With the recent launch of Wave’s brand new payroll tax filing service, Wave Pro Sheryl Schuff offers her advice...

Many small business owners think payroll processing is simple. It can be simple if everything is set up properly at the beginning, but that’s a big if.  Some of the largest financial risks entrepreneurs take are penalties and interest fees for incorrect payroll tax reporting, so it’s definitely worthwhile to understand what’s involved before getting started.

Here are the top 10 things you need to know.

What is “payroll?”

The most common forms of payroll are wages and salaries paid to employees for services performed in a business.  Payroll also includes tips, bonuses, commissions, and fringe benefits such as vacation.

Who are employees?

Improper classification of workers can cause substantial financial consequences and is one of the most important parts of payroll to understand.

It can be tempting to classify all part-time, seasonal, short-term and occasional workers as independent contractors rather than employees to save money on payroll taxes. It’s not a good idea. Descriptions are not what matters. 

What is important is how the IRS and your State classify workers, which is unique to each situation and considers about 20 different items.  The most important are whether you (the employer) have the right to control what work will be done, how it will be done, and where it will be done.  Other items include whether you provide tools, equipment, work space, insurance, vacation, and other benefits.

If you treat workers as independents and the IRS later decides they are employees, you can be liable for back taxes, fines, penalties, and interest fees.  

Does it matter where employees live?

Absolutely! An employee’s permanent residence is considered his or her tax “home” and determines what taxes he or she has to pay (and his employer has to withhold).  Employees who live outside the US generally don’t have to pay US income taxes.  

State income taxes are usually determined by considering the State, where the business operates within the State and where the employee lives. Special income tax arrangements can also be made for bordering states.

What taxes have to be withheld from employee paychecks?

In most cases employers are required to withhold the following taxes (although there are some exceptions):  

  • Federal income tax
  • Social security tax
  • Medicare tax
  • State, county, local income tax

What payroll taxes have to be paid?

All withheld taxes must be paid to the agency responsible for collecting them (e.g. the US Treasury and the State Department of Revenue).

Additionally, employers must match the amount of Social security and Medicare taxes withheld from employee paychecks and pay those, too.

Employers also have to pay Federal and State unemployment taxes from their own funds (i.e. these taxes are NOT withheld from employee pay).

What are the payroll tax rates?

Federal income tax withholding is determined by an employee’s W-4 form. States have their own forms for employees to fill out to determine State withholding. Currently, social security is a 6.2 % on the first $113,700 of wages. The Medicare tax is 1.45% for all wages.

Federal and State unemployment tax rates depend on the length of time the employer has had employees on payroll, the size of any unemployment claims charged to the employer’s business, and whether the State has borrowed Federal funds to pay its workers’ unemployment benefits.

When do payroll taxes have to be paid?

The frequency of payroll tax payments depends on the employer’s tax liability and his or her tax payment history.  Most small businesses pay Federal and State payroll taxes one month after wages are paid.  These businesses also typically pay State unemployment taxes at the end of the month following the end of a calendar quarter.

How are payroll taxes paid?

All Federal payroll and unemployment taxes must be paid electronically; paper checks are not accepted.  Some states also require electronic payments.  Your business must register for an account with each tax collection agency you have to pay.

Are any employees ever exempt from payroll taxes?

Yes.  Children who work for their parent (s) in a sole proprietorship or partnership don’t have to pay social security or Medicare taxes. If they are under 21, they are exempt from Federal and State unemployment taxes as well.  

A husband or wife who works for their spouse in a sole proprietorship is also excluded from paying Federal and State unemployment taxes.

Employees of any business who certify on a Form W- that they had a right to refund of all Federal income tax withholding for the prior year because they had no tax liability AND they expect the same conditions to be true for the current year will be exempt from Federal income tax.

How does the business owner get paid?

This depends on the legal structure of the business, what Federal income tax return is filed by the business, and whether the owner is actively working in the business.

Sole proprietors and single member LLCs who file Schedule C with Form 1040 are not considered employees and do not receive payroll subject to payroll taxes.

Partners in a partnership and members of LLCs who file Form 1065 are not considered employees and do not receive payroll subject to payroll taxes.

Owners of C corporations and LLCs who file Form 1120 and who perform the day-to-day work of the business will be considered as employees and receive payroll subject to payroll taxes. 

Owners who are officers but don’t actively participate in the normal work of the business are not employees but might receive payments such as director’s fees which are not subject to payroll taxes.

Owners of S corporations and members of LLCs who file Form 1120S and who actively work in the business are employees and receive payroll subject to payroll taxes. Owners who are officers who don’t actively participate in the normal work of the business are not employees but might receive payments such as director’s fees, which are not subject to payroll taxes.

Individuals who own 100% of an S corporation or LLC that files Form 1120S are always considered employees. These owners are under increased scrutiny the past several years as they typically prefer to take draws rather than payroll to avoid paying the associated payroll taxes.