Payroll Taxes
How to Maintain
Payroll Compliance

Payroll taxes are all taxes that are collected by federal, state, and local governments, based on salaries and wages paid to employees. These taxes must be withheld from wages by all businesses that have employees. They are remitted on a monthly or semi-weekly basis, depending on the quantity owed.

The Internal Revenue Service (IRS) requires most businesses with employees to withhold and deposit federal payroll, Social Security, and Medicare taxes. Withholding, filing, and remitting payroll taxes can be complicated, but they are tasks that business owners must get right to achieve payroll tax compliance. Failure to make proper tax withholdings or deposits can result in significant fines and penalties for a business.

Types of Payroll Taxes

While the withholding percentage may vary from employee to employee, all employees are subject to a minimum of federal payroll taxes. These taxes are specified in the Federal Insurance Contributions Act (FICA) and include federal income, Social Security, federal unemployment, and Medicare taxes. These tax-withholding rules apply regardless of whether employees are part-time, seasonal, or full time.

In addition to the minimum required federal payroll taxes, different states may require specific withholdings as well. Here are some additional details on federal and state payroll taxes important for employers to understand in order to ensure payroll tax compliance:

1. Federal income tax and state income tax are withheld by the employer from all employees’ wages, based on the information provided by employees on their Form W-4.
2. Federal Insurance Contribution Act (FICA) taxes are calculated on a percent tax for both Social Security and Medicare on all wages. Both of these taxes are split equally between employees and employers so that each pays 6.2 percent for Social Security and 1.45 percent for Medicare. Since 2013, employers have also had to withhold an additional 0.9 percent Medicare tax for annual wages paid to an employee in excess of $200,000 or $250,000 for employees who are married and file taxes jointly.
3. Federal Unemployment Tax (FUTA) is approximately 1 percent of the first $7,000 in wages paid to an employee and is paid in full by the employer. Technically, the federal unemployment insurance payroll tax is 6.2 percent of the first $7,000 of an employee’s wages. However, employers in states with their own unemployment insurance tax programs receive a 5.4 percent credit toward their federal tax payment, reducing their tax rate to 0.8 percent. Since all states have federally approved programs, the effective FUTA rate is 0.8 percent. For 2020, the FUTA tax rate is projected to be 6%, according to the IRS. It is important to note that not all payments made to employees are included in the annual wage that employers use to calculate FUTA payroll tax responsibility. Generally, gross wages, most fringe benefits, and certain employer contributions to employee retirement plans are included in this calculation and this total is subject to the 6% FUTA tax rate.
4. The State Unemployment Tax Act (SUTA) is a type of payroll tax that states require employers to pay. Unemployment Insurance (UI) is a federal-state program jointly financed through federal and state employer payroll taxes. The federal portion is the FUTA. The state unemployment tax differs from state to state, the rate being determined by each state separately and within the state for each employer separately. The UI program is based on experience-ratings. This means that within a given state, firms that lay off a higher percentage of workers and whose employees collect a higher amount of UI benefits pay higher tax rates than firms that lay off fewer workers.
5. Local Payroll Taxes may be imposed by cities and municipalities. These taxes are usually paid by both the employee and employer and vary in range widely.

Difference Between Payroll Tax and Income Tax

Payroll tax and income tax are similar concepts because both taxes are based on an employee’s wages or salary. However, while these terms are used interchangeably, they are different. Since employers are responsible for withholding, reporting, and paying taxes, they need to understand the differences between payroll and income tax to achieve maximum payroll tax compliance.

The payroll tax system usually refers to taxes for Medicare and Social Security that are withheld at essentially a flat rate from employee pay, with a portion also paid by the employer. Income tax is a more complex system because of taxing money earned from sources other than work and employing deductions, exemptions, and credits. Income taxes are mainly used for funding defense and national security programs.

Income taxes are withheld from an employee’s pay based on projected annual tax. They are deducted from employee wages or salary, based on a Form W-4 that the employee files, showing marital status, a number of exemptions for dependents and other allowances, and any additional amount an employee wants to be withheld. An employee does not have to have tax withheld for all dependents and can add any desired amount to the withholding.

