Hiring Your First Employee: Tax Obligations, Payroll Setup, and the Solo 401(k) Impact
The transition from solo operator to employer is the most significant administrative and tax change a small business owner makes. Hiring the first W-2 employee triggers a cascade of new obligations: federal payroll tax withholding and deposits, state payroll tax withholding, workers’ compensation insurance (required in most states), federal and state unemployment insurance (FUTA/SUTA), and changes to the retirement plan (the Solo 401(k) is no longer available). The additional cost of employing a $35,000/year worker is $5,000-$8,000 beyond the salary, depending on the state.
New obligations triggered by hiring the first employee: (1) EIN: The business must have an Employer Identification Number (if not already obtained). (2) Federal payroll taxes: Withhold federal income tax and the employee’s share of FICA (7.65%) from each paycheck; the employer pays the matching FICA (7.65%). Deposit withheld taxes per the IRS deposit schedule (monthly or semi-weekly depending on liability). (3) State payroll taxes: Withhold state income tax (if applicable) and pay state unemployment insurance (SUTA). (4) Federal unemployment (FUTA): 6.0% on the first $7,000 of wages per employee (reduced to 0.6% with full SUTA credit). Maximum FUTA: $420/employee/year. (5) Workers’ compensation: Required in most states. Cost varies by state and industry classification (1-15% of payroll). (6) New hire reporting: Report new employees to the state within 20 days of hire. (7) I-9 verification: Verify employment eligibility (Form I-9). (8) W-4: Collect the employee’s withholding certificate. (9) Quarterly and annual filings: Form 941 (quarterly payroll tax return), Form 940 (annual FUTA return), W-2 and W-3 (annual wage reporting).
What is the true cost of the first employee?
What happens to the Solo 401(k)?
The Solo 401(k) is available only to business owners with no common-law employees (other than a spouse). Hiring one W-2 employee, even part-time, eliminates eligibility. The business owner must transition to a plan that covers the employee:
Options after hiring:
- SIMPLE IRA: Lower deferral ($16,000 vs $23,500), lower employer cost (match up to 3% of compensation).
- SEP IRA: Employer-only contributions, uniform percentage for everyone.
- Safe Harbor 401(k): Higher deferral ($23,500), mandatory 3% non-elective or 4% match on all eligible employees, higher administration cost ($1,500-$3,000/year TPA).
The transition must happen by the plan year-end. If the owner hires an employee in June, the Solo 401(k) remains valid for the year IF the employee does not meet the plan’s eligibility requirements (typically 1 year of service and 1,000 hours). If the employee meets eligibility immediately, the Solo 401(k) must be terminated and a new plan established.
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Yarik Yarosh, CPA. "Hiring Your First Employee: Tax Obligations, Payroll Setup, and the Solo 401(k) Impact." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-hiring-first-employee
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.