One of the issues that small business owners must contend with is staying current with their obligations to pay federal, state, and sometimes local taxes. While business owners often hire an accountant or other tax professional to deal with these matters for them, having a basic understanding of the tax system can head off a lot of problems. That's especially true with payroll taxes.
Here is what you need to know.
Key Takeaways
- Payroll taxes typically include federal taxes, state and local income taxes, FICA taxes (for Medicare and Social Security), and FUTA taxes (for unemployment insurance).
- Some states also have disability insurance taxes and paid family and medical leave taxes.
- Employers must be aware of and meet the various tax deadlines to avoid penalties.
- To calculate payroll taxes, employers must determine which workers are taxable employees and which, if any, are independent contractors.
- Then employers must determine taxable wages and calculate the amount of money that must be withheld from them.
What Are Payroll Tax Obligations?
Any business with employees must withhold payroll taxes from its employees' paychecks and pay applicable federal, state, and local taxes. Taxes typically withheld from an employee's paychecks include FICA (Medicare and Social Security taxes) and federal, state, and local income taxes, if applicable.
In addition to income taxes, other withholding obligations can include:
- Disability insurance taxes in California, Hawaii, New Jersey, New York, and Rhode Island
- Paid family and medical leave (PFML) taxes in California, Colorado, Connecticut, the District of Columbia, Massachusetts, New Hampshire, New Jersey, New York, Oregon, Rhode Island, Vermont, and Washington
- FUTA (Federal Unemployment Tax Act) taxes
Failure to pay these taxes or meet the payment deadlines can result in fines and penalties. So it's important to correctly calculate the amount that's owed and to pay it on time.
These rules apply to the owner's paychecks as well if the business isn't incorporated and there are no employees. The owner is essentially the sole employee of the business in this situation. The owner must pay also estimated taxes on their self-employment income each quarter.
Federal tax payments must be made online through the Electronic Federal Tax Payment System (EFTPS).
Steps To Calculate Payroll Taxes
There are three steps involved in calculating payroll taxes.
1. Identify Taxable Workers
Workers can be employees or independent contractors. Employees are treated as taxable workers subject to payroll taxes. Independent contractors are responsible for paying their own taxes. Workers are usually not considered to be employees if they have the right to direct and control when they work and how they do their work.
But the lines between independent contractors and employees are not always that clear-cut. These are some of the tests that can identify employees:
The Behavioral Test
A worker is an employee if the employer has the right to direct and control their work. The employer doesn't have to actually direct or control the worker but has the right to do so.
The Financial Test
This test looks at the degree of control an employer has over the financial aspects of the job. A worker with significant control over the supplies used for their work is an independent contractor in some professions.
Another way to distinguish an independent contractor from an employee is by the availability of their services. An independent contractor isn't tied to one company and can advertise their services and work for others.
An employee can't do this unless they're also working outside the company as an independent contractor for another business.
The Relationship Test
This test refers to the way the employer and the worker perceive their relationships. The worker is an independent contractor if the employer/worker relationship is expected to last only until the end of a certain project or for a specified period. The worker is a taxable employee if the relationship has no such boundaries.
2. Determine Taxable Wages
Taxable wages are compensation for services performed. They can include salary, bonuses, and gifts. Some forms of compensation, such as business expense reimbursem*nts for travel or meals, don't qualify as taxable wages. Employees must verify expenses with receipts or expense reports for them to be nontaxable. The expenses must also be ordinary, necessary, and business-related.
3. Calculate Withholding
After you've figured out which workers qualify as taxable employees and which payments to them are taxable wages, the next step is determining what you must withhold for federal, state, and local taxes, as well as for FICA and FUTA.
Federal Income Taxes
Every paycheck must withhold federal income tax for the applicable period. The IRS has two sets of tax tables that employers can use to calculate withholding amounts: wage bracket tables and percentage tables.
It's your responsibility as a business owner to determine which is appropriate for your business. Using the wage bracket tables is generally easier, although the percentage tables accommodate more payroll periods (from daily to semiannually).
Percentage tables also allow for the calculation of tax withholding for employees whose incomes are higher than those reflected in the wage bracket tables.
FICA Taxes
The Federal Insurance Contributions Act (FICA) is the federal law that requires employers to withhold Social Security and Medicare taxes from wages paid to employees. It also requires that the employer and employee each pay half of the FICA tax. (If you're self-employed you pay both halves.)
Social Security and Medicare taxes are imposed on both the employee and employer at a flat rate of 6.2% each for Social Security and 1.45% each for Medicare. This creates a combined FICA tax rate of 15.3%: 12.4% for Social Security and 2.9% for Medicare.
FICA taxes are unaffected by the number of withholding allowances claimed by an employee, unlike federal and state taxes. You simply multiply an employee's gross wage payment by the applicable tax percentage to determine how much you must withhold and how much you must pay as the employer.
The Social Security tax only applies to the first $168,600 of income in 2024. This cap is referred to as the Social Security wage base and it's adjusted every year for inflation. The Medicare tax doesn't have an income limit.
FUTA Taxes
Federal unemployment taxes (FUTA) are paid solely by the employer. You must pay unemployment taxes if either of the following situations applies:
- You pay wages totaling at least $1,500 in any calendar quarter, or
- You have at least one employee on any given day for 20 weeks in a calendar year, regardless of whether the weeks are consecutive. The employee can be full-time, part-time, or temporary.
The FUTA tax rate is 6.0% and it's imposed on the first $7,000 of wages for each employee. However, you can claim credits against your gross FUTA tax to reflect the state unemployment taxes that you pay. You're allowed to claim a 5.4% credit that effectively reduces your FUTA tax rate to 0.6% if you pay your state unemployment taxes when they're due.
State Taxes
Most states use tables similar to the federal tax tables and you can find them on the website of your state's tax or revenue department. You don't have to withhold state taxes in states that don't impose taxes on income: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming.
Warning
Failing to deposit federal tax withholdings on time can result in penalties of up to 15%.
What Are Payroll Taxes?
Payroll taxes consist of income taxes (federal, state, and sometimes local) and FICA taxes (Social Security and Medicare). Payroll taxes can also include other taxes, depending on the state and local jurisdiction.
What Is the Difference Between Payroll Tax and Income Tax?
Payroll tax refers to various taxes that are withheld from an individual's paycheck. That definition often includes income taxes, although the term is sometimes limited just to FICA taxes for Social Security and Medicare.
Do You Pay Payroll Taxes on All Income?
You don't pay payroll taxes on all income. Payroll taxes include Social Security tax and Medicare tax, and there's an income cap on the Social Security tax. The cap is $168,600 in 2024. Income earned above this amount is not taxed for Social Security purposes. Medicare tax, however, has no cap.
The Bottom Line
Employers face a series of tax deadlines throughout the year. Knowing them and paying on time can prevent the levying of penalties and late fees.
For example, federal income and FICA taxes must be paid semi-monthly or monthly. The IRS usually sends business owners a notice at the end of each year indicating which method they should use for the upcoming year. FUTA taxes usually must be paid quarterly.