Income and payroll tax obligations are often misunderstood, but it is critical for employers to know the difference and the impact they can have on businesses and employees. Understanding who is responsible for paying each, and the filing and payment deadlines can help employers prevent mistakes and maintain effective payroll tax compliance.

Forms Required to Calculate and Submit Payroll Taxes

For effective payroll tax compliance, it is important to know which forms apply at various stages throughout the employee life cycle. Failure to submit the proper paperwork within the federal guidelines can result in significant fines for businesses.

Before business owners can legally employ anyone in the U.S., they are required to register their company with the federal government and obtain an Employer Identification Number (EIN). This number is like a Social Security Number for businesses and is used to help track all employees’ tax payments. In addition to this, businesses may also need the following forms:

1. Form I-9 (Employment Eligibility Verification) must be filled out for every person hired to verify the person is eligible to work in the United States.
2. Form W-2 (Wage and Tax Statement) must be filled out annually for any employee who worked during the preceding tax year.
3. Form W-4 (Employee’s Withholding Allowance Certificate) is completed by the employee and provides the information needed to calculate how much federal income tax should be withheld from each paycheck.
4. Form 941 is the federal tax return for employers that is filed quarterly with the IRS.
5. Form 940 is the Federal Unemployment Tax Act (FUTA) return, which is filed annually with the IRS.
6. State and local required tax forms.

Form W-2

Form W-2 (Wage and Tax Statement Form) is an IRS tax form used in the United States to report wages paid to employees and the taxes withheld from them. Employers must complete a Form W-2 for each employee to whom they pay a salary, wage, or other compensation as part of the employment relationship. An employer must mail out the Form W-2 to employees on or before January 31. This deadline gives taxpayers about 2 months to prepare their returns before the April 15 income tax due date. The form is also used to report FICA taxes to the Social Security Administration.

Parts of The Form W-2

Form W-2 is a multipart form:

• Copy A goes to the Social Security Administration. Copy A is usually printed on a special laser-scannable red form. If filing a paper copy, employers need to use only the paper provided by the SSA,
• Copy 1 is for the city, state, or locality,
• Copy B is for filing with the employee’s federal tax return,
• Copy C is for the employee’s records,
• Copy 2 is another copy for a city, state, or locality,
• Copy D is for the employer’s records.

Information Necessary to Complete Form W-2

For each Form W-2, employers need to include information about their business:

• Employer ID Number,
• Business Name,
• Business Address,
• Business’s State Tax ID Number.

For each employee, employers need to update personal information:

• Social Security Number or other tax identification number,
• Name,
• Address.

It is necessary to provide information on total wages and withholding for each employee for last year:

• Total wages, tip income, and other compensation,
• Total Social Security wages,
• Total Medicare wages,
• Social Security tips and allocated tips.

Information on Retirement Plans

In Box 12, for each Form W-2 employers need to indicate if each employee participates in a retirement plan or a nonqualified plan with a company, if this employee is a statutory employee, or if the person received third-party sick pay.

Information on Special Benefits

Box 13 of the Form W-2 requires information about deductions for employee benefit plans and other deductions that must be reported on the employee’s income tax return.

Control Number

Employers may want to add an internal control number on each Form W-2 if they are paying many employees.

How to Complete and Send The Form W-2

After gathering all the necessary information and proper forms, employers need to follow instructions provided by the IRS in order to secure payroll tax compliance and avoid any errors.

Employers send the Form W-2 to the Social Security Administration (SSA) by the end of February. The forms can be submitted online to the SSA by using their Business Online service. In case there are 250 or more W-2 forms, employers have to submit them to the SSA online.

The Families First Coronavirus Response Act (FFCRA) and Form W-2

The Families First Coronavirus Response Act (FFCRA) was signed into law on March 18, 2020, as the second major legislative initiative designed to address the COVID-19 pandemic. The Act, which is effective April 1 through December 31, 2020, addresses the impact of COVID-19 by providing expanded nutrition assistance, paid sick leave, enhanced unemployment insurance coverage, free coronavirus testing, and increased federal Medicaid funding.

