Lesson Four
The Simple Guide to Taxes
Lesson four lesson is all about hiring and paying workers. Our four goals for this lesson are:
- Decide if you’ve hired an employee or a contractor.
- Understand how to file 1099s for contractors.
- Understand how to pay employees.
- Know how (and how much!) to pay yourself.
Employee vs. Contractor
When you hire someone to work for your business, you need to know right off the bat if that person will be classified as an employee or a contractor. Why does it matter? Because there are laws about how you can treat one versus the other as well as tax implications for which you choose.
For instance, an employee is someone required to be at a specific place for a required number of hours. There is usually training involved, so the tasks are completed in a specific way. Employees are usually paid by the hour or receive an ongoing salary.
Additionally, employees will need employment taxes withheld from their paychecks, and those taxes must be paid both at the federal and state levels. At the end of the year, you will need to prepare a W-2 for all of your employees. The W-2 reports their income and taxes to the IRS and state.
On the other hand, a contractor is someone who can do the work on their own time without being monitored. They’re paid a flat amount when the project is completed and usually not an hourly wage or salary. Virtual assistants, web designers, and business coaches typically fall in this category. They can complete tasks on their own time and use whatever method they need to get the required task done.
Let’s look at an example in photography. Second shooters are typically considered contract workers because they bring their own equipment and work for more than one company at a time. They also set their own work hours by accepting or declining an invitation to second shoot.
As far as taxes are concerned, all contractors who are paid over $600 for services need to receive 1099s at the end of the year instead of a W-2. They don’t have taxes withheld from their earnings like employees, so they are responsible for paying taxes themselves.
As soon as you hire anyone to do a job for your business, ask them to complete a W-4 (for employees) or a W-9 (for independent contractors) so you don’t have to hunt that down later.
Filing 1099s
There are many different types of Form 1099s. However, when we’re talking about filing a 1099 for a contractor, we’re actually referring to a Form 1099-NEC. The NEC stands for non-employee compensation. This is the tax form that business owners must issue to independent contractors. It’s similar to a W-2, which is given to an employee, and its purpose is to report the total amount paid to a contractor during the year for services rendered (not goods sold).
If you hear someone refer to a “1099 miscellaneous,” that’s what the 1099-NEC used to be called for contractors. The name change was made starting in tax year 2020.
What’s the deadline?
The 1099 deadline is January 31st. You must send all 1099s to their recipients and file them with the IRS by that deadline.
Who receives one?
If you paid $600 or more to an unincorporated person or vendor for services related to your business using cash, check, bank transfer (ACH), Zelle, personal Venmo, Cash App, or PayPal Friends and Family, you need to issue them a 1099-NEC.
What if I paid them with PayPal or credit card?
If you paid an unincorporated vendor using PayPal Business, Venmo Business or a credit card, the payment service is responsible for reporting this information (usually by issuing a 1099-K). You don’t have to do a thing!
How do I file a 1099?
- Make a list of those who meet the qualifications for receiving a 1099-NEC.
- Send them a W-9 to collect their Taxpayer ID Number, address, and business name.
- Create an account with 1099Online.com.
- Create a payer. This will be your business information.
- Create the payees. This is everyone who needs to receive a 1099 (use the information from the W-9).
- Enter the amount of “non-employee compensation” each person received.
- File the 1099s after carefully reviewing them.
What happens if I’m supposed to receive a 1099, but I don’t?
If you’re working as a contractor for someone else’s business, and you don’t receive a 1099, you should still report all income earned. No need to file one for yourself though!
What happens if I’m supposed to issue a 1099, but I don’t?
You may have to pay a penalty to the IRS. The penalty amount is determined by when you file the correct information with the IRS and the contractor.
Pay Employees
If your company has employees, the first step you’ll take towards paying them is applying for an Employer Identification Number (EIN) on the IRS website. You’ll remember we discussed getting an EIN in lesson 1 because even if you’re not paying employees, you should have an EIN to file business taxes and to help protect yourself from identity theft.
You’ll also need to determine whether or not your state requires a state withholding tax identification number and/or an unemployment tax account. If so, get those set up through the state.
