This post is about income taxes in the US. For the Canadian version, click here.
Not all taxes are created equal — in terms of responsibilities, at least.
When we see the words "income tax," we may immediately associate them with our personal taxes we file each year. Or we even think of income taxes for businesses.
But what really are payroll taxes? And are they really that different from the income taxes businesses already have to pay? Short answer: Yes.
How payroll taxes and income taxes intersect
As a business with employees (an employer), you're required to withhold income taxes at the federal, state, and local level. These are taken out every paycheck for each employee.
On top of income tax, there are additional deductions, like federal and state unemployment, and local deductions, like education or emergency services taxes.
All of these items — from income taxes to local taxes — are considered payroll taxes. They're withheld from employee paychecks, combined with employer contributions in some cases, and then reported and distributed to the correct tax authorities.
Income tax responsibilities for US employers
Each pay period, you as an employer are responsible for deducting income taxes from employee paychecks. This goes for each level of taxation, from federal to state to local authorities.
These withholding amounts will show up on reports you file throughout the year, including on employee W2s. These are due to each employee and the IRS by the end of January for the previous calendar year. We'll go into more detail about reporting later.
Income and payroll tax withholding only applies to your employees. When hiring contractors, you're not responsible for withholding any income or payroll taxes for them. As independent contractors are classified as their own employer (self-employed), they will take care of paying and deducting their own taxes themselves.
Knowing how much income tax to withhold
The amount of income tax you're required to withhold for each employee will vary for each level of tax responsibility. It also depends on the allowances and exemptions claimed on the employee's tax forms they complete upon hiring.
Federal income tax withholding
The IRS is responsible for federal-level taxes. When an employee is hired, they will fill out a federal W4 Form which details information about their tax allowances. These allowances can — and will — vary from employee to employee, depending on factors like marriage, dependents, and other jobs.
Note: It's recommended that employees fill out a new W4 Form for 2020 to account for the major changes outlined in the Tax Cuts and Jobs Act.
In terms of your withholding responsibility as an employer, you will combine an employee's allowances with the federal tax rate detailed in the IRS's withholding tables (which can be found at the end of Publication 15). There are two methods for figuring the withholding rate — the wage bracket method and the percentage method:
Wage bracket method: This method uses an employee's taxable wages, marital status, and amount of allowances from their W4 to determine their withholding amount for each pay period. This works best for employees claiming 10 or fewer allowances on their W4, and have taxable earnings below the max listed in the wage bracket table. The wage bracket method is the most straightforward of the two.
Percentage method: This method can be used in place of the wage bracket method. It works for any amount of allowances and any amount of taxable income. While it seems simple, the percentage method is a more complex calculation that requires employers to place a monetary value on each employee's allowances.
Though not required, it's usually recommended that you try to use the same methodology for all your employees — that way your calculations are consistent across the board. But as stated above, if choosing the wage bracket method some employees may fall out of its scope and require the percentage method instead.
These methods only cover the nuances of income tax withholding. Liability for payroll taxes like social security and Medicare are fixed rates and won't change based on an employee's taxable income or their listed allowances.
Encourage your employees to use the IRS Withholding Calculator to determine if their withholding amounts accurately reflect their tax liability for the year. That way, they can add or adjust withholding amounts each paycheck to reduce their year-end balance owed (if they have one at all).
State income tax withholding
States have a similar form to the federal W4 that employees fill out when hired. These differ from state to state — if you have employees working in different states, they will need to complete the state W4-equivalent that corresponds to their workplace state.
Note: Some states don't have an income tax, and therefore don't require a state W4. These states include AK, FL, NV, SD, TX, WA, and WY. Residents of NH and TN do not have an income tax (and don't require a state W4) but do require taxation on dividends and investment income.
In terms of calculating state income tax for each employee, refer to your state tax authority to determine the correct rate. Each state differs in how rates are calculated based on their state W4-equivalent forms.
Local income tax withholding
Just like the state level, not all local taxes are the same across the board. There are municipalities that enforce a number of taxes on its residents and some that require little to no taxes at all. As an employer, you'll have to find out which local tax authorities apply to you and your employees. If you're using payroll software, these taxes will usually automatically populate when you enter your business address and employee information.
Tax withholding from tip income
If your employees earn tips as part of their income, there's an additional protocol for just about everything — a different minimum wage structure, additional income tracking requirements, and more forms to report to tax authorities.
Although tipped wages warrant different rules and regulations, they're still considered taxable earnings for your employees. Employers are still required to include tips when determining an employee's income tax withholding.
Both the employer and employees should keep records of the tips earned each day, which will then be reported on its own monthly schedule. Point-of-sale (POS) systems can make this process a lot easier, especially since it can automatically track credit and debit card tips within each sale. It doesn't hurt that POS systems can help track your employee's work hours as well.
Bonuses and commission
Any sort of earned income, like bonuses and commission, are considered taxable. When entering this information into your payroll, make sure it's classified as taxable so that you and your employees aren't subject to any unhappy notifications from the IRS.
Payroll tax responsibilities for US employers
As mentioned before, income taxes are just a piece of the payroll tax puzzle. In addition to income taxes, there are different kinds of payroll taxes employers are responsible for, too. Just like everything else, there are requirements at the federal, state, and local level.
