People: employees and contractors
Who controls the work decides employee or contractor. An employee gives a W-4 and an I-9 and goes through payroll; a contractor gives a W-9 and invoices.
Whether someone is an employee or a contractor isn't decided by the title, the contract or what both sides would prefer. For federal tax, it's decided by who has the right to control the work. Getting it wrong means back payroll taxes, penalties and interest, owed by the company.
The IRS groups the evidence into three kinds (behavioral control, financial control and the type of relationship) and weighs them together. That's worker classification. Hiring your first employee weighs them for Northwind's two hires, Priya Shah and Marcus Lee, and for the freelancer who designed the logo.
The paperwork, by the first day
The two kinds of worker hand the company different forms. Mixing them up is a common first-hire mistake: a contractor asked for a W-4 or an employee handed a W-9 tells the IRS, and the worker, which way the company was treating them.
The onboarding itself, in order and on Northwind's real dates, is Hiring your first employee. Vendors and contractors are vendor onboarding: W-9 and TIN matching.
What a paycheck puts on the books
Northwind's first payroll, for Priya Shah and Marcus Lee, ran on September 25, 2026: $8,400 of gross wages. $6,707.40 reached the staff's bank accounts. The other $1,692.60 was withheld (federal income tax and the employees' share of Social Security and Medicare) and is owed to the Treasury. On top, Northwind owes its own matching share, $642.60. Both sit in payroll liabilities until they're deposited. Gross to net pay works each paycheck, and recording payroll posts it.
September payroll of $8,400 gross is paid, less the tax withheld from it.
| Account | Debit | Credit |
|---|---|---|
| 6000Payroll expense | 8,400.00 | |
| 2100Payroll liabilities | 1,692.60 | |
| 1000Cash — operating | 6,707.40 | |
| Balanced | 8,400.00 | 8,400.00 |
Payroll expense is the gross wage — what the staff earned — not what reached their bank accounts. Northwind withheld their federal income tax and their 7.65% share of Social Security and Medicare, and that money belongs to the Treasury: it is a liability until it is deposited, not a cost Northwind avoided. Consumed in September and mostly paid in September — which is exactly why it is easy to believe cash and accrual always agree.
Northwind's own share of Social Security and Medicare on September's wages: $642.60.
| Account | Debit | Credit |
|---|---|---|
| 6100Payroll tax expense | 642.60 | |
| 2100Payroll liabilities | 642.60 | |
| Balanced | 642.60 | 642.60 |
The employer matches its staff's Social Security and Medicare out of its own pocket — 7.65% of the gross wage — and that is a cost of September's wages in its own right. Nobody sends a bill for it: it is worked out at month end and deposited with the withholding in October. Unlike the withholding, this part is Northwind's own expense. Federal and state unemployment taxes are employer costs too; this course keeps them out of September's book and accrues them in the payroll track.
JE-11 and AJE-4: September's payroll and the employer's share.
Wrong
Call the first hire a contractor to skip payroll for now, and sort it out after the round.
Right
Before the first day, decide from the three categories. If it's an employee, run them through payroll with a W-4 and an I-9. If it's a contractor, collect a W-9 and pay their invoices.
The title and the contract are evidence, not the answer. If the company controls what is done and how, the person is generally an employee.
Classification is decided by control, not by the contract. The forms follow from it: W-4 and I-9 for an employee, W-9 for a contractor.
Where this goes next: the Payroll track runs this payroll end to end, from gross to net through deposits and the 941. 1099-NEC and 1099-MISC at year end covers the contractors, and whether a startup has to offer health insurance starts the benefits.
Where this lesson's rules come from
The sources behind this lesson's requirements, by kind. Background reading explains; it is never the authority for a rule. Anything marked as a convention is ours, not the rule-maker's.
