Payroll Tax: Everything You Need to KnowStartup Law ResourcesEmployment Law, Human Resources
Payroll taxes are taxes which are imposed on employers when they pay employees and on employee wages by federal, state and local governments,11 min read
2. IRS Audits and Penalties
3. Reporting Period Changes
4. Number of Unemployment Claims
5. Calculating Payroll Tax Withholding
6. What Taxes are Included in Payroll Taxes?
7. How Do I Calculate Payroll Taxes Myself?
8. Self-Employment Taxes
9. Frequently Asked Questions
10. Helpful Resources
What Are Payroll Taxes?
Payroll taxes are taxes which are imposed on employers and employees by federal, state, and local governments. Payroll tax is different than income tax since payroll tax is all the other taxes that aren’t income taxes that are taken out of your check.
The employer and employee split payroll tax half and half. The employer is required to withhold the amount of the employee's share of the payroll tax and submit to the IRS and the state along with payroll tax return.
Needless to say, young entrepreneurs see payroll tax as a big hassle and somewhere along the way, they are told to treat all of their workers as independent contractors so the entrepreneur can:
Skip the withholding and reporting requirements
Only need to send the contractor a 1099 form once each January
Not have to pay their half of the payroll tax since the contractor pays everything
But, that is where the real danger lies.
Regardless of what you call the people who work for you, the IRS may see it differently and they may classify the contractors as employees.
IRS Audits and Penalties
As your company grows, the likelihood of the IRS performing a payroll tax audit grows dramatically. There is a line on your tax return that asks for employee wages and another line that asks for how much you paid consultants. If you have no employee wages and a lot of consultants on your tax return, you are begging for a payroll tax audit.
The IRS fears that consultants will not file their tax return and pay the payroll tax. These fears can lead to a bad day for the entrepreneur since my experience with these audits means the IRS will classify everyone as an employee and shift the burden back to you to take them to tax court to prove otherwise.
The IRS will also give you another surprise: you are responsible for all of the payroll tax that you didn’t withhold from the employee along with your portion of the payroll tax.
You have to prove that the employee paid the taxes, again, that is difficult. Finally, you have to pay the 10% penalty for filing late with interest from when you were required to pay the tax.
However, even the corporate liability shield doesn’t protect you against payroll tax liability.
The penalties for not paying federal income tax withholding and Social Security taxes can be assessed against the company as well as any person having control or custody of the funds from which the payment should have been made.
Just when you thought it couldn’t get worse, it does.
An employee has the right to bring an employment claim for you paying them as an independent contractor and not paying the employer's half of the payroll tax.
Not only is that recoverable, but it means that you didn’t comply with the myriad of employment laws that have statutory penalties, and worst of all, many of those statutes require you to pay the employee’s attorney fees. Many attorneys take these cases just to recover the attorney’s fees and the harder you fight, the higher the bills go.
Once you decide to pay payroll taxes, there many places to trip up here.
Reporting Period Changes
The one that I see most often is when the IRS changes your reporting period. Depending on what you say in the EIN filing about expected employees, there is a good chance that you will only have to report yearly when you first start.
If you report payroll, you should expect that the IRS will start making you report more often and they can and often do, change it frequently as your payroll grows so that you are required to report and pay taxes three days after pay day.
What often happen is that you are not expecting the notice they send that informs you your reporting requirements have been accelerated. As a result, you don’t make the payments on the required interval.
This results in you being assessed a late filing penalty which goes up quickly to 10% plus the interest.
Number of Unemployment Claims
Another problem that I see is that your unemployment taxes are reset each year depending on the number of unemployment claims that you have. Even one claim will likely increase the withholdings rate and the employer pays all of that particular payroll tax.
The tax is only assessed on the first $7,000 of each employee's wages and the percentage can range from 2.5% all the way up to 7% which results in up to $315 more tax per employee.
It is important that you comply with the employment rules regarding dismissing employees and if they file an unemployment claim, you need to contest it so that your unemployment tax rate does not rise.
Calculating Payroll Tax Withholding
So how do you know how much payroll tax to withhold?
There are only two alternatives when it comes to the mechanics of paying payroll tax.
You send it out to a service that handles it all for you and even covers you if they make a mistake.
You use Quickbooks or other services. The services charge you a fee per check that can be twice the cost of the Quickbooks subscription. Quickbooks has really streamlined the process and I recommend it to my clients. It generates the tax forms that you file, calculates the taxes, and produces the W-2s at the end of the year.
It is an important step in a budding entrepreneurs career to be able to comply with the payroll tax reporting requirements successfully.
What Taxes are Included in Payroll Taxes?
