Posted by SG Quality Accounting Corp.

Payroll Taxes

Payroll Taxes

Payroll taxes are all taxes collected by federal, state, and local governments based on wages paid to employees. All businesses that have employees must deduct these taxes from the wages of their employees. They are sent monthly or weekly, depending on the amount owed.

The Internal Revenue Service (IRS) requires that most businesses with employees hold and file Federal Wages, Social Security, and Medicare taxes. It can be difficult to withhold, file, and remit payroll taxes, but these are tasks that business owners need to do well in order to comply with payroll taxes. Failure to comply with appropriate tax withholding or tax filings can result in significant fines and penalties for a business.


Types of payroll taxes

While the withholding rate may vary from employee to employee, all employees are subject to minimum federal payroll taxes. These taxes are defined in the Federal Insurance Contribution Act (FICA) and include federal income taxes, social security, federal unemployment, and Medicare. These tax withholding rules apply whether employees work part-time, seasonal, or full-time.

In addition to federal taxes on the minimum wage required, different states may also require specific deductions. Here are some more payroll tax details that employers need to understand to ensure payroll tax compliance:

  • The employer withholds federal income tax and state payroll tax from all employees, based on information provided by employees on Form W-4.

  • FICA (Federal Insurance Contribution Act) taxes are calculated based on a Social Security and Medicare tax rate for all wages. The two taxes are shared equally between employees and employers, each paying 6.2% for Social Security and 1.45% for Medicare. Employers must also withhold an additional 0.9% Medicare tax on annual wages paid to an employee over $200,000 or $250,000 for married employees who file joint income tax returns.

  • Federal Unemployment Tax (FUTA) represents about 1% of the first $7,000 of wages paid to an employee and is paid in full by the employer. From a technical standpoint, the FUTA payroll tax is 6.2% on the first $7,000 of an employee's salary. However, employers in states with unemployment insurance tax programs receive a 5.4% credit toward paying federal taxes, which reduces the rate to 0.8%. 

Since all states have federally approved programs, the effective rate of FUTA is 0.8%. For the 2020 tax year, the FUTA rate is expected to be 6%, according to the Internal Revenue Service. It is essential to note that not all payments made to employees are included in the annual salary that employers use to calculate FUTA payroll tax. In general, most fringe benefits, gross wages, and some employer contributions to employee pension plans are included in this calculation, and this total is subject to the FUTA rate of 6%.

  • The SUTA (State Unemployment Tax Act) is a type of payroll tax that states require employers to pay. Unemployment Insurance (UI) is a federal-state program funded jointly by federal and state employer payroll taxes. The federal part is FUTA. State unemployment tax varies from state-to-state, with the rate set by each state independently and within the state for each employer separately. The unemployment insurance program is based on experience rating. This means that in a given state, companies that lay off a higher percentage of workers and whose employees receive more unemployment benefits pay higher tax rates than companies that lay off fewer workers.

  • Cities and towns can impose local taxes on wages. These fees are generally paid by the employee and the employer and vary widely.


Forms required to determine and submit payroll taxes

For effective compliance with the payroll tax, it is important to know which forms to apply to the different stages of the employee's life cycle. Failure to follow the proper documentation in accordance with federal guidelines can result in significant penalties for businesses.

Before employers can legally hire anyone in the United States, they must file their business with the federal government and obtain an EIN (Employer Identification Number). This number is like a business social security number and is used to track tax payments for all employees. In addition, companies may also need the following forms:

  • Form 940 is the FUTA filed annually with the IRS.

  • Form 941 is the federal income tax return for employers that is sent quarterly to the IRS.

  • Form I-9 (Verification of Employment Eligibility) must be completed for each employee to verify that that person is qualified to work in the United States.

  • Form W-2 (Wages and Income Tax Statement) must be completed annually for all employees who worked during the previous fiscal year.

  • Form W-4 (Employee Withholding Allowance Certificate) is completed by the employee and provides the information necessary to calculate the amount of federal income tax to be withheld from each salary.

  • State and local forms are required.


Collection and Reporting Payroll Taxes to Avoid Fines and Penalties

Once an employer has withheld or paid a payroll tax, these funds must be remitted to the relevant tax authority:

  • At the federal level, payroll taxes are paid to the Federal Internal Revenue Service (IRS).

  • There is a competent tax authority for states, such as the Department of Revenue for income tax and the Department of Labor for unemployment tax.

  • Local taxes are paid to the relevant local authorities, which may vary depending on the type of tax.

