Summary. Hiring the first employee converts a business into an employer, and the obligations attach immediately, in full, and in every state where the person works. Most are administrative and inexpensive; the expensive ones are the classification decision, the overtime exemption decision, and the failure to register in a state before the first paycheck. This guide walks the sequence a founder actually needs: whether the person is an employee at all, the registrations to complete before payday, the forms to collect on day one, the insurance to buy, the pay practices to get right, the documents to issue, the benefits questions that arrive early, and the records to keep — closing with the compliance calendar and what changes at each headcount threshold.

A two-founder company hires its first three people. All three are paid as independent contractors on 1099s, at $6,500 a month, working full time, on the company's projects, with the company's equipment, under the founders' direction, with no other clients.

Two years later one of them is terminated and files for unemployment. The state agency examines the relationship, finds an employment relationship, and assesses unemployment contributions plus interest and penalties for all three people for the full period. The finding is shared with the state labor department, which opens a wage and hour review, and with the state tax authority.

The bill, in aggregate: unpaid state unemployment and disability contributions; unpaid employer-side FICA of 7.65 percent on roughly $470,000 of wages; failure-to-withhold exposure for federal and state income tax; overtime for hours above forty, which nobody tracked because contractors do not have timesheets, computed at an estimated rate against the employer under the rule that an employer who fails to keep records bears the consequence of the uncertainty; liquidated damages doubling the wage exposure under the FLSA and additional penalties under state law; workers' compensation premium for the uninsured period, plus the exposure of having had three uninsured workers; and penalties for failure to provide wage statements and to file new hire reports.

Against that: the company saved roughly 10 percent in payroll taxes and some administrative effort.

Nothing about the arrangement was unusual, and nothing about the outcome was unpredictable. Employment compliance is one of the few areas where the shortcuts are transparently identifiable in advance and the consequences are arithmetic.

Step one: is this person an employee?

Almost always, yes. The tests differ across statutes, but they converge in the same direction for anyone working full time on the company's core work under its direction.

The IRS common law test looks at behavioral control (instructions, training, evaluation), financial control (unreimbursed expenses, investment in facilities, opportunity for profit or loss, availability to the market, method of payment), and the type of relationship (written contracts, benefits, permanency, whether the services are a key aspect of the business).

The FLSA economic reality test asks whether the worker is economically dependent on the employer or in business for themselves, weighing opportunity for profit or loss, investment, permanence, control, whether the work is integral to the business, and skill and initiative. The Department of Labor's regulation on this test has been revised by successive administrations and has been the subject of litigation; verify the current standard, but note that the outcome for a full-time worker doing the company's core work is the same under every version.

State ABC tests are the strictest and are in force in a growing number of states, presuming employment unless the hiring entity proves all three: (A) the worker is free from control and direction in fact and under the contract; (B) the work is outside the usual course of the hiring entity's business; and (C) the worker is customarily engaged in an independently established trade of the same nature. Prong B is decisive — a software company cannot classify a software developer as a contractor under an ABC test, no matter how the relationship is structured.

A written contract does not decide it, and neither does the worker's preference. Agencies and courts look at the actual relationship.

Where contractor status genuinely works: a specialist engaged for a defined project, working for multiple clients, using their own tools, setting their own hours and methods, bearing business risk, and — ideally — operating through their own entity with their own insurance and marketing. Even then, in an ABC state, prong B remains the obstacle.

If the person is a contractor, use a written agreement covering scope, deliverables, payment, intellectual property assignment (essential — the default rule is that a contractor owns what they create), confidentiality, insurance, and no-benefits acknowledgment; collect a Form W-9; and file Form 1099-NEC by January 31.

If the person is an employee — which they usually are — proceed.

Step two: registrations, before the first payday

Federal:

  • Employer Identification Number on Form SS-4, obtained online in minutes. Free.
  • EFTPS enrollment for federal tax deposits.