Employees will typically see the following deductions listed on their paychecks:
FICA (Federal Insurance Contributions Act): the three categories of this payroll tax include Social Security, regular Medicare contributions and a Medicare surtax (only if the employee earns more than $200,000). Employers also contribute to Social Security and Medicare.
Unemployment Taxes: most states do not have a requirement for employees to pay into unemployment but nearly all employers are required to carry some type of unemployment insurance. Employees in Alaska, Pennsylvania and New Jersey contribute along with their employers.
How Do I Calculate Payroll Taxes Myself?
- Determine Employee Allowances: workers should first complete a Form W-4. This form will contain information about the deductions the employee will claim. They may withhold none, or they may claim a deduction for their spouse and children. The number of allowances will determine how much you as an employer will withhold from their taxes.
- Calculate Pre-Tax Deductions: there are certain deductions that reduce the amount of gross pay that is taxable. These may include contributions for 401(k) plans, health flexible spending arrangements (FSA) and health savings account (HSA). These amounts should be deducted before starting computations.
- Compute Federal Tax Withholding: first calculate the employee's pay for this period including bonuses, tips and hourly wages. Then determine the employee's filing status from their Form W-4. Once you have identified the allowances, determine what amount must be withheld from their pay to cover taxes.
- Calculate Withholding Tax: the IRS provides a withholding calculator which can be used to determine the amount an employer is required to withhold. Before using this, employers will need to know the filing status, number of dependents, gross wages, and frequency of payment. IRS Publication 15 will help you determine the amount of withholding that is required based on the number of allowances and filing status.
- Calculate Social Security Withholding: this federal program which is used for retirement and disability income is funded through payroll deductions. As of 2016, employers are required to withhold 6.2% on employee earnings up to $118,500 for social security taxes. Once this amount is earned, neither the employee or employer owes any social security tax. Note that these funds pay existing retirees, they don’t get put aside into a trust for the person paying into the system.
- Calculate Medicare Withholding: employees will be required to contribute 1.45 percent of their gross pay to Medicare. Any employee who earns more than $200,000 will be assessed an additional 0.9 percent Medicare tax after they have earned this amount. Employers do not have to match the additional Medicare Tax, and assessment is capped at $250,000 for a married couple who intends to file jointly.
- Unemployment Tax Withholding: only if your business is in one of the states requiring unemployment be withheld from employees; specifically, Alaska, Pennsylvania, and New Jersey will you be required to withhold this taxes from employees. Employers are however, generally subject to unemployment taxes by the federal and all state governments. The tax is a percentage of taxable wages up to a certain amount (varies state by state and by employer’s industry and experience rating).
- State Tax Withholding: each state has different guidelines for the amount to be withheld from employees. While the tax rates are different than federal taxes, the calculations to determine the withholding amount is the same. Employers can get this information from the state department of revenue. Make sure to verify the state rules pertaining to taxable wages before processing.
- Local Tax Withholding: some cities and local jurisdictions may have guidelines for taxes to be withheld from employees. Like state taxes, the calculations to determine the amount to withhold are the same and are based on the representations the employee makes on his/her Form W-4.
- Reporting and Paying Withholding Taxes: the amount withheld must be reported regularly and paid to the proper taxing authority in the manner specified by each jurisdiction. There may be different reporting schedules for different types of taxes and for different jurisdictions. Failure to timely and properly pay federal, state or local taxes results in automatic penalties of between 2-10%, as does failure to file required returns and form W-2’s. The penalties for not paying federal income tax withholding and Social Security taxes is particularly severe and can be assessed against the employer as well as any person having control or custody of the funds from which the payment should have been made.
Self-employment tax (SE tax) is computed using Schedule SE (Form 1040). Those who are self-employed will be required to pay their individual state taxes and federal taxes. It is important to note that those who are self-employed will also be required to pay the full amount of Medicare (2.9%) and Social Security (12.4%)
Frequently Asked Questions
What does the federal payroll tax pay for?
FICA which is the combination of Medicare and Social Security taxes are paid one-half by employees and one-half by employers. These amounts are credited into the trust funds of Social Security and Medicaid. The credit is associated with the individual employee. Federal income taxes are the withholding taxes that are deposited into the general fund of the U.S. Treasury and used for funding the federal budget.
What are payroll taxes used to pay for?
There are numerous taxes included in the overall payroll tax. Here is how they are used:
- Federal Unemployment Tax (FUTA): paid by the employer, this tax is used to fund the federal unemployment program. This program benefits employees who lose their jobs due to downsizing and other events. Employees do not pay this tax or have it withheld from their pay. Employers pay an effective rate of 0.6 percent on the first $7,000 of a worker’s wages.