Payments to tax authorities follow a particular schedule generally defined by the size of the business and the amount of tax paid. When business owners register their business with the IRS and any other authority, they are given a payment schedule. If the schedule changes, they should be notified.

To ensure payroll tax compliance and avoid penalties, employers must periodically report payroll tax amounts collected and paid to the Internal Revenue Service, state, and local tax authorities.

  • At the end of the year, employers must provide W-2 forms to their employees and relevant tax agencies by January 31.

  • At the federal level, income taxes, health insurance, social security, and wages paid are reported quarterly using Form 941.

  • At the state level, payroll taxes are reported quarterly using detailed payroll reports.

  • FUTA is reported annually using Form 940.

  • Local tax agencies prepare local reports.



Determination of payroll tax rates

A number of variables are involved in defining and calculating the taxes necessary to maintain effective compliance with payroll taxes. Below is an overview of where you can find your current payroll tax rates and how each of the major payroll taxes works:

  1. Each year, the IRS updates Publication 15 (Circular E), the employer's tax guide, which contains the latest withholding and federal income tax, FICA, and FUTA taxes.

  • At the company level, the amounts withheld for federal income tax are also determined by the gross salary of each employee, the bonus, and the W-4 form.

  • The effective rate is set by parliamentarians of Congress in collaboration with relevant administrative agencies, such as the IRS, SSA (Social Security Administration), and Department of Labor (DOL).

  1. For Medicare, employer and employee each contribute 1.45% for a total of 2.9%.

  • Employees earning over $200,000 pay 9% more.

  • Employers are not responsible for contributing additional amounts for these employees, and there is no upper limit on taxable income.

  1. For Social Security, the employer and employee each contribute 6.2% for a total of 12.4% up to a maximum taxable income of $127,200.

  2. The FUTA is set at 6.0% with a maximum taxable income of $7,000. However, if an employer pays tax on time, they can claim a deduction of up to 5.4%, reducing the rate to 0.6%.

  3. Each state defines income tax and SUTA tax.

  4. Local charges are exclusive to each locality.


Keeping records of payroll taxes

Once employers have paid payroll taxes and filed the necessary returns and reports, their last major obligation to comply with payroll tax is to keep records to support the payroll taxes they have paid.

For federal tax purposes, employers must keep records for at least four years from the filing due date or the tax payment date, whichever is later. There is a similar requirement for record-keeping in each state, with different time intervals.

There is no specific way to properly keep records. However, records should be kept in a manner that allows the IRS and state tax authorities to determine whether any tax liability has been incurred and if so, the extent of that liability.

The types of information employers should keep include:

  • Name, address, and SSN of each employee,

  • The date and total amount of each payment of compensation,

  • The period of service covered by each payment of compensation,

  • The portion of each indemnity payment that was taxable wages,

  • Copies of each employee's withholding tax certificate (form W-4),

  • Dates and amounts of tax deposits made,

  • Copies of returns filed by employers,

  • Copies of all W-2 forms that could not be delivered.

To ensure payroll tax compliance, all necessary records should be kept in convenient and secure locations accessible to IRS officials so that they can be made available for IRS inspections.


Prevention of payroll tax penalties and fines

There are not many opportunities to reduce exposure to payroll taxes. It is not wise to try to avoid unemployment tax liability by classifying workers as independent contractors. The IRS, the Department of Labor, and other state counterparts aggressively attack employers for misclassification, and the fines and penalties are severe. The biggest real opportunity for savings of any kind is for employers to ensure compliance and avoid penalties.

The biggest risk employers face when managing payroll tax obligations is that they may be personally responsible for all FICA income and taxes that they "willfully" fail to withhold from employee wages or fail to pay to the IRS and other relevant agencies.

Even if employers avoid the 100% penalty because their behavior was not "willful," they could face lower penalties if misclassifying employees caused the non-compliance as independent contractors. In the context of tax sanctions, willfulness requires that an individual's behavior be intentional, conscious, and willful. In some cases, careless neglect of the obvious facts will be enough to show willfulness.

Suppose employers do not prepare a W-2 form for employees or intentionally provide the wrong forms. In that case, they will be subject to a penalty for any returns that should have been sent or were prepared incorrectly.

Not all employers can pay payroll taxes on time, given the different responsibilities they have to control. To avoid this, employers should closely monitor the announcements and the ever-changing IRS resources. In addition, each state has rules for recording and filing state payroll taxes. Therefore, in order to ensure payroll tax compliance, employers should pay close attention to national payroll tax regulations in the states where their employees work or get the services of a competent tax expert.


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