This article is written by Sheryl Schuff and was originally published on July 10, 2013. It is intended for the U.S. business audience.
Many small business owners think payroll processing is simple. Well, it’s only simple if everything is set up properly at the beginning. And that’s a big if.
Some of the largest financial risks entrepreneurs suffer are penalties and interest fees for incorrect payroll tax reporting. It’s definitely worthwhile to understand what’s involved before getting started.
Here are the top things you need to know before starting out.
1. What counts as payroll?
The most common forms of payroll are wages and salaries paid to employees for services performed in a business. Wages also includes tips, bonuses, commissions, and fringe benefits such as vacation.
2. 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, workspace, insurance, vacation, and other benefits.
If you classify workers as contractors and the IRS later decides they are employees, you can be liable for unpaid employment taxes, fines, penalties, and interest fees.
3. 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 in that state. Employers withhold the same amount of federal taxes no matter where the employee lives or works.
State income taxes are usually determined by considering the state, which state the employee works (business operates) and where the employee lives. In most cases, employers have a withholding responsibility in the state where their employee actually works, which can either be their resident or nonresident state.
Here’s where things get tricky. Depending on where the employee lives, employers can withhold employee’s state income tax for his/her home state. Special income tax arrangements can also be made for bordering states.
4. 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, city, county and local income tax
- Plus, any additional taxes that can vary by state (e.g. disability insurance)
5. What payroll taxes have to be paid?
All withheld taxes plus any employer contributions (as required) must be paid to the agency responsible for collecting them (either the IRS, State Department of Revenue/Taxation, State Department for Labor, or Employment Services).
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 insurance contributions from their own funds.
6. What are the payroll tax rates?
Federal income tax withholding is determined by an employee’s W-4 form. Most states have their own forms for employees to fill out to determine State withholding, while other states use the federal W-4 form. For 2018, social security is 6.2 % on the first $113,700 of wages. The Medicare tax is 1.45% on the first $200,000 of wages and 0.9% for anything over that (with different thresholds applying for joint and married filing separately). Note that there are employer and employee portions for both social security and Medicare taxes.
State, city, local and municipal tax rates are different for each state.
State unemployment tax rates depend on a variety of factors. These include the type of industry, 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.
7. When do payroll taxes have to be paid?
The frequency of federal tax payments depends on the employer’s tax liability (amount due). Generally, towards the end of each year, IRS mails notices to employers informing the schedule they should use for depositing payroll taxes for upcoming calendar year. The determination is based on the 12-month look-back period, ending June 30th of the previous year (the four prior quarters). Most employers will be required to make semi-weekly or monthly deposits.
State payroll taxes are different for each state and employers have to refer to their state tax laws for determining the state withholding tax deposit schedule.
Calculating payroll taxes is a task that can overwhelm even the most experienced business owners. If you’re a business owner in New York, California, Florida, Texas, Illinois or Washington, there’s an option to have your payroll tax payments and calculations done for you.
8. How are payroll taxes paid?
All Federal withholding and unemployment taxes must be paid electronically through Electronic Federal Tax Payment System (EFTPS); paper checks are not accepted. If the date on which employers are required to make a federal tax deposit falls on a non-business day, then employers have until the close of next business day (any day other than a Saturday, Sunday, or legal holiday) to make a timely deposit.
Some states also require electronic payments. Your business must register for an account with each tax collection agency in the state for which you have to pay.
Employers can be assessed penalties for failing to make payroll tax deposits on time. In general, the timeliness of a deposit is determined the the date it’s received. You don’t want to be late with your deposits.
9. Are any employees ever exempt from payroll taxes?
Yes. Children under age 18 years 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 unemployment taxes as well. Payment for the services of a child are subject to income tax withholding, regardless of age.
A husband or wife who works for their spouse in a sole proprietorship is also excluded from paying federal unemployment taxes.
Once again, the specific rules and regulations do vary from state to state.
10. How does the business owner get paid?
This is such a complex topic that we aren’t fully able to cover in depth here. We’re in the process of researching and writing a detailed article aimed at business owners who are interested in paying themselves—stay tuned in the next few weeks!
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.