State, in every state where an employee performs work — and this is where remote hiring creates surprises, because the obligations follow the employee's work location, not the company's:

  • Income tax withholding registration.
  • Unemployment insurance account, which produces an experience rate.
  • New hire reporting to the state directory, generally within 20 days of hire (some states are faster). Required federally under 42 U.S.C. § 653a, and it is the report companies most often skip.
  • Workers' compensation coverage.
  • Paid family and medical leave program registration where the state has one.
  • State disability insurance where applicable.
  • Local registrations — several cities impose their own payroll taxes, business registration, and paid sick leave ordinances.

Registering after the first payroll is the most common failure, and it produces penalties and, in some states, personal liability for responsible persons. Registration typically takes days to weeks; start it before the start date.

Also confirm: the business is qualified to do business in the state (a remote employee frequently creates the nexus that requires foreign qualification, and separately can create income tax and sales tax nexus); and any professional or occupational licensing that applies to the work.

Step three: day one paperwork

Form I-9, Employment Eligibility Verification. The employee completes Section 1 no later than the first day of employment; the employer completes Section 2 within three business days. The employer must physically examine original documents, or use the alternative remote examination procedure if the employer is enrolled in E-Verify and in good standing.

I-9 practice points: do not specify which documents the employee must present, which is document abuse and is independently actionable; do not complete Section 2 before the first day; store I-9s separately from personnel files, because they must be produced on three days' notice to an agency and the personnel file should not accompany them; and calendar the retention period — three years after hire or one year after termination, whichever is later.

E-Verify is voluntary federally, mandatory for federal contractors under the FAR E-Verify clause, and mandatory or partially mandatory in a number of states. If enrolled, create the case within three business days of the start date.

Form W-4, and the state equivalent where the state has one.

Direct deposit authorization, noting that most states prohibit requiring direct deposit as a condition of employment.

Emergency contact and benefits enrollment forms.

Signed acknowledgments of the handbook, the confidentiality and invention assignment agreement, and any arbitration agreement — with the arbitration agreement as a standalone document with a verifiable acknowledgment, for the reasons discussed elsewhere in this library.

The offer letter, issued before the start date and signed:

  • Position, reporting relationship, and start date.
  • Exempt or non-exempt classification, stated expressly.
  • Compensation, stated as an hourly rate or as a periodic amount — never as an annual salary alone for a non-exempt employee, which invites a claim that overtime was included.
  • Bonus or commission terms, with a plan document where the structure is anything but simple.
  • Benefits eligibility, described generally with a reference to the plan documents.
  • At-will employment, stated clearly, with a statement that only a specified officer may alter it and only in a signed writing. Note that Montana is not an at-will state after a probationary period, and that at-will language must not be undermined by progressive discipline policies phrased as promises.
  • Contingencies — background check, reference check, and I-9 verification.
  • A statement that the letter is the complete agreement and supersedes prior discussions.
  • Not a term of years, and not language implying job security, unless intended.

State-specific notices at hire are required in a growing number of jurisdictions — wage rate notices, paid sick leave notices, workers' compensation notices, whistleblower notices, and in several states pay transparency disclosures. These vary considerably and are easy to miss.

Step four: insurance

Workers' compensation is required in nearly every state, generally from the first employee (with thresholds in a few states and exemptions for certain owners and family members). Coverage is obtained through the commercial market, a state fund, or — in a few monopolistic states — only from the state fund, with employers' liability then obtained separately.

Operating without coverage is a serious offense: stop-work orders, penalties per employee per day, personal liability for officers in several states, and — most significantly — loss of the exclusive remedy, meaning an injured employee may sue the company in tort for full damages, frequently with the ordinary defenses abolished by statute.

Employment practices liability insurance. Not required, and worth buying earlier than most companies do. A single discrimination or wrongful termination claim, defended competently, costs more than several years of premium.

Also review: general liability, which the employee's activities may affect; hired and non-owned auto if the employee ever drives for work, including to a client site in their own car; fidelity and crime coverage if the employee handles money; and cyber if they handle data.

Confirm health insurance eligibility rules if a plan will be offered — waiting periods may not exceed 90 days under the ACA, and the plan's eligibility definition must match actual practice.