Federal Insurance Contributions Act (FICA) tax – funds Medicare and Social Security for those who are retired, disabled, or are children of workers who are deceased. Also, helps fund the healthcare system for those who cannot afford health insurance.
State Unemployment Tax (SUTA) - funds each state’s unemployment insurance program which is administered within federal guidelines. Most states limit beneficiaries to those unemployed through no fault or misconduct of their own and have earned enough money to qualify.
SUTA is the state counterpart to FUTA. Each state has a range of unemployment tax rates and will give each individual employer an unemployment tax rate that they must pay i.e., an assessment. SUTA is also known as SUI in some states (State Unemployment Insurance). Other states have different names for it - e.g., Florida calls its SUTA, reemployment tax.
SUTA is paid by the employer and can have varying rates within each state and by industry. In all but three states (New Jersey, Pennsylvania, and Alaska), employers are solely responsible for paying SUTA for the state’s unemployment insurance program. SUTA is usually filed and paid quarterly.
In addition to the unemployment tax rate, each state also sets a limit to the amount of wages which can be taxed i.e., a taxable wage base. The taxable wage base is different in each state, but the same for all employers in the state. States can also change the taxable wage base every year.
New employers to a state get a standard new employer rate, but as employers gain more experience, the state will assign new rates based on the individual employer’s “experience rating” and/or on their industry. For example, industries with high employee turnover rates may have higher SUTA tax rates.
An employer can take a credit of up to 5.4% of their taxable wages against the FUTA contribution for SUTA taxes paid. As the FUTA rate is 6.2%, this means that if the employer is eligible for the maximum credit, the FUTA rate will be 0.8% (6.2% - 5.4%).
State Income Tax Contributions - Education, healthcare, transportation, corrections facilities, state police, parks and recreation, and in-state economic development programs are a few of the ways your state withholding tax is used.
Local Income Tax – businesses in Alabama, Colorado, Delaware, Indiana, Kentucky, Maryland, Michigan, Missouri, New Jersey, New York, Ohio, Oregon, Pennsylvania, and West Virginia charge a local income tax. These taxes are used for local programs including schools, community improvement, and parks. In some cases, a separate school tax is also paid.
- Why do we have to pay Medicare tax?
Outside of it being the law, these taxes help provide coverage for retirees and even those who believe they will not be eligible for either program must contribute to them.
How much is the social security tax?
In 2016 the current rate for Social Security is 12.4 percent. Unless you are self-employed, your employer will pay 6.2 percent and your pay will be reduced by the other 6.2 percent. If an employee’s portion of the 6.2% tax exceeds the maximum due to the person having multiple employers, the employee can get a refundable tax credit upon filing an income tax return for that year.
How will I know the total amount of taxes my employer is withholding?
Deducted payroll taxes are usually itemized on an employee’s pay stub. All employers must provide employees annual reports on IRS Form W-2 of wages paid and any federal, state and local taxes withheld for the year. Employers must send copies to the IRS (due by January 31st) and some state governments (due by February 28th) also require a copy. Employers must also use Form W-3 to send W-2 forms to the Social Security Administration.
What are the employee’s responsibilities with the IRS?
Withholding of income taxes by an employer does not relieve the employee of his responsibility for filing income tax returns. Employees must annually file income tax returns and self-assess their taxes, claiming amounts withheld as payments.
Payroll taxes vs. Income taxes
Payroll taxes are used for specific programs. Income taxes have rates which increase or decrease as earnings increase or decrease and are put into the government’s general fund.
What exactly is a withholding?
This is the amount of tax employers hold out of an employee’s paycheck and pay to the government. This amount is a credit against the income taxes the employee owes to the government for that year. The amount is based on the earnings of the employee and the number of deductions they have claimed on Form W-4. Federal, state, and local taxes will apply depending on where the employee lives or the employer does business.
Not all states have state income tax – Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, and the District of Columbia do not, while New Hampshire and Tennessee only tax income from interest and dividends.
Some cities may also require income taxes (like New York City). These taxes are more like prepayments to the government. When tax time rolls around, depending on the worker’s tax bracket and deductions, workers may find themselves getting a refund, or may owe more income tax than they have had deducted from their checks.
Which taxes are only paid by the employer?
Employer portions of Social Security and Medicare taxes
State and federal unemployment taxes
Workers compensation insurance – state law usually requires that employers carry this insurance. Rates are usually based on type of business or industry, type of job being performed and employer’s claim history.
Publication 15 Circular E Employer's Tax Guide (current as of 2016)
IRS Form W4 For Employee Withholding