Payroll Taxes 101

Whether you’re a Sole Proprietor with only a handful of workers or a corporation with hundreds of employees, you are responsible for collecting and paying employment taxes to federal and state tax agencies. However, while federal payroll taxes are the same no matter where your business is located, state and local payroll taxes differ according to the jurisdiction’s laws and tax codes.

Payroll taxes can be confusing and overwhelming to new business owners. In today’s article, I’ll break down the types of payroll taxes to help you understand what they are and what you need to consider. While this will get you started, I encourage you to talk with a trusted accountant or tax advisor and an attorney for guidance about your business’s specific obligations.

Payroll Taxes Vs. Income Taxes

Payroll taxes are taxes that help fund Social Security, Medicare, and federal and state unemployment programs. Employers and employees share the burden of some payroll taxes (e.g., Social Security and Medicare), and employers withhold the employee’s portion from the worker’s pay. Other payroll taxes, such as federal unemployment (FUTA), are paid solely by the employer.

Income taxes are levied by federal, state, and local tax agencies on individuals’ and businesses’ income to help cover governments’ operations and program costs. Employees’ wages, salaries, tips, and other compensation are subject to income tax. Employees are fully responsible for paying all of their income tax, and their employers withhold those taxes from their workers’ paychecks and deposit those monies with the appropriate tax agencies.

You might hear payroll taxes and income taxes collectively referred to as payroll taxes or employment taxes.

First Steps First: Obtain an EIN

While all the states and many cities have their own employment registration requirements, the first step for most businesses is to register for an Employer Identification Number (also referred to as an EIN or Federal Tax ID number).

EIN usage requirements:

• An EIN is optional if your business is a Sole Proprietorship if the business does not have employees.
• In most cases, if your business acts as a Corporation or Partnership (including multi-member Limited Liability Companies (LLCs) taxed like a C Corporation, S Corporation, or Partnership), you are required by federal law to have an EIN.
• Sole Proprietorships and disregarded entity single-member LLCs with no employees may use their Social Security Numbers for tax purposes since their tax obligations pass through to owners’ personal tax returns. However, they may still need one for setting up a business bank account and other purposes.

Obtaining and using an EIN:

• You can apply for your EIN online through the IRS website.
• You can also hire third-party companies like CorpNet to obtain an EIN for you.
• During the application process, you’ll need to provide your company’s legal business name, trade name (if different from the legal business name), mailing address, street address (if different from the mailing address), the owner(s) or officer(s) name(s), the county and state where the principal business is located, and other information. You must also provide a general statement about the business’s activities, the business structure, and number of employees.
• Once you obtain an EIN, you will use the number throughout your business’s life on company documents, service agreements, bank accounts, and more. An EIN is how the IRS tracks business transactions and tax records.
• You will keep the same EIN number unless certain circumstances, such as changes in ownership or legal structure, require a new number.

Once you obtain your business’s EIN, your next task is understanding the payroll taxes you are responsible for withholding and paying.

List of Payroll Taxes

In the upcoming sections, I’ll break down the different types of employment taxes to help demystify what they are and who pays them. We’ll cover:

• Federal payroll taxes
• State payroll taxes
• Local payroll taxes
• Out-of-state payroll taxes

Note that besides payroll taxes and income taxes, other deductions — such as wage garnishments, health plan premiums, 401K contributions, etc. —  might also have to be withheld from employees’ pay.

Federal Payroll Taxes

It’s up to employers to verify that each new employee they hire is legally eligible to work in the United States. This requires completing the U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification. Owners of Sole Proprietorships, Partnerships, and LLCs do not need to fill out an I-9 for themselves (the business owner is not considered a company employee), but they must do so for any employees they hire. You can use the Social Security Number Verification Service (SSNVS) to verify that names and social security numbers match. Be aware that a person may have a valid SSN but not be authorized to work in the United States, so use E-Verify to confirm employment eligibility.

Once you verify an employee’s eligibility, the employee should fill out IRS Form W-4. The amount of federal income tax you should withhold from an employee’s pay is based on the employee’s Form W-4 and the withholding tables described in Publication 15, Employer’s Guide. If you use a payroll application through your bank or another provider, the system can determine this for you.

FICA Taxes

FICA taxes are comprised of Social Security and Medicare taxes.

• Most employers must withhold, deposit, report, and pay employment taxes per the Federal Insurance Contributions Act.
• The 2023 Social Security tax rate is 12.4%; employers and employees split the tax evenly (each paying 6.2%). If an employee’s wages reached an earnings threshold of $160,200 in 2023, their earnings beyond that dollar amount are not subject to Social Security tax.
• The 2023 Medicare tax rate is 2.9%, paid equally by employers and employees (1.45% each). Employers must also withhold an extra 0.9% of Medicare tax when an employee’s wage exceeds $200,000, the employee is filing as single. The threshold is $250,000 for married couples filing jointly and $125,000 for individuals who are married filing separately.
• Most employers who withhold federal income tax, Social Security, or Medicare taxes must file Form 941, Employer’s Quarterly Federal Tax Return, each quarter. Employers with small businesses who qualify to file Form 944 instead of Form 941 must file annually. To use Form 944, the employer must receive written notification from the IRS.
• FICA tax deposit due dates may be monthly or semi-weekly, depending on an employer’s total tax liability.