Step five: pay practices

Minimum wage. The higher of federal, state, and local. Many cities set their own, several index annually, and some set different rates by employer size.

Overtime. Under the FLSA, non-exempt employees receive one and one-half times the regular rate for hours over 40 in a workweek. Several states add daily overtime, double time, and a seventh-consecutive-day rule.

The regular rate is not the hourly rate. It includes non-discretionary bonuses, shift differentials, commissions, and most incentive pay, allocated back over the period earned — which means a quarterly production bonus retroactively increases the overtime owed for every week in the quarter. This is the most common overtime miscalculation.

Exempt classification requires both a salary test and a duties test, and the duties test is where classifications fail:

  • Executive — primary duty is management of the enterprise or a recognized department, customarily directing the work of at least two full-time equivalents, with authority to hire and fire or with recommendations given particular weight.
  • Administrative — primary duty is office or non-manual work directly related to management or general business operations, including the exercise of discretion and independent judgment with respect to matters of significance. This is the most abused exemption; performing important work is not the same as exercising discretion on matters of significance.
  • Professional — learned professional (advanced knowledge in a field of science or learning, customarily acquired by prolonged specialized instruction) or creative professional.
  • Computer employee — with a specific duties definition that is narrower than "works in IT."
  • Outside sales — customarily and regularly engaged away from the employer's place of business.
  • Highly compensated — a relaxed duties test above a compensation threshold.

The salary threshold is set by regulation, has been raised and litigated repeatedly, and several states impose higher thresholds. Verify the current federal figure and the applicable state figure before classifying anyone.

The salary basis rule requires a predetermined amount not subject to reduction for variations in quality or quantity of work, with narrowly enumerated permissible deductions. Improper deductions can destroy the exemption for the employee and, if there is an actual practice of improper deductions, for the entire class of employees — with a safe harbor available for employers that have a clearly communicated policy, reimburse promptly, and make a good-faith commitment to comply.

Job titles are irrelevant. "Manager" and "Coordinator" decide nothing.

Recording hours for non-exempt employees, accurately and daily. The employer bears the recordkeeping obligation, and where records are inadequate, the employee's reasonable estimate of hours is credited. Prohibit off-the-clock work explicitly, and enforce it — a policy against unauthorized overtime does not excuse paying for overtime actually worked and permitted.

Meal and rest breaks. Federal law requires none. Many states require both, with premium pay for missed breaks in some, and short rest breaks of 20 minutes or less are compensable under federal law regardless.

Pay frequency is set by state law — weekly, biweekly, semimonthly — and varies by employee category in some states.

Wage statements must accompany each payment in most states, with prescribed content: gross wages, hours worked, rates, all deductions itemized, net wages, the pay period dates, and the employer's legal name and address. Several states impose per-employee, per-period penalties for defective statements, and these claims travel in class and representative actions because the violation is uniform across the workforce.

Deductions are tightly restricted. Federal law permits deductions that do not reduce pay below minimum wage or cut into overtime; many states require written authorization and prohibit deductions for cash shortages, breakage, uniforms, and business expenses entirely.

Expense reimbursement is required in a number of states — including for a portion of an employee's personal phone and internet where used for work, which for remote employees is a live and frequently litigated obligation.

Final pay deadlines are state law and are short: immediately on involuntary termination in several states, within a defined number of days in others, and with waiting time penalties that can equal several weeks of wages. Whether accrued but unused vacation must be paid out is also state law — required in some states, permitted to be forfeited under a clear policy in others.

Payroll taxes. Withhold federal income tax, Social Security and Medicare (with the additional Medicare tax above a threshold), state and local income tax, and any state disability or paid leave contributions. Pay the employer share of FICA and federal and state unemployment. Deposit on the applicable schedule, and file Forms 941 quarterly, 940 annually, W-2s and W-3 by January 31, and the state equivalents.

