Does the IRS require my company to have payroll in 2025-2026?
- Rebecca Tabert, CPA
- Jul 24
- 11 min read
Is it time for you to start payroll for your company? Do you know if you HAVE TO have payroll? Find your answers here.
Many small business owners, especially those just starting out or working in trades like construction, believe that payroll only applies to large companies. But in reality, if your business pays employees, or pays you as the owner in certain situations, you may be legally required to run payroll. This includes calculating withholdings, issuing paystubs, filing tax forms, and sending payments to the IRS and California’s Employment Development Department (EDD).
Failing to do so correctly can result in serious consequences, including back taxes, penalties, and legal issues. Payroll is not just about cutting a check—it is a full system of compliance. The good news is that with the right information, you can figure out what applies to your situation and set things up properly from the start.
What is the difference between subcontractors and employees?
Understanding the difference between subcontractors and employees is one of the most important parts of managing your business payroll properly. Many small business owners assume they can treat anyone who works for them as a contractor to avoid the hassle of payroll—but this can lead to serious tax problems and penalties if the IRS or California's EDD disagrees with how that worker was classified.
Key differences:
Control Over Work: If you direct how, when, and where the work is done, the person is likely an employee. If the person works independently, sets their own hours, and provides their own tools, they may be a subcontractor.
Integration into Business: Workers who perform core tasks essential to your business (like laborers on a construction crew) are usually considered employees. A subcontractor typically works on specific, short-term projects and is not central to daily operations.
Tools and Equipment: If you provide the tools, materials, or workspace, the worker is probably an employee. Subcontractors usually bring their own tools and equipment.
Ongoing Relationship: A continuing or indefinite working relationship is a sign of employment. Subcontractors are typically hired per job or project, with no guarantee of future work.
Risk of Loss and Profit: Subcontractors have a chance to make or lose money on a project, depending on how well they manage their time and expenses. Employees are paid a set wage regardless of business performance.
In California, the ABC Test (based on Assembly Bill 5) is used to determine whether a worker is truly an independent contractor. If the worker does not meet all three parts of the test, you are required to treat them as an employee and set up payroll:
A) The worker is free from your control and direction
B) The work performed is not part of your usual business
C) The worker is regularly engaged in an independently established trade or business
Misclassifying a worker can result in penalties, interest, and even lawsuits. It is best to review your worker relationships carefully or talk to a tax professional before making a decision.
What company must have payroll?
A company is required to have payroll when it has employees, including when the owner is considered an employee of the business structure. The IRS and the State of California both require employers to withhold and pay payroll taxes, provide proper wage documentation, and file the correct forms on time.
Here are the most common situations that trigger payroll requirements:
You hire employees (full-time or part-time): As soon as you hire someone and agree to pay wages, you must register as an employer and run payroll. This includes withholding income taxes, Social Security, and Medicare at the federal level, and withholding California income taxes, SDI (State Disability Insurance), and UI (Unemployment Insurance) at the state level.
You operate as an S Corporation and pay yourself: If your company is taxed as an S Corporation, and you are actively working in the business, the IRS requires you to pay yourself a "reasonable salary" through payroll. Even if you are the only worker, you must treat yourself as a W-2 employee.
You hire family members or friends to help out regularly: Even informal arrangements—like paying your cousin to do landscaping for your business or hiring your spouse for admin work—can require payroll if the work is ongoing and directed by you.
You misclassify workers as contractors when they should be employees: If the IRS or EDD reclassifies your contractors as employees after an audit, you will be responsible for back payroll taxes, penalties, and interest.
Your business provides services that rely on human labor (not just products): Construction companies, restaurants, salons, and many service industries often trigger payroll requirements early because they rely on hands-on work done by others.
Examples:
A single-member LLC hires one laborer for a fence installation crew: Payroll is required.
An S Corp where the owner builds decks and pays themselves only through distributions: Payroll is required.
A sole proprietor hires a bookkeeper for five hours per week: Payroll is required.
A partnership splits profit between two partners, but one partner pays their teenage son weekly to clean equipment: Payroll is required.
California adds additional enforcement layers through the EDD and has strict worker classification rules under AB5. Even if the IRS is lenient in some cases, California may still enforce payroll obligations at the state level.
If you are unsure whether your situation qualifies, it is safer to assume payroll may be required and get professional advice before proceeding.
Who can prepare payroll for my company?
You are responsible for payroll as the business owner, but you do not have to do it alone. Payroll can be prepared by yourself, a payroll service, a bookkeeper, or an accountant. The key is making sure all federal and California payroll laws are followed, especially when it comes to taxes, forms, and deadlines.
