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How Payroll Taxes Affect Your Small Business

Michelle Mire

Blogmaster, content expert and marketing guru at Wagepoint.
Michelle is having fun (seriously I am) extolling the virtues of small business payroll and generating articles with actionable advice for small businesses and startups. Michelle probably needs to get out a little more often.

Everyone has come to accept that taxes are a fact of life. But how often do we stop and take a look at what these taxes really are?

While business and income taxes make the headlines, few of us actually know what payroll taxes are and how they work.

This isn’t a personal fault—we’re all busy. As long as the check clears, we’re happy. We all do it. We read the total paid without taking a careful look at the deposits (amounts put in) and withholdings (amounts taken out).

Surprising Payroll Tax Statistics

While it’s understandable that we don’t know much about payroll taxes, the truth is we should.

Fact #1: Employers and employees pay more in payroll taxes than they do in income or business taxes.

  • Because of the way the rates are structured and the taxes are implemented, 62% of middle-class households pay more in payroll taxes than in income taxes. 
  • The approximately $1 trillion in payroll taxes (employment taxes) collected by the Internal Revenue Service (IRS) in 2016 was nearly triple that of the $345 billion collected in business income taxes.

Fact #2: Most employers are small businesses, and most employees work for small businesses.

  • Of the 5.83 million firms with employees in the United States, 99.7% of have fewer than 500 workers and 89.4% have less than 20 employees.

Fact #3: Payroll taxes are extremely costly and time consuming.

  • The amount paid in tax penalties each year is enough to pay for a new navy destroyer.
  • On average, 1 out 3 business owners are penalized for payroll mistakes.
  • Small businesses are the ones who make the most mistakes.

payroll-tax-payroll-taxes

What Are Payroll Taxes?

Put simply, payroll taxes are the taxes used to fund programs like Medicare, social security, and unemployment insurance. (You’ve heard of them. You just might not have known the lingo.)

But (and there’s always a but), because the U.S. government is divided into federal, state, and local jurisdictions, there are federal, state, and local payroll taxes. Just as it sounds, all these levels of legislation have a multiplier effect. The more taxes there are, the more rules there are to follow.

In a previous post on the complexity of payroll taxes, small business expert Rieva Lesonsky noted that between 2001 and 2012 there was an average of one change a day to the more than 15,000 tax codes in the United States.

Federal Payroll Taxes

In the context of payroll, the three main federal payroll taxes are:

  1. Federal income tax
    • When an employer pays an employee, the employer is responsible for withholding the proper amounts from the employee’s paycheck.
    • The amounts withheld are determined by federal income tax tables, the rate of pay, and the exemptions claimed through employee W-4s.
    • While income tax is a specific kind of tax all its own, it’s categorized under payroll taxes due to the employer’s responsibility to withhold the proper amounts.
  2. Federal Insurance Contribution Act (FICA) taxes—Medicare and social security
    • Employees and employers both pay the same amount for FICA taxes.
      • The 2017 combined rate for Medicare is 2.9%.
        • Employees earning $200,000 or more per year must pay an additional 0.9%. (Employers are not subject to this increase.)
      • The 2017 combined rate for social security is 12.4% on the first $127,200 in earnings.
  3. Federal Unemployment Tax Act (FUTA)—Federal unemployment
    • The employer contributes the entire amount due for FUTA taxes.
    • The 2017 amount is 6% of wages up to $7,000.

State and Local Payroll Taxes

Like the federal government, state and local governments also have payroll taxes, including state income tax and state unemployment taxes (SUTA). Local taxes vary and can be anything from a flat income tax to a tiered transportation or school board tax.

  • Like federal income taxes, state income taxes are withheld from employee paychecks.
    • Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming are the only states without an income tax.
    • Tennessee and New Hampshire only tax dividends and interest income, but not wages.  
  • Like FUTA taxes, SUTA taxes are employer-paid.
    • Once an employer has a consistent record of on-time payments for SUTA taxes, they can claim a credit that reduces their FUTA taxes.
  • Workers’ compensation insurance is required by every state except Texas.
    • Employers pay the premiums.  
    • The thresholds for coverage are set by the number of employees and level of risk within a specific industry, like construction or tightrope walking.
  • California, Hawaii, New Jersey, New York, Puerto Rico, and Rhode Island all require disability insurance.  
    • Payment responsibilities (employee, employer, or both) vary by state.
  • Local taxes vary in terms of whether they’re paid by the employee, employer, or both.