On July 8, 2020, the IRS and the Treasury Department issued Notice 2020-54, providing guidance for employers when reporting the FFCRA wages. According to this Notice, employers need to report Qualified Sick Leave Wages and Qualified Family Leave Wages separately, either on Form W-2 2020 or in a statement provided with the Form W-2. The guidance also gives employers some optional language they can use in the Form W-2 2020 instructions for employees.

Employers with fewer than 500 employees are required to provide mandatory sick and family leave pay to employees unable to work as a result of COVID-19. As these payments are taxable wages, they are reported in boxes 1, 3, and 5 of Form W-2 2020. However, FFCRA amounts must be separately reported either in Box 14 of Form W-2 or on a separate statement. If a separate statement is provided and employees receive a paper Form W-2 2020, the statement should be included with the Form W-2. In the case employees receive an electronic Form W-2 2020, the statement should be provided in the same manner and at the same time as the Form W-2.

Employers that are subject to paid leave requirements need to ensure that their Form W-2 reporting meets the new requirements. In spite of additional efforts to maintain Form W-2 tracking and reporting in accordance with the FFCRA paid leave wages, this is necessary for ensuring payroll tax compliance and adhering to complex and changing tax regulations.

Form W-4

Form W-4 is an IRS form that an employer uses to gather tax withholding information for an employee. Form W-4, which is the employee’s withholding allowance certificate, is typically provided once an employee has accepted an offer of employment and it needs to be completed prior to the first payroll. The payroll department will use the information on the W-4 to determine how much federal, state, and local taxes need to be taken out of the employee’s paycheck, based on what they choose on the Form W-4. The employee must indicate:

• Marital Status,
• Number of allowances,
• Additional deduction amounts.

The Tax Cuts and Jobs Act (TCJA) made significant changes to tax rates, deductions, tax credits, and withholding calculations, beginning in 2018. New IRS withholding tables were published in January, and the 2018 Form W-4 was released in February. The IRS made few changes for 2018 and determined that employees would not be required to complete a new Form W-4 for 2018. However, it was strongly recommended and for some people, it may be advisable.

Changing Amounts on Form W-4

Employees may change the amounts on Form W-4 at any time and as often as they wish. There is no time limit on how long Form W-4 stays in effect – it remains in effect until the employee changes it. At termination, Form W-4 continues in effect for withholding of FICA taxes for payments made after the termination date.

The most current Form W-4 must be signed by the employee and kept in the employee’s payroll folder to verify the amount of federal income tax withholding.

U.S. States and Form W-4

Many U.S. states use their own variation of the Form W-4 to record state withholding amounts. Some states do not allow electronic capture of W-4 information.

2020 Form W-4

On December 5, 2019, the IRS issued the redesigned 2020 Form W-4 that was expected ever since the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017. The 2020 Form W-4, Employee’s Withholding Certificate, is an updated version of the previous Form W-4, Employee’s Withholding Allowance Certificate. Major revisions included in the new form aim to simplify the process of filling out Form W-4 for employees and improve tax withholding accuracy.

The 2020 Form W-4 no longer uses the concept of withholding allowances to account for additional income, deductions, and tax credits. However, it includes lines where employees can enter those amounts directly so they can be used to calculate the withholding amount. Even though this Form W-4 is different, the IRS designed the withholding tables to work with a prior year form or the 2020 form and simplify payroll tax compliance.

Also, the IRS does not require all employees to complete a new form. However, the new form is required for all new hires in 2020 and for employees who have completed a Form W-4 before 2020 and want to make changes to their withholding in 2020. Employers may not require employees to complete a new form, they may ask them to do so. To explain how withholding is calculated with the prior year and 2020 Form W-4, the IRS also created Publication 15-T, Federal Income Tax Withholding Methods.