Unfortunately, setting up payroll can be a headache thanks to the federal and state forms that are due throughout the year. I highly recommend investing in a payroll service to do all of this for you. The only payroll service I recommend to clients is Gusto because they automatically file all of the forms you need and have exceptional customer support. If you pick a different payroll service provider, make sure they file all of the necessary forms for you.
To give you a better idea of how time-consuming this can be, here’s a list of the payroll forms that need filed with the IRS:
- Employer copies of Wage and Tax Statements and Corrected Wage and Tax Statements (Form W-2, Form W-3, and Form W-2C)
- Employee’s Withholding Certificate (Form W-4)
- Employer’s Quarterly Federal Tax Return and Report of Tax Liability for Semiweekly Schedule Depositors sent annually (Form 941 and Schedule B)
- Employer’s Annual FUTA Tax Return and Multi-State Employer and Credit Reduction Information sent annually (Form 940 and Schedule A)
- Qualified Small Business Payroll Tax Credit for Increasing Research Activities sent quarterly (Form 8974)
- Employer copies of Non-employee Compensation both individual and company summary (Form 1099 and Form 1096)
The required state forms vary, but you may need to file:
- Annual employer withholding report
- Unemployment insurance quarterly report
- W-2s
- 1099s
- New hire reports
- Quarterly wage and withholding reports
I know some of you may look at that list and just shut down, but that’s the last thing you should do. Take a deep breath. If the list still seems daunting, hire out for those payroll services and get back to the parts of your business that you enjoy. Knowing your worth means understanding your business finances and valuing your time enough to hire someone to do this part right.
Pay Yourself
Now it’s time to show yourself the money! How you’ll pay yourself, how much you’ll pay yourself, and how often you’ll pay yourself are all under your control, but there are several things you’ll want to consider. If you are a sole proprietor or running a single member LLC, your considerations will be a little different than if you’re running an S corporation.
As a sole proprietor or single member LLC, you’re able to take money out of your business at any time. This transaction is recorded as an “owner’s draw” and not wages or expenses when you go to categorize it. You can write yourself a check or transfer the funds from your business account to your personal banking account. An owner’s draw shouldn’t show up on your income statement (also called profit and loss statement).
For tax purposes, keep in mind that all income your business makes after you deduct expenses will be taxed, regardless of whether or not you physically paid yourself.
One way to pay yourself as a sole proprietor or single member LLC is to split up your income into chunks. Every time you receive money, place a chunk in each category. Some example categories could be:
- Taxes
- Business expenses
- Paying yourself
- Retirement
- Money staying in the business for future use
Dividing your money this way ensures you have enough money to cover your business needs and also guarantees you’re getting paid for the hard work you’ve put in. The percentages you divvy up into each category will be different for everyone and should be based on your business and personal needs. There is no one-size-fits-all method. Be sure to re-evaluate your percentages at least once each year and make any necessary adjustments.
If you are a member of a partnership, you’ll take a draw on a portion of the profits just like you would as a sole proprietor or single member LLC. However, in a partnership, you will follow your partnership agreement to determine how much and how often you’ll take a draw, and you may also have instructions in your agreement about guaranteed payments for the partners.
S corporations operate a little differently since they’re required to pay the owners a reasonable salary before the owner takes out additional money. What’s tricky is that “reasonable” can mean different things in different locations. I offer an S-Corp Reasonable Compensation Report through my website that helps you determine an amount that will be easily defendable against IRS scrutiny. Another great tool is salary.com. Their website can help give you an idea of the salary level you should consider.
When making your calculations, don’t forget to account for the Social Security, Medicare, and income taxes that will come out of your pay (discussed in lesson 3). Once you’ve decided upon your salary, be sure to keep your accountant in the loop and make sure your business is bringing in enough revenue to support that salary amount. Your next step will be deciding how often you’re going to pay yourself and setting up automatic transfers or calendar reminders for that schedule.
Luckily, actually getting the money from your business to you is the easy part! You can write yourself a check or transfer the funds from your business account to your personal banking account.