Payroll taxes are trust fund money. Under 26 U.S.C. § 6672, a responsible person who willfully fails to collect or pay over withheld taxes is personally liable for the full amount, and the liability is not dischargeable in bankruptcy. This is the single most dangerous obligation in this guide, and it becomes dangerous exactly when a company is short of cash and decides to pay vendors first.

Use a payroll provider. For a company with fewer than a hundred employees, a reputable provider costs a modest amount per employee per month and handles registrations, calculations, deposits, filings, and forms. Doing it manually is not a meaningful saving, and the failure modes are severe. Note that the employer remains liable for the provider's failures, so confirm deposits are actually being made — provider defalcation has left companies liable for taxes they thought were paid.

Step six: policies and postings

A handbook is not legally required and is nearly always worth having. It communicates expectations, establishes the complaint procedure the Faragher-Ellerth defense depends on, and documents the at-will relationship.

Contents:

  • An at-will disclaimer and a statement that the handbook is not a contract, at the front and in the acknowledgment.
  • Equal employment opportunity and anti-harassment, with multiple reporting channels and a non-retaliation commitment.
  • Complaint and investigation procedures.
  • Accommodation procedures for disability and religion, describing the interactive process.
  • Leave policies — FMLA if covered, state leave laws, paid sick leave, vacation or PTO with the accrual and payout rules stated, jury duty, voting, military, and bereavement.
  • Timekeeping and pay practices, including a prohibition on off-the-clock work and a safe harbor statement for improper deductions.
  • Attendance, conduct, and discipline — phrased as guidelines, not as a promise of progressive discipline, which can create contractual obligations in some states.
  • Confidentiality, drafted to avoid restricting employees' protected right to discuss wages and working conditions.
  • Technology, acceptable use, and monitoring, with a statement of no expectation of privacy on company systems, and state-specific consent where required for monitoring.
  • Social media, drafted to avoid overbreadth under the National Labor Relations Act, which applies to non-union workplaces.
  • Safety and workplace violence.
  • Drug and alcohol, reconciled with state marijuana laws, several of which now restrict adverse action for off-duty use.
  • Remote work, if applicable, covering expense reimbursement, timekeeping, and safety.
  • Signed acknowledgment, retained.

Review the handbook against every state where an employee works, and reissue on material change with a new acknowledgment.

Required postings — federal (FLSA, OSHA, EEO, FMLA if covered, USERRA, EPPA, and others), state, and local. Remote employees must receive them electronically, and the Department of Labor has issued guidance permitting electronic posting where employees work exclusively remotely and can access them readily. Poster services are inexpensive and handle updates.

Required training in a growing number of states — sexual harassment prevention with defined frequency, content, and duration, with separate supervisor requirements.

Step seven: benefits, and the thresholds

Health insurance is not required below 50 full-time equivalent employees. Above that, the ACA employer mandate requires offering minimum essential coverage that is affordable and provides minimum value, with penalties for failure, plus Forms 1094-C and 1095-C reporting.

Retirement plans. No federal requirement — but a growing number of states now mandate that employers either offer a plan or enroll employees in a state-facilitated IRA program, with thresholds as low as one employee in some states and registration deadlines that carry penalties. Check the state before assuming there is no obligation. Voluntarily, a SEP-IRA, a SIMPLE IRA, or a 401(k) (including low-cost pooled and safe-harbor designs) are all available to small employers, with tax credits available for startup costs.

The headcount thresholds that change obligations — worth calendaring, because they arrive without notice:

  • 1 employee: workers' compensation, most state wage and hour law, many state anti-discrimination statutes, state paid sick leave, new hire reporting, and state-mandated retirement in several states.
  • 4+: IRCA anti-discrimination provisions.
  • 15+: Title VII, the ADA, and GINA.
  • 20+: the ADEA and COBRA.
  • 50+: the FMLA (with the 75-mile and hours-worked conditions), the ACA employer mandate, and EEO-1 reporting for federal contractors.
  • 100+: EEO-1 reporting, and the WARN Act for mass layoffs and plant closings — with several states imposing mini-WARN statutes at lower thresholds and with longer notice periods.

