hire fill out Form I-9, Employment Eligibility Verification.  You can also get their SSN at this stage.

Employee vs. Independent contractor.  While you may want to classify a person as independent contractor to avoid the hassle of dealing with payroll taxes, make sure the classification is proper.   Generally speaking, an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.  Not sure what your new hire will be?  Check out this site for a little assistance.

Independent Contractors Agreement.  If you do determine that the person who’ll work for you does qualify to be classified as an independent contractor, it’s a good idea to draft an agreement.  This document should outline the duties they will/won’t perform, how they are compensated and the responsibilities with reporting their earnings to the IRS.  This way you are protected in case the employee disagrees that they were an independent contractor or worse files a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

Fill out Form W4.  To know how much income tax to withhold from an employees’ wages, you should have them complete Form W-4, Employee’s Withholding Allowance Certificate.  Ask all new employees to give you a signed Form W-4 when they start work. Make the form effective with the first wage payment.  If the employee claims exemption from income tax withholding, they must indicate this on their W-4. The amount of income tax withholding must be based on filing status and withholding allowances as indicated on the form. If a new employee does not give you a completed Form W-4, the IRS recommends that you withhold tax as if he or she is single, with no withholding allowances.

Withholding & Matching Taxes.  So as an employer you will act as a collector and depositor of taxes.  You should withhold the proper amount of federal income tax based on the employees Form W4.  Additionally, you are required to withhold social security and Medicare taxes from your employees’ wages and pay the employer’s share of these taxes.  Generally speaking the employee AND employer tax rate for social security is 6.2% on wages while the tax rate for Medicare is 1.45% each for the employee and employer (2.9% total).  All of the above is deposited via a system called EFTPS by the employer.

Reporting.  In addition to withholding and depositing payroll taxes, employers must periodically report these amounts to the government.  These are done via Form 940, 941 or 944.  You may be asking yourself “What is the difference between Federal 940, 941 and 944 taxes?”  941 tax filings are submitted each quarter. 944 tax is the same as the 941, but is filed and paid on an annual basis.  The IRS makes the determination on which tax form you will file and how often you need to deposit your tax withholdings depending on the size of your payroll.  940 tax is Federal Unemployment. Unless you are exempt, you are required to report/pay this tax on an annual basis in addition to your 941 or 944 taxes.

Retirement Options For The Self Employed

One of the biggest mistakes entrepreneurs make is not planning adequately for their retirement. This isn’t all that surprising. If you’re self-employed, it’s a squeeze to set the money aside, even if it is tax-deferred. There’s a fear that you may need those funds to keep things rolling if the business doesn’t grow the way you expect, or clients are lax on paying your invoices.

The good news is that Uncle Sam does offer help in a variety of relatively painless plans to help self-employed small-business owners save for retirement in tax-favorable accounts. Here’s a round-up of the three main options:

SEP-IRA If you’re a one-man/woman band, this account is a good bet. A simplified employee pension, or SEP IRA, is a basic way to set aside pretax savings. You can contribute as much as 25 percent of your net self-employment income, up to a maximum of $50,000.

Best features: Flexibility. There’s no need to fund the account until you file your tax return (i.e. there is no requirement that you fund it each year). So if your net income turns out to be higher than expected, you can make a larger contribution and trim your tax bill. If you have a bad year, you can reduce your contribution.  Furthermore, if you’re building your new business on the side while still working for an employer who’s sponsored 401(k) plan you contribute to; your contributions to a SEP don’t interfere with your current workplace plan.

Considerations: This plan may be costly eventually if you have employees, as opposed to contract workers.  The plan requires that you must make the same percentage contributions for all “covered,” workers, or those who are 21 and older who have been employed by you for at least three of the last five years and are expected to earn $550 in the current year. Generally, you can deduct the contributions you make each year to each employee’s SEP-IRA. If you are self-employed, you can deduct the contributions you make each year to your own SEP-IRA.

Tax Filer Tip:   You have until the due date for your tax returns, including any extensions (meaning as late at October 15th), to both set up and fund the plan. You can open SEP-IRA at practically any financial service company including banks, mutual fund companies or brokerage firms. Firms such a Fidelity, Schwab, T. Rowe Price or Vanguard will set up an account gratis and account fees are low or nil.

Solo 401(k) This is a good choice for business owners and their spouses who are able to set aside a significant portion of their earnings. With a solo 401(k), as an employee, you can stash away as much as $17,000. As the employer, you can contribute another 25% of compensation, up to a ceiling of $50,000 including your employee contribution. If you’re 50 or older, you can toss in another $5,500 extra. Total savings: a whopping $55,500.

Best features: Generous contribution limits. If there’s a set-up or annual fee, it will be low. You might pay a small set-up fee, $100 or less, plus an annual fee of $10 to $250. There are no set-up fees, for example, at Fidelity or Vanguard.

