There's more to paying taxes than just federal and state income taxes. Another major tax chore for employers is payroll taxes. These expenditures can be significant, and the reporting requirements can be onerous. So it's important for small business owners to understand the basics.
First off, employers are required to report and deposit payroll taxes on a regular schedule, typically on a quarterly basis. This includes amounts withheld from employee compensation based on the frequency of payment. Failure to meet these obligations can trigger back taxes, interest and penalties — a veritable tax disaster.
Here's a quick rundown of six major types of payroll tax obligations that employers must contend with during the year.
Employers are required to withhold federal income tax from the paychecks of their employees. The amount of income tax to be withheld from regular pay depends on two factors:
Additional withholding rules apply to commissions and other forms of compensation. Ask your tax pro for more information.
Employers generally must withhold state income tax from the wages of employees. However, seven states — Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming — have no state income tax. Plus, two states — New Hampshire and Tennessee — don't tax wages.
In addition, certain cities — including New York City, Detroit, Philadelphia and San Francisco — also impose income taxes. Finally, in several places, withholding is required to cover short-term disability, paid family leave or unemployment benefits.
Important: The withholding requirements are more complicated for employees that live and work in a different state than where their employers are located. (See "Beware: Remote Work May Complicate State Income Taxes," below.)
The Federal Insurance Contributions Act (FICA) authorized a payroll tax that includes the following components:
Social Security tax. The Old Age, Survivors, and Disability Insurance (OASDI) portion is taxed at a 6.2% rate on the amount up to an annual wage base. The inflation-adjusted base for 2023 is $160,200 (up substantially from $147,000 in 2022).
Medicare tax. The Hospital Insurance (HI) portion of the tax is 1.45% on all wages. There's no wage base for this component.
For example, say that your company's CIO earns $200,000 in 2023.The OASDI portion would be $9,932 (6.2% of $160,200), and the HI portion would be $2,900 (1.45% of $200,000). The combined total would be $12,832 ($9,932 plus $2,900). All amounts are rounded to the nearest whole dollar.
Employers withhold the employees' share from their paychecks, and they're also responsible for matching the amount withheld. Thus, in the example above, the employer would have to pay $25,664 ($12,832 times 2).
Uncle Sam helps states pay employees who have been involuntarily terminated from their jobs. Accordingly, the Federal Unemployment Tax Act (FUTA) created a special tax that applies to the first $7,000 of wages of each employee.
The basic FUTA rate is 6%. However, employers can benefit from a credit for state unemployment tax of up to 5.4%, creating an effective 0.6% FUTA tax rate. This credit may be reduced if a state borrows from the federal government to cover its unemployment benefits liability and doesn't repay the funds.
States are responsible for paying unemployment benefits to eligible workers who are involuntarily terminated. Much like insurance, the rate that employers pay is based on their claims experience.
The more claims that are made by former employees, the higher an employer's tax rate will be. The state updates this rate, which can't fall below a specified minimum, on an annual basis.
An additional Medicare tax of 0.9% is required to be withheld on all wages above $200,000. Note that while the employee may or may not ultimately be liable for the tax, the employer is still required to withhold it. Unlike FICA, employers don't have to pay a corresponding amount of the additional Medicare tax.
When the employee files a personal income tax return, the additional Medicare tax is effectively treated the same as other federal withholding. Whether the employee is subject to the additional Medicare tax depends on the total amount of earned income showing on the employee's personal income tax return. For example, an unmarried individual will be subject to the additional Medicare tax on earned income in excess of $200,000, whereas the threshold for a jointly-filed return is $250,000 of earned income.
Also, be aware that the six responsibilities outlined above apply only to amounts paid to employees. If your business uses independent contractors, they're not covered by these rules, although other reporting requirements may apply.
That's far from the end of an employer's payroll tax requirements. There are several other issues for small business owners to consider.
Notably, payroll taxes must be deposited with the government in a timely manner. The IRS sets the tax deposit deadlines for federal payroll taxes. Most employers fall under the monthly schedule, but larger corporations must deposit taxes on a semi-weekly basis.
As you might expect, there's some additional paperwork involved. This includes various tax returns that must be filed for federal payroll taxes, such as:
Employers must also report withholding to employees, as well as Social Security tax withholding to the Social Security Administration (SSA). For this purpose, they must send Form W-2 to employees and Form W-3 to the SSA. The latter summarizes all the W-2s sent to employees.
Payroll taxes are a necessary part of doing business. Contact your tax or payroll advisor for help navigating the rules.
Generally, employees incur state income tax liability based on where they're physically present while earning the income. In a nutshell, if an employee lives and works in a different state than where the employer is located, the employee pays state income taxes only in the home state where he or she has established domicile.
But the so-called "convenience rule" applies in some states. Under this rule, remote employees could end up paying state income taxes in both their home states and the states where their employers are based.
Say, for example, that Tom works for a company located in New York, but he decides to move to another state for personal reasons. Tom will still need to pay New York state income taxes on his compensation. Plus, he might be on the hook for taxes in his home state on the same income.
Some states offer a credit against the employee's tax liability for income taxes paid to other states. But not all states do so, and the credit amounts can vary. Moreover, an employee might not receive a full credit if the amount of taxes paid in the employer's state exceeds the amount of their liability on that compensation in the home state. In other words, employees that work for companies in high-income tax states and live in low-income tax states won't receive dollar-for-dollar home state credits if the credit isn't refundable.
Also, state unemployment tax is generally based on the employee's location. This can further complicate matters.
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