Understanding Employee Classification: Key Differences and Tax Implications

1. Chapter 10 Skyline College

2. An employee is a person who is hired by and works under the direction of the employer. Who Is an Employee? • Works under the control of the employer • Uses equipment provided by the employer • Works hours that are set by the employer

3. An independent contractor is one who is paid by a company to carry out a specific task or job but is not under the direct supervision or control of the company. • Does not work under the direct supervision or control of the company • Furnishes his or her own tools or equipment • Sets his or her own working hours • No withholding for independent contractors • No payroll tax for independent contractors

4. How do employees differ from independent contractors? Works under the control and direction of the employer Does not work under the direct supervision or control of the company Uses tools or equipment provided by the employer Furnishes his or her own tools or equipment Sets his or her own working hours Works certain hours that are set by the employer

5. The Fair Labor Standards Act of 1938 • Also referred to as the Wage and Hour Law • Applies only to firms engaged directly or indirectly in interstate commerce • Sets a minimum hourly rate of pay and maximum hours of work per week to be performed at the regular rate of pay • Employees who work beyond 40 hours a week are entitled to • “time and a half.”

6. Time and a half is the rate of pay for an employee’s work in excess of 40 hours a week. It is one and one-half times the regular hourly rate of pay. Time and a half

7. Social security tax is a tax imposed by the Federal Insurance Contributions Act (FICA) and collected on employee earnings to provide retirement and disability benefits. Social Security Tax

8. Social Security Tax As of 2005 The amount of social security tax is determined by: • rate • 6.2% • $90,000 • earnings up to a calendar year earnings base The rate (6.2 percent) has remained constant in recent years. The earnings base has increased each year.

9. Medicare tax is a tax on employees and employers to provide medical care for the employee and the employee’s spouse after each has reached age 65. Medicare Tax

10. Medicare Tax As of 2005 The amount of Medicare tax is determined by: • rate • 1.45% • total earnings • earnings The rate (1.45%) has remained constant in recent years. The Medicare tax does not have an earnings base limit.

11. Medicare tax (1.45%) social security tax (6.2% up to an earnings base limit) Gross Wages Employee Earnings

12. Let’s assume an employee earns $100,000 in the calendar year. FICATax Employee (withheld) 6.2% X $90,000 = $5,580.00 MedicareTax Employee (withheld) 1.45% X $100,000 = $1,450.00

13. $5,580.00 $5,580.00 $3,100.00 $50,000 X 6.2% = $3,100.00 Tax payable $90,000 X 6.2% = $5,580.00 $90,000 X 6.2% = $5,580.00 Employee 1$50,000 Employee 2$90,000 Employee 3$100,000 Social Security Tax and Medicare Tax Social Security Tax Medicare Tax Earnings 

14. $50,000 X 1.45% = $725.00 $90,000 X 1.45% = $1,305.00 $100,000 X 1.45% = $1,450.00 Social Security Tax and Medicare Tax $5,580.00 $5,580.00 Social Security Tax Tax payable Medicare Tax $3,100.00 $1,450.00 $1,305.00 $725.00 Earnings  Employee 1$50,000 Employee 2$90,000 Employee 3$100,000

15. Federal Income Tax Employers are required to withhold an estimated amount of federal income tax from the employee’s earnings.

16. Medicare tax (1.45%) federal income tax social security tax (6.2% up to an earnings base limit) Gross Wages Employee Earnings

17. State and Local Taxes • Most states, and many local governments, may require employers to withhold income taxes from employees’ earnings to prepay the employees’ state and local income taxes. • The rules are generally almost identical to those governing federal income tax withholding.