Federal payroll taxes
Along with federal income tax, employees are required to make tax contributions to federal programs. Employers are also required to make contributions on top of employee withholdings based on the employee's taxable earnings. In some cases, the employer is the only party making a contribution.
Federal Insurance Contribution Act (FICA) Taxes: This includes social security and Medicare taxes. The rates for these programs don't change based on an employee's earnings — they are taken as a set percentage of taxable income. Employees and employers split this contribution evenly.
Federal Unemployment Act (FUTA) Taxes: This tax contributes to the federal unemployment program for employees who leave their company involuntarily. These are paid solely by employers, but can result in a credit based on payments of state unemployment.
State payroll taxes
Payroll taxes for your state always include State Unemployment Tax Act (SUTA) contributions. Each state determines their own rate for SUTA, so employers will be assigned this rate when they register with their state tax agency. In most cases, SUTA is an employer-only tax, similar to FUTA.
Local payroll taxes
Local contributions will vary greatly depending on where your business is located. Your local tax authorities are going to have the most up-to-date information about your responsibilities as an employer.
Remitting payroll taxes
Withholding payroll taxes from employee paychecks is just the first step. After that money has been withheld, it has to be distributed to the correct tax authorities based on your remittance (payment) schedule. Your schedules can vary for each authority.
If you're an employer processing payroll manually, you are responsible for each part of the process. That includes calculating the correct amount of withholding, holding the funds, and distributing (remitting) them on time. But if you're using self-service payroll software like Wagepoint, the process is often taken care of automatically — including calculations and remittances.
Federal income and payroll tax remittances
When you start your business, you will register with the IRS and receive a business number. This allows you to make tax payments of all kinds to them and have those payments attributed to your business correctly. This number is also used when you start hiring employees and subsequently start paying payroll taxes.
If you're making payroll tax payments to the IRS yourself, you can do so electronically or physically by mail. When you use payroll software, they likely make these payments on your behalf.
State income and payroll tax remittances
State income taxes are paid to state tax authorities. Just like registering with the IRS, you will need to register your business in the state it is located. If you have employees located in other states that are required to pay income tax, you'll need to register with those states, too.
Local income and payroll tax remittances
Again, local taxes are more nuanced and unique to your business's location. Check with your local tax authorities to find out what your responsibilities and payment schedule look like.
Payroll tax reporting requirements
Along with paying income and payroll taxes each period, employers are also required to generate reports about the amounts they're withholding. These reports are due throughout the year — four times in the form of quarterly reports, and another reporting period spanning January through April that details the entire fiscal year (called year-end).
Federal quarterly reports
Each fiscal year for your business is broken down into four quarters. Reports on the quarter are usually due by the last day of the following month (or the next business day if it falls on a weekend):
- Quarter 1: January 1 - March 31 (reports due April 30)
- Quarter 2: April 1 - June 30 (reports due July 31)
- Quarter 3: July 1 - September 30 (reports due October 31)
- Quarter 4: October 1 - December 31 (reports due January 30 of the following year)
Quarterly numbers are filed using the IRS Form 941: Employer's Quarterly Federal Tax Return. It will total all the employee and employer contributions to federal payroll taxes like income tax, FUTA, and FICA.
Federal year-end reports
Year-end is a beast in itself. Not only are quarterly reports due at the end of January, but the new year marks the need for additional reporting as well. This includes handing out employee W-2s — which summarize each employee's income and tax contributions for the year — and annual reporting of social security, Medicare, and tipped wages on Form 940.
W-2s and Forms 940/941 are all basic reporting requirements for any employer with employees. Businesses who hire contractors have another set of forms to report, and you may have additional obligations that fall outside of payroll taxes depending on your industry.
Some states require wage detail reports on a quarterly basis, following the same due dates as the federal Form 941. These reports include you state unemployment (SUTA) contributions for the quarter.
At year-end, state tax authorities require payroll tax reporting similar to the Federal Form 940. What form you need to complete and file depends on the state. All employers will need to file employee W-2s and contractor 1099s with their state authorities, too.
It sounds monotonous, but local tax authorities vary greatly. You'll need to find out from your tax agencies what reporting requirements apply to your business.
How year-to-date amounts relate to income and payroll taxes
Reporting needs to be done each quarter and year. But as time passes, the amounts to be used on those reports accrue into what's called year-to-date (YTD) amounts. This refers to the gross pay and tax contributions you've withheld for each employee from the beginning of the year to the present.
YTD amounts are important because they allow you to track how much you've already withheld compared to your tax liability as an employer. They also matter to employees who see these YTD amounts listed on each of their paystubs.
YTD totals are also crucial for payroll providers if you're switching in the middle of the year — it allows them to see what you've withheld up to this point, pair it up with your current rates and remittance schedules, and then continue to withhold the correct amounts for the rest of the year.
Not having YTD information means your tax withholding may be inaccurate for your employees. This can result in some frustration when they see their tax liability at year-end, which is never fun.
Income tax and payroll tax have a symbiotic relationship
It's the argument that a square is always a rectangle, but a rectangle isn't always a square. In this analogy, income taxes are squares, and payroll taxes include a lot more variety like the rectangle.
The point is, the two are separate but intimately related. And as you add employees into your business, you'll be tracking and making payments for both.
The advice we share on our blog is intended to be informational. It does not replace the expertise of accredited business professionals.
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