Small Business Tax Obligations: Payroll Taxes

One of the issues small-business owners have to contend with is staying current with the many obligations for local, state, and federal taxes. While most business owners hire an accountant or a tax professional to deal with tax-related issues, understanding the tax system is important to those who bear the ultimate responsibility for fulfilling all tax obligations. This article will focus on the business owner's obligations with regard to payroll taxes.

What Are Payroll Tax Obligations?

Any business with employees must withhold payroll taxes from employees' paychecks and pay applicable federal, state, and local taxes. The taxes usually withheld from employee paychecks include FICA (Medicare and Social Security taxes) and federal, state, and local income taxes, if applicable.

Other withholding obligations include FUTA (Federal Unemployment Tax Act) and, in states such as California, Hawaii, New Jersey, New York, and Rhode Island, disability insurance taxes. Failure to pay taxes or missing a payment may result in heavy fines and penalties, so it is important to calculate the amount of payroll taxes owed and to pay them on time.

If the small-business owner does not have outside employees but is incorporated, the above rules apply to the owner's paychecks as well, because they are essentially the sole employee of the corporation. If the business is not incorporated and there are no employees, the owner will need to pay estimated taxes on self-employment income each quarter.

There are three steps to calculating payroll taxes:

1. Determine taxable workers
2. Determine taxable wages
3. Calculate withholding amounts

Identifying Taxable Workers

Workers can be employees or independent contractors. Employees are treated as taxable workers subject to payroll taxes, while independent contractors are responsible for paying their own taxes. Usually, workers are considered employees if they have the right to direct and control the way they do their work, rather than merely the results of the work.

However, the lines between independent contractors and employees are not always clear-cut. In order to help business owners determine which workers are taxable employees, the Internal Revenue Service (IRS) has common law rules, which include behavioral, financial, and relationship tests.

Behavioral Test

A worker is an employee when the employer has the right to direct and control the worker. The employer does not have to actually direct or control the worker but has the right to do so.

Financial Test

This test looks at the degree of control an employer has over the financial aspects of the job. In some professions, having significant control over supplies used for work supports a worker's status as an independent contractor.

One definite way to distinguish an independent contractor from an employee is by the availability of services. An independent contractor is not tied to one company and can advertise services; an employee cannot advertise services unless they are working outside the company as an independent contractor.

Relationship Test

This test refers to the way the employer and the worker perceive their relationship. If an employer-worker relationship is expected to last until the end of a specific project or for a specified period of time, then the worker is an independent contractor. On the other hand, if the relationship has no boundaries, the worker is a taxable employee.

Determining Taxable Wages

Taxable wages are compensation for services performed and may include salary, bonuses, or gifts. Some forms of compensation, such as business-expense reimbursements for travel or meals, do not qualify as taxable wages. For the expenses to be nontaxable, employees must verify them through receipts or expense reports. They must also be necessary, reasonable, and business-related.

Calculating Withholding

After you've figured out which workers qualify as taxable employees and which wages are taxable wages, the next step is figuring out the amount you must withhold for federal, state, and local taxes, as well as FICA and FUTA.

Federal Taxes

Every paycheck must withhold federal income taxes for the applicable period. The IRS has two sets of tax tables that employers can use to calculate withholding amounts: the wage bracket tables and the percentage tables.

The wage bracket tables are segregated for five different payroll periods (daily, weekly, bi-weekly, semi-monthly, and monthly). To determine withholding amounts, employers pick the applicable pay period and wage bracket for employees, then read across the table to the column that shows the filing status.

Like the wage bracket tables, the percentage tables are available for five payroll periods (daily, weekly, bi-weekly, semi-monthly, and monthly) and are segregated by filing status. Employers start by reducing wages by the value of exemptions claimed. Next, they use the table corresponding to the employee's filing status and look for the withholding amount based on the wage bracket.

As a business owner, it is your responsibility to look at the two sets of tables and determine which one is appropriate for your business. The percentage tables are more inclusive, in terms of payroll periods, so if you are in a situation where different employees are paid at different payroll periods, then the percentage table should be the table of choice.

For example, if your employees are paid quarterly, the percentage tables will be more appropriate than the wage bracket tables. To get these tables, visit the IRS online to access Publications 15 and 15-T.

State Taxes

Most states use tables similar to federal tax tables, and you can get them by going to the tax section of your state's website or contacting the Small Business Administration. You do not need to withhold state taxes in jurisdictions that do not impose state taxes on income, such as Alaska, Florida, Texas, Wyoming, and Washington. Other exceptions include states whose personal income taxes are a fixed percentage of the federal tax, like Arizona, and where state taxes are a fixed percentage of gross wages, such as Pennsylvania.

FICA

The Federal Insurance Contributions Act (FICA) is a federal law that requires employers to withhold Social Security and Medicare taxes from wages paid to employees. It also requires the employer and employee each to pay half of the FICA tax.

Social Security and Medicare taxes are imposed on both the employee at a flat rate of 6.2% for Social Security and 1.45% for Medicare and the employer's single flat rate of 6.2% and 1.45%, respectively, creating a combined FICA tax rate of 15.3% (12.4% for Social Security and 2.9% for Medicare). Self-employed individuals are responsible for paying the entire 15.3% tax themselves.

Unlike federal and state taxes, FICA taxes are unaffected by the number of withholding exemptions claimed by the employee. You simply multiply an employee's gross wage payment by the applicable tax rate to determine how much you must withhold and how much you must pay as the employer.

In 2022, the Social Security tax only applies to the first $147,000 of income, also called the Social Security wage base. In 2023, that amount increases to $160,200. The wage base is adjusted every year for inflation. The Medicare tax does not have an income limit.

FUTA

Unemployment taxes, or FUTA, are taxes paid solely by the employer. You must pay unemployment taxes if either of the following applies:

a) You pay wages totaling at least $1,500 in a quarter
b) 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 FUTA tax rate is 6.0% and it is 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. If you pay your state unemployment taxes when they are due, you are allowed to claim a 5.4% credit, which effectively reduces your FUTA tax rate to 0.6%.

The Bottom Line

Calculating payroll taxes can be very complicated, and it is important to send out payments on time to avoid penalties and late fees. Federal tax payments must be made online through the Electronic Federal Tax Payment System (EFTPS).

FUTA taxes are usually paid quarterly and income and FICA taxes are deposited semi-monthly or monthly. The IRS usually sends business owners a notice at the end of each year detailing which method to use for the upcoming year.

In general, the timeliness of a deposit is determined by the date it is received; however, if you are late, you can be penalized up to 15%. To learn more about small-business employers' payroll duties and obtain the relevant forms, go to the IRS website or call the IRS live helpline for businesses at 1-800-829-4933.