Form 940

IRS Form 940 is the federal unemployment tax annual report form. This form is used to report and pay unemployment taxes to the IRS.

The form calculates the employer’s federal unemployment tax liability, then adjusts for any state unemployment taxes paid, and calculates the unemployment tax due. Finally, the form compares the unemployment tax due for the year to the tax already paid. Employers need to pay any unemployment tax still due to the IRS.

Businesses have to file Form 940 if:

• Employers paid wages of $1,500 or more to employees in a calendar quarter of the year,
• Employers had one or more employees for at least some part of a day in any 20 or more different weeks in either of the past two years. Employers must count all full-time, part-time, and temporary employees, but not owners or partners.

The due date for Form 940 is January 31, for the previous year.

Completing Form 940

IRS Form 940 is used to compute the amount of federal unemployment tax liability of a business from the previous year. The form also is used to determine the amount of unemployment tax owed for the previous year, and any unpaid and due unemployment taxes.

The process of completing Form 940 includes:

• Calculating the total amount of payroll (the gross pay) for all employees for the year in question,
• Subtracting payments not included in unemployment tax liability, such as fringe benefits,
• Subtracting employee payments in excess of $7000 for the year,
• Finally, the federal unemployment tax is calculated based on these totals. The calculation is the total of all unemployment-taxable wages times the rate.

Form 941

Form 941 is the form used by employers to report withholding amounts for federal income taxes and FICA taxes, employer payments for these withholding amounts, and any amounts due to the IRS.

Form 941 includes quarterly calculations and reports:

• Reports of amounts withheld from employee paychecks for federal income taxes and FICA taxes,
• Calculation of amounts due, from taxable social security wages and Medicare wages from both employees and employer,
• Adjustments for tips and sick pay,
• Calculation of amount due in payment by the employer,
• Amounts already paid by an employer, on either a monthly or semi-weekly basis, depending on the number of employees and size of payrolls, and
• Any over or underpayment.

Form 941 Due Dates

Form 941 is due on a quarterly basis, at the end of the month following the end of the quarter, on the following schedule:

• For the first quarter of 2018, ending March 31, it should be submitted by April 30,
• For the second quarter, ending June 30, it should be submitted by July 31,
• For the third quarter, ending September 30, it should be submitted by October 31, and
• For the fourth quarter, ending December 31, it should be submitted by January 31, 2019.

If the due date falls on a weekend day or holiday, the due date is the next business day.

How to Complete Form 941

Form 941 calculations include totals for:

• Number of employees and total pay for the period being reported,
• Amounts withheld from the pay of employees for the period,
• Taxable Social Security and Medicare wages for the period,
• Calculation of total Social Security and Medicare wages.
• Adjustments for sick pay, tips, group-term life insurance, and others.

The form requires a calculation of the total taxes and the total deposits made during the period. The difference between the total taxes due and the total deposits is the amount still owed that must be paid.

Form 941 may be submitted electronically using Federal E-file.

Updated Form 941 for 2020

Given that several COVID-19 legislation introduced recently, including tax credits for employers, the IRS released the updated version of Form 941 for quarters two, three, and four of 2020. The purpose of the updates is to allow employers to report wages paid out due to the Families First Coronavirus Response Act (FFCRA) and the Coronavirus Aid, Relief and Economic Security Act (CARES). 

Form 941 is an essential part of claiming FFCRA and CARES credits. Therefore, it is critical that employers take into account not only updates to Form 941 but also to Schedule B and Schedule R in order to avoid costly disputes with the IRS and maintain payroll tax compliance.

The updated version of Form 941 includes many new fields for reporting data on coronavirus-related employment tax relief. The form itself has three parts, and while Part 1 and Part 3 have the new fields, Part 2 has no changes. Also, employers reporting tax credits under the CARES Act or FFCRA are required to complete Worksheet 1, Credit for Sick and Family Leave Wages, and the Employee Retention Credit.

Difference Between Form 940 and Form 941

These two forms are often confusing, but they are used for different types of taxes that employers must pay. Both forms go to the IRS.

