Payroll and Expenses

What you will build in this module: By the end, you will be able to classify a worker as an employee or contractor using the IRS three-factor test, calculate the true fully loaded cost of an employee, and build an expense reimbursement policy — the compliance and cost-management skills that prevent the penalties and financial surprises that destroy growing businesses.

The startup that misclassified everyone

In 2015, a food delivery startup in California had 400 drivers. They called them "independent contractors" — no benefits, no payroll taxes, no overtime, no workers' compensation insurance. The drivers used their own cars, set their own schedules, and got paid per delivery.

The state of California disagreed.

After an investigation, regulators determined the drivers were actually employees — the company controlled their routes, set delivery standards, required branded uniforms, and the drivers' work was integral to the core business. The ruling triggered $12 million in back payroll taxes, penalties, and unpaid benefits. The company was also on the hook for unemployment insurance, workers' compensation claims, and overtime pay for every driver who worked more than 40 hours.

The founders argued it was a grey area. The IRS and the California Employment Development Department argued it was not. When you control how work is done (not just what work is done), the worker is an employee — regardless of what your contract says.

This distinction — employee vs. independent contractor — is one of the most consequential decisions a business makes. Get it wrong, and the penalties can destroy you.

Employee vs. independent contractor

The distinction comes down to control and independence:

The IRS uses a three-factor test to determine classification:

1. Behavioural control — Does the company control how the work is done?
2. Financial control — Does the company control the business aspects (payment method, expenses, opportunity for profit/loss)?
3. Relationship type — Is there a written contract? Benefits? Permanency?

If the answer to most of these is "the company controls it," the worker is an employee — even if both parties agreed to a contractor arrangement.

There Are No Dumb Questions

"Can a worker agree to be a contractor even if the IRS would classify them as an employee?"

No. Classification is determined by the actual working relationship, not by what the contract says. You cannot sign away employee status. The IRS looks at how the work is actually performed, not what the paperwork claims. A contract that says "independent contractor" while the worker follows a company schedule, uses company equipment, and cannot work for anyone else will be reclassified by the IRS on audit.

"Why would a company want to misclassify workers?"

Money. Contractors are cheaper — no employer FICA taxes (7.65%), no unemployment insurance, no benefits, no overtime, no workers' compensation. For a company with 100 workers, the savings can be hundreds of thousands of dollars per year. That is why regulators audit aggressively — the incentive to misclassify is enormous.

Payroll: what it involves

Running payroll means calculating, withholding, and remitting taxes for every employee, every pay period. You saw the four tax types in Tax Basics for Business — payroll is where three of them (income tax, Social Security, and Medicare) get collected and deposited on a strict schedule. Here is what goes into a single paycheck:

Payroll compliance: what you must do

Payroll has more compliance requirements than almost any other area of business accounting. Miss a deadline and penalties start immediately.

Most small businesses use payroll services (Gusto, ADP, Paychex, QuickBooks Payroll) rather than handling payroll manually. The cost — typically $40-100/month plus $4-8 per employee — is trivial compared to the risk of errors and penalties.

Expense tracking: the foundation of good accounting

Every dollar your business spends should be categorized, documented, and recorded. This matters for three reasons:

1. Tax deductions — You can only deduct what you can prove. No receipt, no deduction.
2. Financial visibility — You cannot manage what you do not measure.
3. Audit protection — If the IRS audits you, documentation is your defence.

Expense categories

A standard small business uses categories like these:

There Are No Dumb Questions

"Should I use a personal credit card for business expenses?"

No. Get a separate business credit card and business bank account from day one. Mixing personal and business expenses makes bookkeeping a nightmare, weakens the liability protection of your LLC or corporation, and creates headaches at tax time. A separate business account also makes it trivial to track and categorize expenses.

"What about reimbursements? If an employee pays for something and I reimburse them?"

The reimbursement is a business expense — not income to the employee (as long as you have an accountable plan: the employee submits receipts, the expense has a business purpose, and any excess reimbursement is returned). Without an accountable plan, reimbursements are treated as taxable income to the employee.

<classifychallenge xp="25" title="Employee or Contractor?" items={["Graphic designer: works 9-5 in the office, uses company equipment, one employer, annual reviews","Freelance web developer: works from home, owns their laptop, 4 clients, bills per project","Delivery driver: own car, but follows company routes, wears branded shirt, cannot work for competitors during shifts","Tax accountant: visits monthly, has 15 other clients, sets own schedule, uses own software"]} options={["Employee (W-2)","Independent Contractor (1099)"]"} hint="Focus on who controls HOW the work is done. If the company controls methods, schedule, tools, and exclusivity, the worker is likely an employee — regardless of what the contract says.">

Expense reimbursement policies

When employees spend their own money on business expenses, you need a clear reimbursement policy. The IRS requires an accountable plan for reimbursements to be tax-free:

Three requirements of an accountable plan:

1. The expense must have a business connection — it was incurred while performing services for the company
2. The employee must substantiate the expense within a reasonable time (usually 60 days) — receipts, date, amount, business purpose
3. Any excess reimbursement must be returned within a reasonable time (usually 120 days)

If any requirement is not met, the reimbursement becomes taxable income to the employee.

Best practices for expense reimbursement:

• Set clear spending limits by category (e.g., meals up to $50/person, hotels up to $200/night)
• Require receipts for everything over $25
• Use expense management software (Expensify, Ramp, Brex) to automate submissions and approvals
• Process reimbursements within one to two pay periods
• Define what is and is not reimbursable in writing

Back to the food delivery startup

Remember those 400 "independent contractors" who were really employees? The $12 million penalty did not come from a single dramatic moment — it came from a pattern of control that accumulated over years. Company-controlled routes. Branded uniforms. Required ratings. No competing work during shifts. Each decision seemed small at the time. Together, they painted a clear picture of an employment relationship. The founders could have avoided the entire disaster by running each factor through the three-factor test you just learned and asking one question: "Are we controlling how this work is done, or just what work gets done?" That single question, asked honestly, is worth $12 million.

In the final module, you will learn to take everything from this track — the accounting equation, financial statements, double-entry bookkeeping, cash flow, budgets, taxes, payroll — and use it to make real business decisions with Financial Analysis: ratios, break-even analysis, and benchmarking.

Key takeaways

• Employee vs. contractor classification is determined by the IRS, not your contract. Control over how work is done is the key factor. Misclassification triggers severe penalties.
• Payroll involves withholding, matching, and depositing multiple taxes — federal income, state income, Social Security, Medicare, and unemployment. The total employer burden is roughly 25% above the base salary.
• Payroll taxes are trust fund taxes. Late deposits trigger immediate penalties. Use a payroll service — the cost is trivial compared to the risk.
• Track every business expense with receipts and categorization. No documentation means no deduction and no audit defence.
• Keep personal and business finances completely separate from day one. Separate bank account, separate credit card.
• Reimbursements require an accountable plan to be tax-free — business connection, substantiation, and return of excess.