Payroll Taxes
How to Maintain
Payroll Compliance
Author
Jeff Aleixo
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. 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:
- 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.
- 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.
- 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.
- State Unemployment Taxes. 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.
- Local Payroll Taxes. Cities and municipalities may impose a payroll tax. These taxes are usually paid by both the employee and employer and vary in range widely.
Federal, State and Local Payroll Taxes
Level
Name
Type of Tax
How It Works
Who Is Responsible
Federal
Federal Income Tax
Withholding Tax
Federal income tax is considered a pay-as-you-go tax that is withheld of an employee’s paycheck by the employer each time the employee is paid. The tax rate is determined by withholding tables that are published each year by the IRS as of Publication 15 – The Employer’s Tax Guide.
The employer is responsible for withholding federal income tax by taking it out of the employee’s paycheck with each payroll.
Federal Insurance Contribution Act (FICA) Taxes
Shared Tax
These are Medicare and Social Security Taxes. Rates are reviewed on an annual basis.
FICA taxes are split evenly between the employer and the employee. The employer is responsible for withholding the employee amount and depositing the employer amount with each payroll.
State
State Income Tax
Withholding Tax
Every state with the exception of Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming, has an income tax. Tennessee and New Hampshire only tax dividends and interest income, but not wages.
The employer is responsible for withholding state income tax by taking it out of the employee’s paycheck with each payroll.
State Unemployment Tax (SUTA)
Employer Tax
Every state has an unemployment tax that works in conjunction with the federal tax. The rates are determined by the state tax authorities and assigned to businesses upon registration.
In most states SUTA taxes are employer paid. In Alaska, New Jersey and Pennsylvania, both the employee and the employer contribute to these taxes.
Local
Local Taxes
These can be local income, school board, transit, municipality or almost any other kind of taxes.
Responsibilities vary depending on the tax authority and type of tax.
Difference Between Payroll Tax and Income Tax
Both payroll taxes and income taxes are based on an employee’s wages or salary. The difference is who pays – payroll tax is paid at least partly by the employer, while income taxes are paid by employees. Income taxes are withheld from an employee’s pay based on projected annual tax.
Income taxes are deducted from employee wages or salary, based on a Form W-4 that the employee files, showing marital status, number of exemptions for dependents and other allowances and any additional amount an employee wants withheld. An employee does not have to have tax withheld for all dependents and can add any desired amount to the withholding.
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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:
- 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.
- Form W-2 (Wage and Tax Statement) must be filled out annually for any employee who worked during the preceding tax year.
- 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.
- Form 941 is the federal tax return for employers that is filed quarterly with the IRS.
- Form 940 is the Federal Unemployment Tax Act (FUTA) return, which is filed annually with the IRS.
- 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 W-2 Form
A W-2 form 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 W-2 Forms
For each 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 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 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 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 W-2 Form
After gathering all the necessary information and proper forms, employers need to follow instructions provided by the IRS in order to avoid any errors.
Employers send the W-2 form 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.
Form W-4
A 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 W-4 form. 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 a W-4
Employees may change the amounts on a W-4 form at any time and as often as they wish. There is no time limit on how long a W-4 stays in effect – it remains in effect until the employee changes it. At termination, the W-4 continues in effect for withholding of FICA taxes for payments made after the termination date.
The most current 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 W-4 Forms
Many U.S. states use their own variation of the W-4 form to record state withholding amounts. Some states do not allow electronic capture of W-4 information.
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 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 employer, on either a monthly or semi-weekly basis, depending on the number of employees and size of payrolls, and
- Any over or under payment.
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 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 other.
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.
Difference Between Form 940 and Form 941
These two forms are often confused, but they are for different types of taxes that employers must pay. Both forms go to the IRS.
- Form 940 is for reporting and paying unemployment taxes annually.
- Form 941 is 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.
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 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.
Employers are also responsible for filing 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 for payroll taxes. 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.
Maintaining Payroll Tax Records And Avoiding Penalties
Once employers pay over payroll taxes and file any necessary returns and reports, their last significant obligation 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.
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.
Manage your direct and indirect tax compliance and reporting obligations effectively and get full support no matter what area of payroll or income tax is required.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.