18. Employer’s Payroll Taxes and Insurance Costs • Employers withhold social security and Medicare taxes from employees’ earnings. • In addition, employers pay social security and Medicare taxes on their employees’ earnings. • Employers are also required to pay: • Federal unemployment tax • State unemployment tax • Workers’ compensation insurance

19. Medicare tax (1.45%) federal income tax social security tax (6.2% up to an earnings base limit) The employer matches the social security tax withheld from the employee’s earnings. Employee Earnings

20. Medicare tax (1.45%) federal income tax social security tax (6.2% up to an earnings base limit) The employer matches the Medicare tax withheld from the employee’s earnings. Employee Earnings

21. FICATax Employee (withheld) 6.2% X $90,000 = $5,580.00 Employer 6.2%X $90,000 = $5,580.00 Total 12.4 % Let’s assume an employee earns $100,000 in the calendar year.

22. Federal unemployment taxes (FUTA) are taxes levied by the federal government against employers to benefit unemployed workers. Federal Unemployment Tax FUTA

23. State unemployment taxes (SUTA) are taxes levied by the state government against employers to benefit unemployed workers. State Unemployment Tax SUTA

24. Unemployment Rate Taxes • The FUTA and SUTA tax rates are applied to FUTA wages: • The federal tax rate is 6.2 percent. • This can be reduced by the state tax rate (5.4 percent for many states). • This text assumes that the taxable earnings base per employee is $7000 per year.

25. SUTA tax rate 5.0% 4.8% 5.4% FUTA tax rate 6.2% 6.2% 6.2% (Less) SUTA tax rate (5.0) (4.8) (5.4) 0.8 1.4 Net FUTA tax rate 1.2 Total taxes 6.2% 6.2% 6.2% The SUTA-FUTA Connection

26. unemployment taxes (6.2% up to a taxable earnings base) Medicare tax (1.45%) federal income tax social security tax (6.2% up to an earnings base limit) Gross Wages Employee Earnings

27. Workers’ compensation insurance is the insurance that protects employees against losses from job-related injuries or illnesses, or compensates their families if death occurs in the course of employment. Workers’ Compensation Insurance

28. Employee Records Required by Law Federal laws require that certain payroll records be maintained. For each employee the employer must keep a record of: • Employee’s name, address, social security number, and date of birth • Hours worked each day and week, and wages paid at the regular and overtime rates (certain exceptions exist for employees who earn salaries) • Cumulative wages paid during the year • Amount of income tax, social security tax, and Medicare tax withheld for each pay period • Proof that the employee is a United States citizen or has a valid work permit

29. Meet Kent Furniture and Novelty Co. • Kent Furniture and Novelty Co.imports furniture and novelty items to sell over the Internet. • The firm is a sole proprietorship owned and managed by Sarah Kent. • Kent Furniture and Novelty Co.has five employees. • Payday is each Monday.

30. The first step in preparing payroll is to compute the gross wages or salary for each employee. There are several ways to compute earnings. Computing Total Earnings of Employees • Hourly rate basis • Salary basis • Commission basis • Piece-rate basis

31. Hourly rate basis is a method of paying employees according to a stated rate per hour. Commission basis is a method of paying employees according to a percentage of net sales.

32. Piece-rate basis is a method of paying employees according to the number of units produced. Salary basis is a method of paying employees according to an agreed-upon amount for each week, month or other period.

33. Determining Pay for Hourly Employees Two pieces of data are needed to compute gross pay for hourly rate basis employees: • number of hours worked during the payroll period • rate of pay

34. Hours Worked • Many businesses use time clocks for hourly employees. • Each employee has a time card and inserts it in the time clock to record the times of arrival and departure. • The payroll clerk collects the cards at the end of the week.

35. Total hours Rate of pay Gross pay Computing Gross Pay The gross pay for hourly employees for the week ended January 6 is determined as follows: Alicia Martinez 40 hours X $ 10.00 = $400.00 Jorge Rodriguez 40 hours X $ 9.50 = $380.00 George Dunlap 40 hours X $ 9.00 = $360.00

36. Regular earnings: 40 hours X $ 9.00 $360.00 = Overtime earnings: 5 hoursX $13.50 $ 67.50 = Gross Pay $427.50 Overtime George Dunlap earns $9.00 per hour. He worked 45 hours. He is paid 40 hours regular rate of pay and 5 hours at time and a half. Therefore, Dunlap’s gross pay adds up to:

