If you have at least one employee, you’re responsible for payroll taxes. These include withholding federal and income taxes and FICA tax from employees’ wages as well as paying the employer share of FICA tax and federal and state unemployment taxes. The penalties for missteps make it essential that you do things right. There are several common mistakes you should avoid.
Misclassifying workers. This is today’s hottest audit issue. Some treat workers as independent contractors rather than employees. While payroll taxes and employee benefit costs are high, one’s only tax responsibility for a contractor is a Form 1099-MISC when payments are $600. To call someone a contractor, you must meet several conditions. If you have complete control over when, where, and how the work gets done, you have an employee. If work can be done at the time and place of their choosing, you can argue they are contractors. Having an independent contractor agreement is helpful in showing that you do not intend any employer-employee relationships, but it doesn’t bind the IRS, who is not a party to the agreement. The IRS usually throws the agreement out if you’re the “contractor’s” only customer. For more information see the IRS or your tax advisor.
Lack of an accountable plan for employee out-of-pocket expenses. If you normally reimburse travel, entertainment, tools or other employee business-related expenses, you need an accountable plan to avoid payroll taxes on those payments. An accountable plan must formalize the arrangement and set reasonable times for employee action. Advances should not be made over 30 days before the expense. Sixty days is a reasonable time within which employees should request repayment. Employees should return excess reimbursements to the employer within 120 days of the expense. The IRS has a booklet describing accountable plans.
Failure to keep payroll records. You are required to maintain time sheets, expense accounts, copies of W-2s and other payroll records and have them available for IRS inspection. Usually, you should keep this information for at least four years. You should also retain copies of Form I-9, which shows an employee’s eligibility to work in the U.S. Some states may also have other hiring forms that should be retained (e.g., E-verify forms). I-9 information should be obtained from the INS rather than the IRS.
Choosing to pay creditors before the IRS. When funds are short, it may be tempting to pay the landlord, vendor, or utility company before the IRS. As a business owner, you are personally liable for “trust fund” taxes (amounts withheld from employees’ wages), even if your business is incorporated or is a limited partnership. Your best approach is to set aside cash to cover payroll taxes so you won’t use these funds for any other purpose. The IRS will provide details about the trust fund recovery penalty.
Failing to monitor payroll company activities. Many small businesses use outside payroll companies to handle withholding and transferring funds to the U.S. Treasury for payroll taxes. Some of these companies may not do their job, by error or intentionally. If you use an outside payroll company, you remain responsible for payroll taxes despite an error they make. Monitor your tax account to see that funds are deposited on time and in the correct amount. If deposits are electronic (throughEFTPS.gov), you can easily track activity in your account.
Stay on top of your responsibilities. Avoid penalties from the IRS, the Department of Labor, or your state’s agencies.
We thank lawyer and author Barbara Weltman for this great advice.