And these contribution amounts are optional, so you can save the top figure in flush years and zilch in leaner times. If you already have an individual retirement account funded by money rolled from a previous employer’s 401(k), you can roll those retirement savings into your new solo 401(k).

It’s also possible to take out a loan against a solo 401(k). That can be useful if you need funds in a pinch. You can borrow half the account’s balance, up to $50,000, and normally can take up to five years to pay it back (provider rules differ).  We don’t recommend borrowing from your plan unless it’s a serious situation. But having the option can make it easier to get over the psychological hurdle of opening a retirement account.

Considerations: No extra employees can participate – only self-employed business owners and a spouse. This is not the best option if you’re still working a day job. If you contribute to an employee 401(k) at your day job, you might already be saving the max. You get only one combined $17,000 employee contribution limit to a 401 (k) plan, no matter how many jobs you’re working.

Tax Filer Tip: The deadline to open a new plan is typically December 31st (or fiscal year end) and must be funded by your tax return due date, plus extension. This is a traditional “qualified” pension. That means you must file an annual Form 5500 report once you have $250,000 of assets in it.  So you may have some paperwork here. Fidelity and Vanguard, for example, provide the information you need for the form, but do not complete or file it for you.

SIMPLE IRA. A SIMPLE IRA is designed specifically for small businesses and self-employed individuals. If you have a few employees, say, less than 10, who make more than $5,000, but far from six figures, and want to offer a plan for them as a perk, this is probably the one for you. It was designed for firms with no more than 100 employees.

For 2012, you can make an employee contribution of up to $11,500 pretax, or $14,000 if you’re 50 or older. There isn’t any percentage of income restrictions. Your contributions are tax deductible, and your investments grow tax deferred until you are ready to make withdrawals in retirement.

A SIMPLE IRA is a little burdensome if you’re a fledgling firm. You’re generally required to make a contribution to match each employee’s salary reduction contributions on a dollar-for-dollar basis up to 3% of the employee’s salary or a flat 2% of pay – no matter what the employee contributes to the account.

Best features: Easy paper work. It should take about 15 minutes or less to fill out the forms.

Considerations: This one isn’t for moonlighters – you can’t contribute if you’ve already maxed out employee contributions to a 401(k) at your day job. Also, if you need to make a withdrawal from a SIMPLE IRA plan within two years of its inception, the 25% penalty is significantly higher than the 10% fee you’d be charged for early withdrawal from a SEP IRA.

Tax Filer Tip: SIMPLE IRAS must be set up by October 1st to make contributions for that year, and all employee contributions must be made by December 31st.

For additional guidance on retirement plans for the self-employed, see IRS Publication 560.

Trials of Finding Good Employees

Q:  I’m a one man band and have recently decided to hire someone to lend me a hand.  What do I need to keep in mind as I take my first steps towards being an employer?

A:  At some point, many small business owners consider bringing in some outside help in order to ease their workload.  However, hiring your first employee is not a process that should be done hastily.  If done incorrectly, firing your first employee can be even more problematic then bringing them on board.  Thus, below we’ll examine some of the challenges you’ll run into as well as other important items you’ll want to keep in mind so that employee No. 1 is a good fit.

Do Your Math. Many owners are sometimes taken aback at how much it actually costs to have an employee.  The actual cost of the employee will be more than you think because of payroll tax obligations, benefits, etc.  It’s not uncommon for a $10 per hour employee to cost the employer $12.50 – $14 per hour “fully burdened.”   In a post later this month we’ll talk about the payroll tax obligations and how to make sure you cover yourself.

The Job Post.  Whether you are hanging a help wanted sign in your shop window or posting to a job board, this is the first step in attracting applicants.  Make sure the post is clear, concise, specific and informative.  You don’t want to waste your time dealing with candidates that aren’t what you’re looking for.  So be upfront about who you want to join your team and what you consider a good candidate (i.e. skill set).

Location, Location, Location.  Where you post your job impacts the quality of candidates you get.  The job pool who browses Craigslist (e.g. independent freelancers) vs. that of Indeed can vary significantly.  Likewise, using an employment agency or staffing firm will land another caliber of employee.  Thus keep in mind that if you want to find a highly skilled worker, you will typically need to pay more to post your role.

It Takes Time.  Be prepared for a lengthy process.  Many first time employers think that they’ll slap together a job post, tons of candidates will come flocking and they’ll simply pick the best one.  Right?  Unfortunately, most employers have to be patient as it often takes some time to find interested, qualified AND responsive candidates.  It’s not uncommon for you to encounter candidates who initially appear interested but then disappear into the wild-blue-yonder without so much as an email.  Likewise, commission only roles often take longer to fill.  And when you do find that perfect match, you’ll still need time to do reference, background and criminal checks.  Thus, make sure you allow enough lead time in your process, especially if you need someone to start by a certain time.