Also: many state statutes apply at lower thresholds than their federal counterparts, so a company with eight employees may be covered by a state discrimination statute while outside Title VII.

Step eight: records

Keep, and keep separately:

  • Personnel file — application, offer letter, acknowledgments, reviews, discipline, and separation documents.
  • Payroll records — three years under the FLSA for payroll records and two years for the records on which wage computations are based; longer under many state laws.
  • I-9s — separate, retained three years after hire or one year after termination, whichever is later.
  • Medical information — ADA accommodation records, FMLA certifications, workers' compensation files, and drug test results — in a separate confidential file, because the ADA requires it.
  • Benefit plan records under ERISA, six years.
  • Tax records, four years after the tax is due or paid.
  • Job applications and hiring records, one year under the EEOC's regulations, two years for federal contractors.

A litigation hold suspends all destruction schedules, and destruction after a claim is anticipated is spoliation.

A short case study

A four-person startup hires its first employee, a customer success manager, in a state where no founder lives.

Two weeks before the start date. Classification analysis: full time, on core work, under direction, using company systems — an employee. The state is an ABC state, which ends the discussion. Registrations begin: state withholding, unemployment insurance, paid family leave, and foreign qualification, because the employee's presence creates nexus. Workers' compensation is bound. A payroll provider is engaged and given the registration numbers as they arrive.

One week before. The offer letter issues: title, start date, non-exempt classification (the role does not satisfy any duties test), an hourly rate, at-will language, contingencies, and a benefits reference. The handbook is drafted against that state's requirements, including its paid sick leave ordinance and its expense reimbursement statute. A confidentiality and invention assignment agreement is prepared.

Day one. Section 1 of the I-9 completed; Section 2 within three business days. W-4 and the state form. Direct deposit authorization. Handbook acknowledgment. Required state notices at hire delivered. Electronic postings provided. New hire report filed within the state's window.

First payroll. The wage statement is checked against the state's required content. Hours are recorded daily in the payroll system. The remote work stipend is set to cover the state's expense reimbursement obligation.

Month three. The employee begins working occasional weekends. Overtime is paid at the correct regular rate, including the quarterly bonus allocated back across the period — a calculation the payroll provider performs only if it is told the bonus is non-discretionary.

Month nine. The company hires two more people in two more states. The registration sequence repeats, the handbook acquires state-specific addenda, and the state-mandated retirement program in one of the states is registered for before its deadline.

Total incremental legal and administrative cost across the first year: modest. Cost of the alternative described at the beginning of this guide: several hundred thousand dollars, plus the officers' personal exposure for unpaid trust fund taxes.

Conclusion

Three points carry the weight.

Classify correctly, and understand that the ABC test ends the argument in a growing number of states. The contractor shortcut saves a small percentage and creates exposure across payroll tax, wage and hour, unemployment, workers' compensation, and benefits simultaneously — with liquidated damages and penalties layered on top.

Register before the first paycheck, in the state where the employee works. Remote hiring makes this the most commonly missed step, and it is the cheapest one on the list.

Payroll taxes are trust fund money. Section 6672 liability is personal, non-dischargeable, and reaches anyone with authority over the payment decision. When cash is tight and the choice is between the IRS and a vendor, the IRS is not the flexible creditor it appears to be.

Frequently asked questions

Can we start someone as a contractor and convert them later? You can, and it is usually a misclassification for the contractor period. Agencies examine the whole relationship, and a conversion is frequently the event that prompts the examination — because the worker's duties did not change, only the paperwork did.

Can an employee agree to be a contractor? No. The classification is determined by the relationship, not by consent, and a worker cannot waive statutory protections. An agreement reciting contractor status is evidence, and it is not controlling.

Can we pay a salary instead of tracking hours? Only if the employee is properly exempt. A non-exempt employee can be paid a salary, but hours must still be tracked and overtime paid on top — and paying a flat salary "for all hours worked" without an enforceable fluctuating workweek arrangement is one of the most common wage claims.

