PAYROLL

Employee Wages Tax Deduction

Many successful sole proprietors reach a point when they can no longer do everything on their own. To continue to grow, often times solo entrepreneurs will hire employees to assist with the workload. While contractors and employees may carry out similar tasks, a key distinction between independent contractors and employees is that you have control over what your employees do and how they carry out their job. In addition to paying wages, hiring an employee comes with some additional responsibilities including paying employer payroll taxes and filing related reports. The good news is employee wages will almost always be a deductible business expense on your Schedule C.

DESIGNER

Yany is a graphic designer who recently hired an employee. Before issuing her first paycheck, Yany contacted her state revenue office and set up an employer account so she could properly withhold income taxes from her employees pay. She also contacted her state unemployment department and set up an employer account so she could pay unemployment tax on her employees wages. To make managing payroll easier, Yany also contacted Zenefits and subscribed to a their full service payroll offering, which includes taking care of all of her state and federal quarterly and annual payroll tax filings, W2 preparation and even direct deposits for her employee. Had Yany simply started writing her employee a paycheck at the end of each pay period and deducted the wages on line 26 of her Schedule C, at the end of the year she would have discovered she had quite a bit of catching up to do to be compliant.

ENTREPRENEUR

Khan is an artist who makes silver and turquoise jewelry he sells through Etsy. During the year, Khan withdrew $45,000 from his business bank account as compensation for his work. Since Khan is an unincorporated sole proprietor, the amounts he paid himself would not be a deductible business expense. To deduct his personal compensation, Khan would need to have his business organized as an entity where he could be an employee of the company or take guaranteed payments (Note that both of these options have other tax implications).

PHOTOGRAPHER

Collin is a photographer who hired an assistant at the beginning of the year. His employee cost Collin a total of $55,000 last year, which included $40,000 of base salary, $5,000 of employer taxes, $4,000 of bonus and $6,000 of retirement benefits. When Collin prepares his Schedule C he should deduct the $44,000 of base pay, bonus, and employee portion of taxes on line 26 of his Schedule C, $5,000 of employer paid payroll taxes on line 23 of his Schedule C and $6,000 of retirement contributions (fringe benefit) on line 19 of his Schedule C.

REAL ESTATE AGENT

Etim is an independent real estate agent. He has an administrative employee who works 40 hours per week who he pays $10 per hour. During the summer, he employed his son to help him prepare listings for showings. While working, all his son did was read books to prepare for his SAT exam and play games on his phone. Etim's son "worked" 40 hours per week for 10 weeks and was paid $15 per hour. When Etim is ready to file his taxes, he would not be allowed to deduct the wages that he paid his son because the amount was unreasonable and his son did not provide any service.

DEVELOPER / ENGINEER

Vicky is a sole proprietor website designer who often hires other local developers to help her build her websites. Vicky decides what features her websites must have and how the finished products should look and feel. She also is heavily involved in managing how, where and when her developers complete their work. When Vicky filed her tax return, she classified amounts paid to these developers as contract labor on line 11 of her Schedule C in order to avoid paying employer payroll taxes. The following year, Vicky was audited by the IRS, which determined the developers Vicky hired should have been classified as employees. Vicky was forced to retroactively pay employer payroll taxes, interest and penalties because of her misclassification.

WHAT TO KNOW ABOUT INDEPENDENT CONTRACTOR TAXES

  • For an employee's wage to be deductible it must be an ordinary and necessary business expense, you need to pay or incur it, the pay must be reasonable and services must be performed. For services to be reasonable you should consider the duties performed by an employee, the cost of living in your locality, the pay compared to the gross and net income of the business and the character and amount of responsibility the job requires, amongst other things.
  • Employee pay can include base wages, sick and vacation pay, fringe benefits (including meals, lodging and benefit programs), awards, bonuses, loans or advances, and certain reimbursements, amongst other things. Note that deductibility of certain pay types may be limited. You should refer to IRS guidance and consult with your tax advisor to determine how your specific employee pay should be treated.
  • Certain components of an employee's wage should be excluded from line 26 of your Schedule C. Exclusions include employer tax credits, health benefits, pension and profit sharing benefits, taxable fringe benefits you provided to your employees (reported elsewhere on Schedule C) and the employer paid portion social security, medicare and unemployment taxes (deductible on line 23 of your Schedule C).
  • If you are ready to hire employees, you will be responsible for withholding federal and state taxes from their wages. You will also need to pay the employer portion of Social Security and Medicare as well as state and federal unemployment tax. Note that you will need to contact your state's department of revenue and unemployment to set up the appropriate employer payroll accounts. Remember that you can always work with a payroll company like ADP or Zenefits to help guide you through the process. Refer to our page on Payroll taxes for additional information.
  • If you are self employed you typically should not deduct payments or withdrawals made to yourself. There may be exceptions to this general rule depending how your business is organized or if you take guaranteed payments. Consult with your tax advisor regarding how you should treat your compensation.

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