Here are your main options:
You (the business owner):
You can run payroll manually or using software. You will need to:
Calculate withholdings correctly for both federal and state taxes
File federal payroll tax forms like 941s and W-2s with the IRS
File state payroll reports and pay taxes to the California EDD
Stay on top of deadlines and form changes
This is time-consuming and risky unless you are already trained in payroll processing.
Payroll software providers (e.g., Gusto, QuickBooks Payroll, ADP):
These platforms help automate calculations, generate paystubs, file tax forms, and even make tax payments on your behalf.
They are user-friendly and ideal for small businesses
Many will file both federal and California reports for you
You are still legally responsible if something is filed incorrectly
Bookkeepers or accountants:
Many small business accountants offer payroll as a service.
A good choice if you already have a tax professional you trust
Ensures tax compliance and proper employee classification
Often includes additional help with EDD registration and reporting
Professional Employer Organizations (PEOs):
Larger or growing businesses may contract with a PEO to manage payroll, HR, and benefits under a shared employer model.
Offers robust compliance help
Can be more expensive and complex to set up
Examples of what works well:
A self-employed electrician who hires one apprentice may use Gusto or QuickBooks Payroll to stay compliant. Bear in mind, you can use many, many other payroll companies. Read the reviews and look at the costs & contracts carefully.
A small painting company with several employees might have their accountant run payroll alongside bookkeeping and tax prep.
A mid-size landscaping business with benefits and HR needs may work with a PEO. I recommend doing careful research or speaking with others who can recommend a PEO they use.
Whether you use software or a service provider, the IRS and the California EDD still consider you responsible for any errors or missed filings. Make sure whoever runs your payroll understands both federal and state rules and is updating things as laws change.
When does my company need to start payroll?
You need to start payroll as soon as your business hires an employee or begins compensating the owner through wages that are subject to payroll tax. This applies regardless of how small the company is or how informal the work arrangement might seem. Both the IRS and the California Employment Development Department (EDD) expect businesses to begin payroll immediately when those conditions are met.
Here are common triggers that mean it is time to start payroll:
You hire your first employee: Even one part-time or seasonal worker creates payroll obligations. You must withhold federal income tax, Social Security, and Medicare, and in California, state income tax, SDI, and UI.
You elect S corporation status and begin paying yourself: Once you start taking compensation as an S Corp owner, you are required to pay yourself through payroll and issue yourself a W-2. This is a federal requirement and applies regardless of whether you are the only person in the company.
You reclassify a contractor as an employee (or are forced to): If your worker was a contractor but you or the government determine they are actually an employee, you must begin payroll immediately and may owe back payroll taxes.
You pay someone under the table or in cash: As soon as wages are paid, even informally, you are likely required to run payroll. Not doing so is illegal and can result in audits and penalties.
You hire a household employee (nanny, cleaner, etc.) through your business: Household employees often trigger payroll if they earn above the IRS threshold. If paid through your business, you must report and withhold payroll taxes.
Examples:
A one-person S Corp general contractor starts drawing a paycheck to cover living expenses: Payroll must start immediately.
A sole proprietor hires a cousin to help paint a house over the weekend for $600: Payroll is required (plus filing Form DE 34 in CA).
A business pays a bookkeeper weekly as a 1099 contractor but controls their hours and workflow: Reclassification may apply, and payroll must begin.
In California, you must register with the EDD as an employer within 15 days of paying wages over $100 in a calendar quarter. Missing this deadline can result in penalties even if you correct your filings later.
The bottom line: As soon as you plan to pay someone wages-whether it is yourself or someone else-federal and California rules may require that you establish payroll. Starting early helps you avoid stress, penalties, and compliance issues later on.
What steps do I need to do to start payroll?
Starting payroll involves more than just writing checks. There are several steps you must follow to stay compliant with both federal and California requirements. Whether you are hiring your first employee or paying yourself as the owner of an S corporation, setting up payroll the right way from the beginning will help protect your business.
Apply for an Employer Identification Number (EIN) from the IRS:
This is required to report taxes and other documents to the IRS.
You can apply online at irs.gov.
Register with the California Employment Development Department (EDD):
You must file a DE 1 form to register as an employer in California.
Once registered, you will be responsible for state payroll taxes including unemployment insurance and disability insurance.
Register online at edd.ca.gov.
Set a payroll schedule and frequency:
Determine how often employees will be paid (weekly, biweekly, semimonthly).
California law requires regular and predictable pay periods, and you must follow timely wage payment rules.
