Tax

Payroll Tax Cut Explained

10.28.2020

Emptech's founder, Jeff Aleixo

Author

Jeff Aleixo

Payroll tax cut, payroll tax compliance

After weeks of negotiations in Congress, President Trump signed executive orders on payroll taxes, unemployment benefits, student loans, and evictions. The aim of these orders is to provide relief to American workers who are struggling financially as a result of the coronavirus recession.

One of those executive measures includes a directive to suspend certain payroll taxes for workers earning less than $4,000 on a biweekly basis or about $104,000 annually. The start date for the payroll tax cut is listed as Sept. 1. By signing the Presidential Memo, the President is taking a step toward his longtime goal of cutting payroll taxes, a move he believes would provide savings to workers and encourage businesses to rehire employees.

How Payroll Taxes Work

The federal government levies payroll taxes on wages and uses most of the revenue to fund Social Security, Medicare, and other social insurance benefits. Federal income taxes also finance defense and security.

The Internal Revenue Service and state tax agencies publish annual tables to determine the amount of tax to be withheld from each paycheck depending on the employee’s gross wages, filing status, number of withholding allowances, and pay frequency. Social Security and Medicare taxes put together are called the Federal Insurance Contributions Act (FICA) taxes and have specific rates and thresholds.

For 2020, the Social Security tax rate is 6.2% on the first $137,700 of wages paid. The Medicare tax rate is 1.45% on the first $200,000 of wages, plus an additional 0.9% for wages above $200,000.

Payroll Tax Cut and Proposed Changes

According to the Presidential Memo, payroll tax cut defers Social Security taxes on wages or compensation of less than $4,000 on a pretax biweekly basis. That means that this will apply to workers earning less than approximately $104,000 in 2020. The amounts deferred are to be ultimately remitted without additional payments, such as interest, penalties, or other additional amounts or taxes.

The payroll tax cut does not include Medicare taxes. Also, this decision does not apply to the employer portion of Social Security taxes or Medicare or Additional Medicare taxes. The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act already gives employers the option to defer payment of the employer portion of Social Security taxes. This refers to the period of March 27, 2020, through December 31, 2020, with 50% of the deferred taxes to be paid by December 31, 2021, and the remaining balance to be paid by December 31, 2022.

It is important to note that payroll taxes accumulated between Sept. 1 and Dec. 31 will be deferred, not forgiven. If no permanent payroll tax cut is enacted, taxes will have to be repaid beginning with January 2021.

Use this comprehensive guide to help you effectively handle tax responsibilities, prevent costly mistakes, and stay in compliance with tax requirements.

Payroll Tax Cut Impact

Since payroll tax cut is based on wages, a worker earning a relatively high salary, such as up to $104,000 in this case, takes home a bigger benefit than a worker earning $25,000. Supporters of payroll tax cut argue that it helps the economy by benefiting a broad number of American workers. On the other side, unemployed, retirees, and employees whose income derives from government benefits, will not benefit from the payroll tax cut. Therefore, it leaves out those most financially impacted by the COVID-19 health crisis.

It is not clear whether there will be a formal process for employees to opt in or out of deferring the withholding, deposit, and payment of payroll taxes. If employers choose to continue to withhold and pay payroll taxes while waiting for Congress to pass a tax cut, they could seek refunds of overpaid taxes after a tax cut becomes law. However, this would be a complicated process, and such an approach would defeat the purpose of the payroll tax cut as an economic stimulus in response to the effect of the COVID-19 pandemic.

How Should Employers Prepare for Payroll Tax Cut

President’s payroll tax order poses a dilemma for U.S. companies. It is difficult for employers to decide if they should continue withholding the money from workers expecting bigger paychecks or pass it on and potentially put themselves or their employees at risk.

It can also be very difficult for many employers to update their payroll systems as these changes require more clarifications from the Treasury Department and IRS about how the executive order works. Legal experts also point out it is possible that employers would continue to withhold payroll taxes from paychecks because the order does not eliminate the taxes. If that happens, employees cannot get a four-month 6.2% raise.

It is advisable for employers to exercise caution before making any payroll system changes in the absence of implementing guidance. At the same time, they need to follow further developments and legislation and determine how to prepare for potential implementation of the payroll tax cut, if it does become necessary. Lastly, employers should consider a payroll tax management software to ensure constant compliance with evolving tax regulations, avoid potential errors and penalties, and stay ahead of payroll tax obligations and changes.

Automate tax filing and simplify time-consuming and complex tax obligations to avoid penalties, reduce tax risks, and remain compliant with tax laws and regulations.

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