A key difference between paying employees versus contractors is the employer's responsibility for payroll taxes. If you're paying an employee, your business is responsible for withholding the correct amount of federal, state and local income taxes from each employee paycheck. Withholding is based on an employee's income and the withholding allowances calculated in his or her W-4 form. You then pay the withheld employee taxes to the IRS and state agencies as necessary. As a business owner, you're also responsible for withholding any other necessary payroll deductions, such as health care or retirement plan benefits. Employees receive a W-2 at the end of the tax year to help them square away their tax obligations with the IRS.