Don’t Settle. No matter how frustrating the process gets, don’t settle on a candidate just to fill the role. If they aren’t what you are looking for keep plugging on until you find your match.  If this means rewriting your job post, paying more to have it posted in a different media or partnering with an outside firm, do it.  Nothing beats hiring a person who at best isn’t a fit and worst is either detrimental to your company or causes financial issues (e.g. fraud or embezzlement).

IRS Notices & How To Handle Them

So, you go to the mailbox and one of the letters has a return address that sends chills down your spine: IRS.  While your first instinct is to drop the letter on the ground and hightail it back into the house and hide under the bed, that’s probably not the best choice.  While most people don’t like being contacted by the IRS, many of their letters are no cause for panic because they are not audit related.  This post will help you determine what type of notice you received and the steps you should  take to begin clearing matters up.

The first step in the process is to determine what type of notice you have received.  This IRS has over 76 different form letters that you can receive for various reasons.  Listed below are the four main categories that they fall into.

Automated Adjustment Notice.  These notices tend to start with a CP### and tend to contain the language “Summary of Proposed Changes.”  The good news is that this is a computer generated notice and its far more straightforward and easier to deal with than an audit.  About 3% of tax returns filed will produce an automated adjustment notice.  The notice you receive will be due to one of the following four reasons:

  • Error correction – the IRS believes it has found a math error or similar problem in the return
  • Penalty assessment – the IRS believes you did not meet a filing or tax payment deadline
  • Interest assessment – the IRS believes you did not pay a tax bill on time
  • Under reporting – your tax return doesn’t list all the income others have reported to the IRS via 1099 or W-2 forms.

Next Steps

  • Read the notice and determine what the IRS is asking you about
  • Call the IRS (800-829-1040 if the numbers isn’t on the notice) and ask the representative for an explanation of the automated adjustment
  • If you are prepared, state why you believe the notice is wrong or correct
  • If you don’t clear up the matter on the phone, ask the person to note on its record that you disagree with the notice (take down the date and time you called)
  • Draft and send in your response.  If you agree with the IRS/amount then sign the form and return it to the IRS along with payment.  If you disagree, draft a brief letter stating why and send it (along with a copy of the notice) back to the IRS

Correspondence Audit.  These notices tend to contain a check list of items, some of which may or may not be checked.  While the bad news is that this is in fact an audit, the good news is that of the three audit types, this one is typically the easiest to deal with.  Correspondence audits make up 75% of all IRS audits and do not require you to meet face-to-face with an IRS auditor.

Correspondence audits are used to verify straightforward matters.  For example, the IRS may request that you send in purchase and sale documentation to verify gains or losses on stock sales, or closing statements for real estate sales.  Typically resolution can be had by simply sending in the requested documents, but sometimes the IRS is proposing changes that you may disagree with.

Next Steps

  • Read the notice and determine what the IRS is asking you to do/provide
  • Make photocopies of the documents you gather and neatly organize them so they can easily be examined by the IRS (don’t send your originals)
  • Write a clear and concise cover letter to send with your items (send it to the IRS agent that send you the letter) that list all the documents you are providing
  • Send your items certified mail, return receipt requested, so you have a record of actually responding

Office Audit.  This letter will typically have the numbers 2202 located on it somewhere and may reference an appointment date/time.  Just as it sounds, an Office Audit takes place at an IRS office where you will meet face to face with an auditor.  According to IRS statistics, the average additional tax and penalties owed resulting from an office audit is about $6,000.  The notice you receive should list the specific issues on your tax return that the IRS wants to examine.

Next Steps

  • Call the IRS to schedule the audit or confirm the day and time that the IRS has proposed
  • Highlight or circle all the listed issues on the notice as you find them so you can ensure you gather all of the needed information
  • Review your records and find the documentation needed to justify each issue
  • Organize all relevant documentation into neat categories based on the items in question (only include documentation directly related to the item in question)
  • Make necessary copies to provide to the auditor during your meeting
  • Remain credible during your meeting.  If you lie to the auditor once, they may not believe anything else that you say
  • If further documentation is needed to prove your case and you have it, schedule a date/time to send it to the auditor

Field Audit.   This letter will typically have the numbers 3253 located on it somewhere and may reference an appointment date/time.  Field audits are the most serious of the three and the amount owed often runs into several thousands of dollars.  The subjects of these audits tend to be small business owners, self-employed taxpayers, owners of multiple rental real estate properties, earners of more than $100,000 and individuals with complex tax returns.

The steps to resolve a field audit are essentially the same as an Office Audit.  However, due to their nature and the rigor involved, it’s probably advisable that you secure someone to represent you.  This can be an Enrolled Agent (EA), Attorney or Certified Public Accountant (CPA).  Your agent will then help you gather the necessary information and can even speak to the IRS on your behalf if you prefer not to.  However, the real benefit of representation is that the person can address complex tax matters that you may not know the specifics of (especially if someone else prepared your return).