How to Pay Employees as a Sole Proprietor: Setup, Payroll, and Filings

To pay employees as a sole proprietor, you need to get an Employer Identification Number, confirm the worker is actually an employee rather than a contractor, collect a signed W-4 and I-9 before the first day of work, register with your state’s tax and labor agencies, run each paycheck with the correct withholdings, deposit those taxes electronically on the schedule the IRS assigns you, and file quarterly and year-end returns. The rules are the same ones a corporation follows. What is different is your personal exposure: there is no separate entity between you and the tax bill.

You Are Not on Your Own Payroll

One thing to clear up before anything else. A sole proprietor cannot be an employee of the business, because you and the business are the same legal person. You pay yourself through owner’s draws and settle your own taxes through self-employment tax on Schedule SE and quarterly estimated payments.1Internal Revenue Service. Paying Yourself2Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes) Everything below is about the separate process for the people you hire.

First, Confirm the Person Is an Employee

If the worker is a genuine independent contractor, you skip payroll entirely. You pay them in full, issue a Form 1099-NEC after year end, and they handle their own taxes. If they are an employee, every step in this article applies. Misclassifying an employee as a contractor exposes you to back taxes and penalties.

The IRS weighs three categories of evidence to decide which one you have:3Internal Revenue Service. Topic No. 762, Independent Contractor vs. Employee

  • Behavioral control: whether you direct how and when the work is done.
  • Financial control: whether the worker invests in their own tools, markets to other clients, and can realize a profit or loss.
  • Relationship of the parties: whether there is a written contract, whether you provide benefits, and whether the arrangement is open-ended.

The more control you exercise, the more likely the worker is an employee.

Set Up Before the First Paycheck

Get an EIN

Apply for an Employer Identification Number using IRS Form SS-4. The application is available online and returns your number immediately. The EIN identifies your business on every federal employment tax return and deposit.4Office of the Law Revision Counsel. 26 U.S. Code 6109 – Identifying Numbers

Collect a W-4 and an I-9

Before the employee starts, get two forms in hand. The W-4 tells you how much federal income tax to withhold based on the employee’s filing status, other-job income, and dependents.5Internal Revenue Service. About Form W-4, Employee’s Withholding Certificate The I-9 verifies identity and work authorization; the employee presents documents such as a passport, or a combination like a driver’s license and Social Security card, and you examine them.6U.S. Citizenship and Immigration Services. I-9, Employment Eligibility Verification Paperwork violations and unauthorized-hire violations carry civil fines that scale with severity.7Federal Register. Civil Monetary Penalty Adjustments for Inflation

Keep employment tax records for at least four years after the tax becomes due or is paid, whichever is later.8Internal Revenue Service. Recordkeeping – Section: How Long Should I Keep Employment Tax Records? I-9 forms follow their own schedule: three years from the hire date or one year after termination, whichever is later.

Register With Your State

Federal setup is only part of it. You also need to register with your state, and the specifics vary. In most states that means three things:

  • A state withholding account with the department of revenue so you can withhold state income tax.
  • A state unemployment insurance (SUTA) account. Taxable wage bases range from $7,000 to over $60,000 per employee depending on the state, and your rate depends on industry and claims history.
  • Workers’ compensation insurance. Most states require coverage once you hire even one employee, though a few set higher thresholds or allow limited exemptions.

A handful of states also require employer contributions to disability insurance or paid family leave programs; register for those if your state has them.

Report the New Hire

Federal law requires you to report every new and rehired employee to your state’s Directory of New Hires within 20 days of the start date, though some states give you less time.9The Administration for Children and Families. New Hire Reporting You typically submit the employee’s name, address, and Social Security number along with your EIN through the state’s online portal.

Running a Paycheck

Calculate Gross Pay

For hourly employees, multiply hours by rate. Non-exempt employees who work more than 40 hours in a workweek get overtime at one and a half times their regular rate for those extra hours.10U.S. Department of Labor. Fact Sheet #23 – Overtime Pay Requirements of the FLSA For salaried employees, divide the annual salary by the number of pay periods.

The federal minimum wage floor is $7.25 an hour, and many states set a higher one. Federal law does not set a pay frequency, but nearly every state does (weekly, biweekly, or semimonthly).

Withhold From the Employee

Three federal taxes come out of each paycheck:

If your state has an income tax, add state withholding on top.

Pay Your Employer Share

On top of what you withhold, you owe:

Issue an itemized pay stub with each check showing gross wages, each withholding, and net pay. Most states require it.

Deposit Federal Taxes and File Form 941

Withheld income tax plus the combined employee and employer shares of Social Security and Medicare must be deposited electronically, usually through the Electronic Federal Tax Payment System.18Internal Revenue Service. Depositing and Reporting Employment Taxes The IRS assigns you a monthly or semiweekly deposit schedule based on your history:19Internal Revenue Service. Employment Tax Due Dates

  • Monthly depositors send taxes for a given month’s wages by the 15th of the following month.
  • Semiweekly depositors send taxes for Wednesday–Friday paydays by the following Wednesday, and for Saturday–Tuesday paydays by the following Friday.

Every quarter, file Form 941 to report total wages, federal income tax withheld, and Social Security and Medicare taxes.20Internal Revenue Service. Instructions for Form 941 (Rev. March 2026) Form 941 is due by the last day of the month following the end of each quarter. If your total annual employment tax liability is $1,000 or less, you can request permission to file Form 944 once a year instead.

Year-End Reporting

By February 1, 2027 (for the 2026 tax year), give each employee a Form W-2 showing total wages and taxes withheld, and file copies of the W-2s along with a transmittal Form W-3 with the Social Security Administration.21Internal Revenue Service. General Instructions for Forms W-2 and W-3 (2026) Extensions are not automatic; you have to apply on Form 8809 before the due date.

File Form 940 annually to report FUTA. It is due January 31 after the calendar year ends, or February 10 if you deposited all FUTA taxes on time during the year.17Internal Revenue Service. Topic No. 759, Form 940 – Filing and Deposit Requirements

Post the Required Notices

Federal law requires you to display certain posters where employees can see them, including a Fair Labor Standards Act poster and OSHA’s “Job Safety and Health” poster.22U.S. Department of Labor. Workplace Posters Employers with 50 or more employees add a Family and Medical Leave Act notice. States typically have their own required posters on top of the federal set.

What It Costs to Get It Wrong

A sole proprietor’s exposure to payroll penalties is personal. The three that hurt the most:

Late deposits. If you miss a deposit deadline, the IRS charges a tiered penalty that starts at 2% of the undeposited amount and rises to 15% once a delinquency notice has been outstanding for 10 days.23Office of the Law Revision Counsel. 26 U.S. Code 6656 – Failure to Make Deposit of Taxes

Trust fund recovery penalty. The federal income tax, Social Security, and Medicare you withhold from paychecks are trust fund taxes; you hold them for the government. If you willfully fail to collect, account for, or pay over those amounts, the IRS can assess a penalty equal to 100% of the unpaid tax against you personally, and it is not dischargeable in bankruptcy in most cases.24Office of the Law Revision Counsel. 26 U.S. Code 6672 – Failure to Collect and Pay Over Tax

Late or unfiled 940 and 941. A late return draws a failure-to-file penalty of 5% of the unpaid tax per month or partial month, capped at 25%.25Internal Revenue Service. Failure to File Penalty A separate failure-to-pay penalty of 0.5% per month runs on any unpaid balance.26Internal Revenue Service. Failure to Pay Penalty When both apply in the same month, the failure-to-file penalty is reduced by the failure-to-pay amount so they do not fully stack.