37. Withholdings for Hourly Employees Required by Law Recall that federal law requires employers to make three deductions from employees’ gross pay: • FICA (social security) tax • Medicare tax • Federal income tax withholding

38. Tax-exempt Wages • Earnings in excess of the base amount ($90,000 as of 2005) are not subject to FICA withholding. • If an employee works for more than one employer during the year, the FICA tax is deducted and matched by each employer. • When the employee files a federal income tax return, any excess FICA tax withheld from the employee’s earnings is refunded by the government or is applied to payment of the employee’s federal income taxes.

39. Employee Gross pay Tax rate Tax Cindy Taylor $400.00 X 6.2% = $24.80 Jorge Rodriguez 380.00 X 6.2% = 23.56 George Dunlap 427.50 X 6.2% = 26.51 Cecilia Wu 560.00 X 6.2% = 34.72 Total social security tax $109.59 Social Security Tax To determine the amount of social security tax to withhold, multiply the taxable wages by the social security tax rate and round off to the nearest cent.

40. Alicia Martinez $400.00 X 1.45% = $ 5.80 Employee Gross pay Tax rate Tax Jorge Rodriguez 380.00 X 1.45% = $ 5.51 George Dunlap 427.50 X 1.45% = $ 6.19 Cecilia Wu 560.00 X 1.45% = $ 8.12 Total Medicare tax $25.62 Medicare Tax To compute the Medicare tax to withhold from the employee’s paycheck, multiply the wages by the Medicare tax rate, 1.45 percent.

41. The amount of federal income tax to withhold from an employee’s earnings depends on: • Earnings during the pay period • Length of the pay period • Employee’s instructions: Marital status Number of withholding allowances

42. Withholding Allowances In the simplest circumstances, a taxpayer claims a withholding allowance for: • The taxpayer • A spouse who does not also claim an allowance • Each dependent for whom the taxpayer provides more than half the support during the year As the number of withholding allowances increases, the amount of federal income tax withheld decreases.

43. The Employee’s Withholding Allowance Certificate, Form W-4 is a form used to claim exemption (withholding) allowances. The wage-bracket table method is a simple method to determine the amount of federal income tax to be withheld using tables provided by the government.

44. Computing Federal Income Tax Withholding • The wage-bracket table method is the most common way to compute the federal income tax withholding. • The wage-bracket tables are in Publication 15, Circular E or online on www.IRS.gov

45. Wage-Bracket Table Method Use the following steps to determine the amount to withhold: • Choose the table for the pay period and the employee’s marital status. • Find the row in the table that matches the wages earned. Find the column that matches the number of withholding allowances claimed on Form W-4. The income tax to withhold is the intersection of the row and the column.

46. Cecilia Wu is married, claims two withholding allowances, and earned $560 for the week. The tax to withhold is $30; this is where the row and column intersect. • Go to the table for married persons paid weekly. • Find the line covering wages between $560 and $570. Find the column for two withholding allowances.

47. Other Deductions Required by Law • Most states and some local governments require employers to withhold state and local income taxes from earnings. • In some states employers are also required to withhold unemployment tax or disability tax. • The procedures are similar to those for federal income tax withholding. • Apply the tax rate to the earnings, or use withholding tables.

48. There are many payroll deductions not required by law but made by agreement between the employee and the employer. • Some examples are: • Group life insurance • Group medical insurance • Company retirement plans • Bank or credit union savings plans or loan repayments • United States savings bonds purchase plans • Stocks and other investment purchase plans • Employer loan repayments • Union dues

49. Determining Pay for Salaried Employees A salaried employee earns a specific sum of money for each payroll period. Exempt employees are salaried employees who hold supervisory or managerial positions who are not subject to the maximum hour and overtime pay provisions of the Wage and Hour Law.

50. Withholdings for Salaried Employees Required by Law • The procedures for withholding taxes for salaried employees is the same as withholding for hourly employees. • Apply the tax rate to the earnings or use withholding tables.