Hiring Your First Employee Guide
Everything you need to know about payroll, taxes, and compliance when hiring.
Hiring your first employee is a milestone that transforms your business from a solo operation into an employer. It also introduces significant legal, tax, and administrative obligations. From obtaining an EIN to setting up payroll, workers' compensation, and tax withholding, this guide walks you through every step of the process.
Before You Hire: Legal Setup
Before bringing on an employee, ensure your business is set up correctly. You need an Employer Identification Number (EIN) from the IRS—apply online for free at irs.gov. If you already have an EIN for your business, you can use the same number. The EIN is used on all employment tax filings.
Register with your state's labor department and tax agency for state employer taxes (income withholding, unemployment insurance). Each state has different registration requirements and deadlines. Some states also require registration with local agencies.
Obtain workers' compensation insurance, which is required in nearly every state for businesses with employees. Workers' comp covers medical costs and lost wages if an employee is injured on the job. Rates vary by industry and state, and are based on your payroll amount and the risk level of the work performed.
Employee vs. Independent Contractor
Misclassifying an employee as an independent contractor is one of the costliest compliance mistakes a small business can make. The IRS uses a three-factor test (behavioral control, financial control, and relationship type) to determine classification. If you control when, where, and how the work is done, the worker is likely an employee.
Employees receive W-2s, and you withhold income tax, Social Security, and Medicare. You also pay employer-side FICA (7.65%), federal and state unemployment taxes, and workers' comp. Independent contractors receive 1099-NECs and handle their own taxes. The cost difference is significant—an employee costs roughly 20–30% more than a contractor at the same pay rate when you factor in taxes and benefits.
The penalties for misclassification are severe: back taxes, penalties, interest, and potential liability for the worker's unpaid employment taxes. The IRS, Department of Labor, and state agencies all actively investigate misclassification. When in doubt, consult an employment attorney.
Setting Up Payroll
Payroll involves calculating gross pay, withholding federal and state income taxes, deducting the employee's share of Social Security (6.2%) and Medicare (1.45%), and remitting taxes to the appropriate agencies. You also pay the employer share of Social Security and Medicare (matching 7.65%) and federal unemployment tax (FUTA—0.6% on the first $7,000 of wages after state credits).
Use a payroll service (Gusto, ADP, Paychex, or your accounting software's payroll feature) rather than calculating payroll manually. Payroll services calculate withholding, generate pay stubs, file tax deposits, prepare quarterly and annual returns (Form 941, W-2s, W-3), and handle direct deposit. The cost ($30–$100/month plus per-employee fees) is well worth the compliance protection.
New hires must complete Form W-4 (for withholding calculations) and Form I-9 (employment eligibility verification) on or before their first day of work. You must also report new hires to your state's new hire reporting agency within 20 days (varies by state).
Ongoing Employer Obligations
Federal employment tax deposits are due semi-weekly or monthly depending on your total tax liability. The IRS assigns your deposit schedule based on your payroll tax history. New employers typically start on a monthly schedule. Late deposits incur penalties of 2–15% depending on how late.
File Form 941 quarterly to report wages, tips, and employment taxes. File Form 940 annually for federal unemployment tax. Provide W-2s to employees by January 31 and file with the Social Security Administration by the same date.
Beyond taxes, employers must comply with labor laws: minimum wage, overtime pay (for non-exempt employees), meal and rest breaks (state laws vary), anti-discrimination laws, and workplace safety regulations (OSHA). Post required labor law notices in the workplace. Small employers (under 50 employees) are exempt from some federal requirements like FMLA, but state laws may impose additional obligations.
Determining Total Cost of an Employee
The total cost of an employee goes well beyond their salary. Employer payroll taxes add approximately 7.65% (FICA) plus 1–6% for state unemployment insurance. Workers' compensation insurance adds 1–5% depending on the industry risk level. Benefits like health insurance, retirement contributions, and paid time off can add another 20–30%.
As a rough estimate, an employee's total cost is 1.25 to 1.4 times their base salary. An employee earning $50,000 in salary may cost the business $62,500 to $70,000 after taxes, insurance, and basic benefits. Factor this total cost into your pricing and financial projections before making the hire.
Also consider the indirect costs: time spent managing, training, and supervising; the cost of equipment and workspace; and the productivity ramp-up period before a new employee is fully effective. Most employees take 3–6 months to reach full productivity, and the business absorbs their learning curve costs during that period.
Key Takeaways
- ✓Obtain an EIN, register with state agencies, and get workers' comp insurance before your first hire.
- ✓Use the IRS three-factor test to correctly classify workers as employees or independent contractors.
- ✓Use a payroll service—the compliance risk of manual payroll far exceeds the cost of automation.
- ✓Budget 1.25–1.4× base salary for the true total cost of an employee.
- ✓File Form 941 quarterly, deposit employment taxes on schedule, and provide W-2s by January 31.
Frequently Asked Questions
When should I hire my first employee vs. using contractors?
Hire when you need someone to perform core business functions on an ongoing basis with your direction and control. Use contractors for specialized, project-based work where the worker controls how the work is done. If you need someone 20+ hours per week for ongoing tasks, it is probably an employee role.
How much does it cost to set up payroll?
Most payroll services charge $30–$50 per month base fee plus $4–$10 per employee per pay period. Setup is usually free. The total for one employee on biweekly payroll is roughly $40–$70 per month. This covers tax calculations, filing, direct deposit, and year-end forms—far cheaper than the cost of a payroll error or penalty.
What happens if I pay an employee as a contractor?
If the IRS or a state agency determines misclassification, you owe back employment taxes (both employee and employer shares), penalties (up to 40% of back taxes), and interest. You may also owe back benefits, overtime, and workers' comp coverage. In egregious cases, criminal penalties can apply. Correct classification from the start is far cheaper than fixing misclassification later.