- IRS guidance
- IRS Pub. 15-A (2026), §2 — Common-Law Employees (opens in a new tab)The common-law test: the right to control what and howFree to read
- IRS, Independent contractor (self-employed) or employee? (opens in a new tab)Behavioral control, financial control and the type of relationshipFree to read
- IRS Pub. 15 (2026), Hiring New Employees — New hire reporting (opens in a new tab)Every new employee is reported to the stateFree to read
- Instructions for Forms 1099-MISC and 1099-NEC (12/2026), What's New and Filing dates (opens in a new tab)Form 1099-NEC: the $2,000 threshold and the January 31 deadlineFree to read
- Tax — not GAAP
- IRS Publication 15 (2026), Circular E — Introduction (opens in a new tab)Withheld payroll taxes are the government's money, held in trustFree to read
- Official form
- Form W-4 (2026) (opens in a new tab)Form W-4, Employee's Withholding CertificatePDF · Free to read
- USCIS Form I-9 (Edition 01/20/25), Sections 1 and 2 (opens in a new tab)Form I-9, Employment Eligibility VerificationPDF · Free to read
- Form W-9 (Rev. 3-2024) (opens in a new tab)Form W-9, Request for Taxpayer Identification Number and CertificationPDF · Free to read
- Background reading — not an authority
- Wikipedia, “Form I-9” (opens in a new tab)Form I-9Free to read
The words this lesson teaches
Each links to its glossary definition, which also names the authority behind it and the components that render it.
- Worker classificationDeciding whether a worker is an employee or an independent contractor — federally by the common-law control test (behavioral, financial and relationship facts), in some states by the stricter ABC test. It decides who withholds and pays employment taxes
- ABC testA state test presuming a worker is an employee unless the hiring entity proves all three: (A) free from its control, (B) work outside the usual course of its business, and (C) customarily engaged in an independent trade — California (AB 5), Massachusetts, and New Jersey for unemployment
- Form W-4The form a new employee gives the employer to set federal income tax withholding — filing status, the two-jobs checkbox, credits, other income, deductions and extra withholding. Kept by the employer, not sent to the IRS unless it asks. A state with an income tax may use its own certificate, such as California's DE 4
- Form I-9The Department of Homeland Security form proving a new hire may work in the US. The employee completes Section 1 by the first day of work; the employer examines documents and completes Section 2 within three business days. Kept on file, never filed with the government
- New-hire reportingThe employer's report of each new employee — name, address, SSN, start date and the employer's EIN — to the State Directory of New Hires where the employee works, within 20 days of hire or sooner if the state says so. It feeds child support enforcement
- Form W-9The IRS form a US payee gives a payer to certify its name, tax classification and taxpayer identification number — collected before the first payment, because it drives 1099 reporting and backup withholding
- Form 1099-NECThe IRS information return for nonemployee compensation paid to a contractor in the course of business — required at $600 a year for payments through 2025 and $2,000 from 2026 (indexed from 2027), due to the recipient and the IRS by January 31
- Backup withholdingFederal income tax a payer must withhold at 24% from reportable payments — contractor fees, interest, dividends, card settlements — when the payee has not given a correct TIN or the IRS has notified the payer to withhold. Deposited and reported on Form 945
- Payroll liabilitiesWhat an employer owes on wages it has already paid — the income tax and the employees' share of Social Security and Medicare withheld from their pay, plus the employer's own payroll taxes — until it is deposited with the government. The withheld part was never the employer's money: IRS Pub. 15 calls it trust fund taxesConvention
In the founder glossary
This lesson’s ideas, explained for the founder running the company. Each has an entry in the founder glossary.
See also
- Journal entry for payrollOn payday, debit Wages and salaries for gross pay, credit Cash for net pay and credit liabilities for everything withheld. Book the employer's own taxes separately (debit Payroll tax expense, credit Payroll taxes payable), and clear both payables when they are remitted.
- Contractor or employee? Classification for startupsContractor or employee depends on control, not the contract. The IRS test, state rules, 1099s, payroll registration and the cost of getting it wrong.
- W-9s and backup withholding: a vendor onboarding guideWhen to ask for a W-9, how IRS TIN matching works, and what happens when a vendor won’t give you one: 24% backup withholding, owed by you.
- Form 1099-NEC for startups: threshold, deadline, e-filingWho gets a 1099-NEC, the new $2,000 threshold, why a W-9 comes first, what goes on a 1099-K instead, and the deadlines, penalties and state copies.
- Payroll journal entries, from gross to netGross wages, employer taxes, withholding and net pay as journal entries: what each payroll run books, how to accrue it at month end, and where benefits go.