Classify your workers properly:
Decide whether each worker is an employee or an independent contractor. Use the IRS guidelines and California’s ABC test to determine classification.
Misclassifying workers can lead to penalties and back taxes.
Collect employee tax forms and documentation:
Have each employee complete Form W-4 (for federal income tax withholding) and Form DE 4 (for California state withholding).
You may also need an I-9 for employment eligibility verification.
Choose a method to calculate and process payroll:
Decide whether you will run payroll manually, use payroll software, or work with a professional (such as an accountant or payroll service).
Ensure your method calculates all necessary withholdings and deductions.
Track and document all wage payments:
Maintain accurate records of hours worked, pay rates, overtime, bonuses, and deductions.
California law requires employers to provide detailed wage statements (paystubs) with each payment.
File and pay federal and state payroll taxes on time:
Submit IRS Forms 941 or 944 quarterly or annually.
Submit payments for Social Security, Medicare, and federal withholding through the EFTPS.
File California payroll tax returns, including DE 9 and DE 9C, and remit payments to the EDD.
Issue annual tax forms to employees and agencies:
Provide Form W-2 to employees by January 31 each year.
File W-2s with the Social Security Administration and California EDD.
File Form 940 annually for federal unemployment tax (FUTA).
These steps may feel overwhelming at first, but once your payroll system is in place, it becomes easier to maintain. Taking the time to do it right from the beginning will help avoid audits, fines, and missed payments.
Most common myths about starting company payroll
Myth: If I only pay in cash, I do not need to run payroll.
Reality: This is false. Paying in cash does not remove your legal obligation to withhold and report payroll taxes. The IRS and California EDD treat cash payments the same as checks or direct deposit, and failure to report them can result in major penalties.
Myth: Payroll is only required once my business makes a profit.
Reality: Even if your company is not making money, payroll is required as soon as you pay yourself or any workers for services. There is no profit requirement tied to payroll responsibilities; it is based on compensation paid, not business income.
Myth: Independent contractors and employees are treated the same for taxes.
Reality: The tax treatment is very different, and misclassifying a worker can lead to serious consequences. Employees require tax withholding, wage reporting, and insurance coverage, none of which apply to true contractors.
Myth: I do not need payroll if I only hire temporary or part-time help.
Reality: Employment status does not depend on how many hours someone works. Even temporary or part-time employees must be paid through a proper payroll system if they meet classification tests.
Myth: Setting up payroll is too expensive for a small business.
Reality: While there are some costs involved, there are many affordable payroll solutions available for businesses of any size. Avoiding payroll to save money usually results in higher expenses down the line due to penalties, interest, and corrective filings.
(FAQ) Frequently asked questions about starting company payroll
Question: Do I need to run payroll if I only hire family members?
Answer: Yes, hiring family members still requires payroll in most cases. You must withhold and report taxes just as you would for any other employee, especially in California. Some exemptions apply for minor children working for sole proprietors, but those are limited and must be handled carefully.
Question: Can I delay setting up payroll until the end of the year?
Answer: No, payroll must be set up and run as soon as wages are paid. Delaying payroll reporting can result in missed deadlines, late fees, and noncompliance with tax withholding requirements. Payroll taxes are due throughout the year, not just at year-end.
Question: Do I need workers’ compensation insurance before starting payroll?
Answer: Yes, in California, you must have workers’ compensation insurance in place before you pay any employees. This includes part-time and temporary workers. Failing to do so can result in penalties and legal liability if someone gets hurt on the job.
Question: Can I run payroll just once a year to save time?
Answer: No, payroll must follow a regular schedule that complies with state and federal wage payment laws. California requires specific pay period frequency depending on the type of work. Annual payroll is not permitted unless you meet strict exceptions, which are rare.
Question: Is it okay to use personal bank accounts for payroll?
Answer: No, business payroll must run through a business bank account. Using personal accounts creates accounting problems and may raise red flags during audits. It is also more difficult to track taxes and properly report wages when accounts are mixed.
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Final Thoughts
Starting payroll is one of the most important steps in building a legitimate, well-run business. Whether you are paying yourself as an S corporation owner or hiring your first employee, knowing when payroll is required and setting it up properly can help you stay compliant and avoid expensive penalties.
Both the IRS and the State of California take payroll obligations seriously, and misunderstanding the rules is a common source of trouble for small business owners. If you are unsure about your specific situation, it is always a good idea to speak with a qualified tax professional or payroll advisor to ensure you are meeting all legal requirements. A little planning now can protect your business for years to come.
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