Other Considerations

Payroll contributions, like bonuses, commissions, overtime pay, back pay, and accumulated sick pay are all considered taxable income. As a result, these bonus wages are subject to a 25% flat tax by the IRS and an additional percentage by the state. Basically, almost every form of income falls under some kind of taxation.

Employer Responsibilities

Employer responsibilities for payroll taxes include:

  • Calculating the proper tax amounts and either withholding or depositing these sums.
  • Reporting and paying these amounts to the proper federal, state, and local authorities—according to schedules.
  • Make sure that employee withholding amounts are processed with every payroll.
  • Paying the employer contributions on a timely basis, according to schedules set by the various tax agencies.
  • Providing year-end documentation to the tax authorities and employees.

January 31st is a key annual deadline for employers. By this date, employers must have given each employee a W-2 reflecting income and tax amounts. (One part of each W-2 is sent to the Social Security Administration as well.)

IRS Forms 940 Employer’s Annual Federal Unemployment (FUTA) Tax Return and 941 Employer’s Quarterly Federal Tax Return are also due on January 31st. (As its name implies, Form 491 is also due once a quarter. The deadlines are April 30th, July 31st, and October 31st.)  

On a state level, employers must file quarterly wage detail reports to document SUTA amounts.

The term for following all these rules is compliance. The more you learn about payroll and payroll taxes, the more you’ll hear about compliance.

Employee Responsibilities

An employee’s role in relation to payroll taxes is primarily advocacy—specifically with providing correct information when providing a W-4 to an employer. When completing this document, employee must accurately provide their full legal name, social security number, and current address. And they must accurately select which tax exemptions apply.

Throughout the year, employees should review their pay stubs to ensure that right deductions are made and that the numbers add up. If anything seems off, the employee should speak up and ask questions.

Whenever there’s a change to the employee’s tax exemptions, like getting married or having a child, the employer needs to be notified, using a revised W-4, so that this can be applied to the payroll taxes. Name and address changes should also be shared with employers. If the information doesn’t match up at the tax agency, it can cause problems and delays.

Note: The exchange of accurate information should be a collaborative process. It’s also a good idea for employers to check in with employees once or twice a year to ensure that all of their personal and tax information is up to date.

Ultimate Responsibility  

With the sheer number of taxes, rules, and process, mistakes are almost par for the course. Using small business accounting software and payroll software definitely help by automating calculations, withholdings, deposits, and reporting. However, they are only tools and only as good as the information that’s entered.

This is why, time and again, the ultimate responsibility for any mistake falls back to the employer (business owner). In extreme cases, the IRS will even seize personal assets and seek criminal charges.

In addition to the legal and financial consequences, payroll mistakes also impact employee morale. Employees trust that their employers will pay them accurately and on time. Once this trust is broken, it can take a long time to repair.

Where to Find More Payroll Tax Information

While this post is detailed, it really only scratches the surface of everything that’s involved with payroll taxes. Employers who want to learn more about payroll taxes can use any of these resources to track down the information they need:

  • A professional accountant or bookkeeper. (If you’re not a financial whiz, a good accountant and bookkeeper are lifesavers.)
  • The IRS overview of employer taxes and Publication 15 The Employer’s Tax Guide.
  • This interactive, state-by-state payroll tax map and companion guide.

Where to Go From Here

One of the mottos for all things entrepreneurs is never stop learning. Find the news sites and blogs you like and stay up-to-date on the topics that matter to you and your business.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.

Michelle Mire

Blogmaster, content expert and marketing guru at Wagepoint.
Michelle is having fun (seriously I am) extolling the virtues of small business payroll and generating articles with actionable advice for small businesses and startups. Michelle probably needs to get out a little more often.

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