• Form 940 is used for reporting and paying unemployment taxes annually.
• Form 941 is used for reporting payroll taxes quarterly. The payroll taxes included in this report are for federal income tax withholding and for withholding of FICA taxes for Social Security and Medicare.

It is easy to disregard some of the IRS requirements, especially when it comes to different forms that all seem similar. However, if taxes are paid without the proper form or with a form that contains inadvertent or deliberate errors, the taxes are not considered paid in full, resulting in penalties. Therefore, to avoid huge and costly mistakes and maintain payroll tax compliance, employers have to understand the differences between various IRS forms.

Collecting and Reporting Payroll Taxes

Once an employer either withholds or pays a payroll tax amount, these funds must then be paid to the appropriate tax authority:

• On a federal level payroll taxes are remitted to the Internal Revenue Service (IRS).
• For states, there is a relevant tax authority, such as the department of revenue for income taxes and the department of labor for unemployment taxes.
• Local taxes are paid to the appropriate local authorities, which can vary depending on the type of tax.

Payments to tax authorities follow a specific schedule that is often set by the size of a company and the amount of tax paid. When employers register their business with the IRS and any other authorities, they are given a payment schedule. If the schedule changes, they should receive a notification.

To ensure payroll tax compliance, employers have to file regular reports of the payroll tax amounts collected from payroll and paid to the IRS, state, and local tax authorities.

• On a federal level, income tax, Medicare, social security, and tipped wages are reported on a quarterly basis using Form 941.
• FUTA is reported annually using Form 940.
• On a state level, payroll taxes are reported quarterly using wage detail reports.
• Local reporting is set by the local tax agencies.
• At year-end, employers must provide W-2s to their employees and the relevant tax agencies by January 31.

Determining Payroll Tax Rates

There are a number of variables involved in setting and calculating the rates necessary for maintaining effective payroll tax compliance. The following is a general overview of where the current payroll tax rates can be found and how each of the main payroll taxes works:

• Each year the IRS updates Publication 15 (Circular E) — The Employer’s Tax Guide — containing the latest withholding tables and tax rates for federal income tax, FICA taxes and FUTA.
• The actual setting of the rates is done by lawmakers in Congress in collaboration with the related administrative agencies, such as the IRS, Social Security Administration (SSA) and Department of Labor (DOL).
• On a company level, the amounts withheld for federal income tax are also determined by each employee’s gross wages, bonus wages and W-4.
• For Medicare, the employer and employee each contribute 1.45% for a total of 2.9%.
  • Employees earning over $200,000 pay an additional 9%.
  • Employers are not responsible for contributing any additional amounts for these employees and there is no maximum taxable earnings limit.

• For social security, the employer and employee each contribute 6.2% for a total of 12.4% up to a maximum taxable earnings amount of $127,200.
• FUTA is set at 6.0% with a maximum taxable earnings amount of $7,000. However, if an employer pays their SUTA tax on time, they can receive up to a 5.4% deduction, taking the rate down to 0.6%.
• State income tax and SUTA rates are set by each individual state.
• Local taxes are unique to each locality.

Keeping Payroll Tax Records

Once employers pay over payroll taxes and file any necessary returns and reports, their last significant obligation necessary for payroll tax compliance is to maintain records that substantiate the payroll taxes they paid.

For federal tax purposes, employers need to retain records for at least four years after the due date of the return or the date the taxes were paid, whichever is later. A similar record-keeping requirement exists in each state, with varying time periods.

There is no particular form prescribed for properly retaining records. However, the records should be kept in a manner that will enable the IRS and state tax authorities to ascertain whether any tax liability has been incurred and if so, the extent of that liability.

The types of information employers should retain include:

• The name, address, and Social Security number of each employee,
• The total amount and date of each payment of compensation,
• The period of service covered by each payment of compensation,
• The portion of each payment of compensation that constituted taxable wages,
• Copies of each employee’s withholding exemption certificate (Form W-4),
• Dates and amounts of tax deposits made,
• Copies of returns employers filed,
• Copies of any undeliverable Form W-2.