What if the employee volunteers to work extra hours without pay? The employer must pay for hours it knew or should have known were worked, whether or not authorized. A policy prohibiting unauthorized overtime is enforceable through discipline; it is not a defense to paying for the time.

Do we need a handbook? Not legally. Practically, yes — it establishes the complaint procedure the harassment affirmative defense depends on, documents at-will status, and communicates the pay and leave policies several states require you to have in writing.

How do we handle a remote employee in a state where we have no presence? Register there before the first paycheck: withholding, unemployment, workers' compensation, paid leave where applicable, and foreign qualification. Then layer that state's wage, leave, notice, and posting requirements onto the handbook. One remote employee makes the company a multistate employer.

Do we have to give paid time off? No federal requirement. A growing number of states and cities mandate paid sick leave with accrual, carryover, and usage rules, and several have paid family leave programs funded by payroll contributions. Vacation is not mandated anywhere, but where it is offered, several states treat accrued vacation as earned wages that must be paid out at separation.

When can we terminate someone? At-will means with or without cause, on notice or without it, subject to the substantial exceptions: no discrimination, no retaliation, no violation of a contract or a policy that created one, and no violation of public policy. Document the reason contemporaneously, apply the decision consistently with prior comparable cases, and confirm the final pay deadline before the termination meeting rather than after.

What is the single most expensive mistake at this stage? Misclassification — either employee versus contractor, or exempt versus non-exempt. Both are decided once, applied to everyone in the role, and compound across years before anyone examines them.

The annual calendar

Once the first hire is on payroll, the obligations recur. Put them on a calendar rather than reacting to notices.

January. Forms W-2 and W-3 to employees and the Social Security Administration by the 31st; Forms 1099-NEC to contractors and the IRS by the same date; Form 940 (federal unemployment) by the 31st; fourth-quarter Form 941 by the 31st; state annual reconciliations; ACA Forms 1095-C to employees and 1094-C to the IRS if the company is an applicable large employer; and updated minimum wage and salary threshold checks, because many jurisdictions index on January 1.

Quarterly. Form 941 and state withholding and unemployment returns by the last day of the month following each quarter. Reconcile the payroll provider's deposits to the tax accounts — do not assume.

Ongoing. New hire reports within the state's window for every hire. I-9 completion within three business days for every hire, and reverification of any expiring work authorization on schedule. Handbook acknowledgments for new hires and for every material revision. Poster updates when they change.

Annually. Handbook review against every state and locality where an employee works. Wage and hour self-audit of exempt classifications and of the regular rate calculation. Workers' compensation audit, and a review of the class codes, which are frequently wrong. Insurance renewal. Harassment training where a state mandates it, on the mandated cycle. Benefit plan compliance — Form 5500 where required, nondiscrimination testing for retirement plans, and ACA measurement period tracking. A review of headcount against the thresholds listed above, because crossing 15, 20, or 50 changes the obligations mid-year and nobody sends a notice.

On every new state. The full registration sequence again, plus the handbook addendum, plus the notices at hire, plus the postings.

A closing note on cost. Everything in this guide, done properly for a first hire in a single state, costs a few thousand dollars of professional time plus a payroll provider at roughly forty to seventy dollars per month plus a per-employee fee, plus workers' compensation premium scaled to payroll. That is a rounding error against the salary being paid. The reason companies skip it is not cost; it is that none of it feels urgent until something goes wrong, and by then the exposure has been accruing for two years across five statutes at once.

And one habit worth building from the first employee: keep a written record of every compensation decision, every classification decision, and every discipline conversation, made at the time and not reconstructed later. It takes minutes, it makes consistency possible as the company grows, and it is what every later audit, charge, or claim will be resolved against.

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This guide is provided for general informational purposes and does not constitute legal or tax advice. Employment obligations vary substantially by state and locality, thresholds and salary levels change, and several standards discussed here have been subject to recent revision and litigation. Consult qualified employment counsel and a payroll professional before the first hire, and again before hiring in a new state.