To ensure payroll tax compliance, it is necessary to keep all required records at convenient and safe locations that are accessible to IRS representatives, so they can be available in case of IRS inspections.

Preventing Payroll Tax Penalties

There are not many opportunities for reducing exposure to payroll taxes. It is unwise to try and avoid employment tax liability by classifying workers as independent contractors. The IRS, the Department of Labor, and their state counterparts are aggressively targeting employers to uncover misclassification, and the penalties are severe. The biggest opportunity for realizing any kind of real savings is for employers to make sure they tend to obligations and avoid getting hit with penalties.

The biggest risk employers face in administering payroll tax obligations is that they can be held personally liable for all income and FICA taxes that they willfully either fail to withhold from employees’ wages or fail to pay to the IRS and state tax agencies.

Even if employers avoid the 100-percent penalty because their conduct wasn’t willful, they could face smaller penalties if their failure to withhold was due to misclassification of an employee as an independent contractor. In the context of tax penalties, willfulness requires that the individual’s conduct be intentional, knowing, and voluntary. In some cases, a reckless disregard of obvious facts will be enough to show willfulness.

If employers fail to prepare a Form W-2 for employees, or willfully furnish incorrect ones, they will be subject to a penalty per each statement that should have been sent or that was incorrectly prepared.

Failing to pay payroll taxes on time can happen to any employer given the different responsibilities they need to keep track of. To avoid this, employers have to closely follow constantly changing IRS announcements and resources. Also, each state has rules for depositing and reporting payroll taxes at the state level. Thus, to secure payroll tax compliance, employers need to pay close attention to state payroll tax regulations in the states where their employees work.

2020 Payroll Tax Changes and Payroll Tax Compliance Challenges

As the biggest relief bill in U.S. history, the CARES Act aims to reduce the economic impacts of COVID-19 and offer assistance to tens of millions of affected Americans. Apart from supporting small and large employers and specific industries, one of the key provisions of the CARES Act refers to payroll tax changes, in the form of payroll tax deferment and payroll tax credits.

Typically, employers have to remit their share of Social Security taxes for each employee’s covered wages on a semi-weekly or monthly basis. However, Section 2302 of the CARES Act allows employers to defer certain payroll taxes incurred between March 27, 2020, and December 31, 2020.

As a result, employers can defer their 6.2% share of the Social Security tax on each employee’s covered wages for the rest of the year and pay half at the end of 2021 and a half at the end of 2022. However, it is important to note that payroll tax changes do not cover other payroll taxes such as the Medicare tax or employee’s share of the Social Security tax. Also, there is no dollar cap on the total amount of employer social security taxes that may be deferred through December 31, 2020.

The CARES Act also provides tax credit for eligible employers to encourage them to continue paying employees. This benefit allows a 50 percent refundable payroll tax credit on wages paid up to $10,000 during the crisis. It can be claimed for employees who are retained but not currently working due to the crisis for firms with more than 100 employees, and for all employee wages for firms with 100 or fewer employees.

While 2020 payroll tax changes may be attractive to many employers, it is important to understand that they constitute a deferral, rather than a waiver of tax obligations. Therefore, employers should maintain concise records of their tax deferrals and credits, and be prepared to make timely payments of their payroll taxes when they come due.

As the impacts of the coronavirus change constantly, it is critical that employers keep a close eye on the latest developments and legislation affecting their payroll taxes, especially tax-saving and tax-deferral mechanisms. Also, to assure payroll tax compliance, employers have to follow laws as they adjust at the federal, state, and local levels of government.

Even though the relief legislation is beneficial to businesses, payroll tax updates present employers with new compliance challenges and potential penalties for errors. Outsourcing payroll tax management is the most effective and secure way to stay ahead of tax obligations and payroll tax changes. Thus, employers can ensure payroll tax compliance and adherence with ever-changing tax laws and regulations. As a result, they minimize tax and payment compliance risks, possibly reduce taxes and other expenses, and efficiently handle all aspects of the tax filing and remittance process.