Business owners of Sole Proprietorships, Partnerships, and disregarded entity LLCs do not receive paychecks from which FICA taxes are withheld. But they are still responsible for paying into Social Security and Medicare. They do so by paying a Self-Employment Tax (SE tax) quarterly, which comprises Social Security and Medicare taxes.

Keep Learning: What is FICA?

FUTA Taxes

Federal Unemployment Tax Act (FUTA) helps fund unemployment benefits for employees who lose their jobs through no fault of their own. FUTA is paid separately from federal income tax, Social Security, and Medicare.

• Only employers pay FUTA taxes; no funds come from employees’ wages.
• FUTA taxes are paid quarterly.
• After an employer has paid at least $1,500 to employees in any calendar quarter, they must pay the 6% FUTA tax on the first $7,000 paid to each employee during the year.

Keep Learning: What is FUTA Tax?

Federal Income Taxes

Employers must withhold federal income tax from employee pay based on employees’ taxable wages and information (marital status, dependents, and adjustments) on their W-4 forms.

State Payroll Taxes

SUTA

All states require employers to pay a State Unemployment Tax (SUTA) unless they are a nonprofit with a 501(c)(3) designation. SUTA is paid to the state’s unemployment benefits fund. If an employee is laid off, they can collect state unemployment insurance.

State Income Tax

As part of the payroll process, employers must also withhold state income tax in states that collect personal income tax. States either use the federal W-4 form or a state W-4 form for determining withholdings requirements.

States that do not collect personal income tax:

• Alaska
• Florida
• New Hampshire (doesn’t tax wage income but does tax dividends and interest income)
• Nevada
• South Dakota
• Tennessee (currently no personal income tax and the tax on interest has been repealed as of January 1, 2021)
• Texas
• Washington (doesn’t tax wage income but does tax capital gains)
• Wyoming

Local Payroll Taxes

Some counties and cities charge local income taxes. Employers must withhold those taxes from employees’ pay and deposit them to the appropriate local government agency. Rules and rates vary depending on location.

Out-of-State Payroll Taxes

What if a company has employees living in different states from where the business is located (all the more possible with so many remote workers getting hired)? When an employee doesn’t live in the same state as their employer, the payroll taxes of the jurisdiction where the employee lives and works apply.

Employing workers in other states requires a business to register with that state’s tax agency, acquire a state income tax withholding number, get an unemployment insurance number, and withhold income taxes. It must also register with the state’s Department of Labor and follow its laws for employees — including minimum wage, labor regulations, state disability insurance, and workers’ compensation rules.

In addition, a business with remote employees may have to foreign qualify (register as a foreign entity) in the state where its remote employees live and work. The requirement for foreign qualification depends on whether the employer has nexus in the remote employee’s state. If required to foreign qualify, the company must fulfill the business compliance requirements (e.g., obtain licenses, file annual reports, pay sales and income taxes, etc.) in that state.

How to Report Payroll Taxes

Employers typically use the following IRS forms to report money withheld from employees’ paychecks for federal requirements. They can be submitted electronically or by mail:

• Form 940 – Used to report annual FUTA tax.
• Form 941 – Used to report income taxes, Social Security tax, and Medicare tax withholdings quarterly.
• Form 944 – Used instead of Form 941 by small employers whose annual liability for Social Security, Medicare, and withheld federal income taxes is $1,000 or less.

These forms may be submitted electronically or by mail. The IRS requires employers to deposit federal payroll and income taxes through electronic funds transfer using the Electronic Federal Tax Payment System^® (EFTPS).

State and local regulations and forms vary. Employers must follow their jurisdiction’s rules for reporting employee withholdings and submitting payments to the proper agencies.

Who should handle reporting and depositing payroll taxes for your company? It’s important to make sure someone has the knowledge, attention to detail, and time to do it accurately. Small businesses often outsource payroll reporting to an accountant, bookkeeper, or a payroll management company. In larger companies, payroll is usually a function of HR or the finance department.

Keep Learning: What is Payroll?

Tips for Controlling Payroll Taxes

If you want to minimize your payroll tax obligations, discuss your situation with an accountant or other tax professional. Two things to consider that might potentially help reign in payroll tax responsibilities include:

• Hire independent contractors (ICs) – ICs are not considered employees, and therefore, your business does not have to withhold, pay, or deposit payroll taxes. Be careful to stick to the guidelines established for IC status to avoid the IRS and state coming to you for back payment of employer taxes.
• Elect S Corp status – C Corporations and LLCs can elect to be taxed as S Corporations, as long as they meet IRS S Corporation qualification requirements. S Corporations are structured as pass-through business entities, which means profits and losses are passed through to the company’s owners/shareholders. S Corporation owners who work in the business are employees, so only income from their wages and salaries are subject to FICA taxes, thus lowering the individuals’ Social Security and Medicare tax burden. While the business owners’ remaining income from the S Corp’s profit distributions is subject to income tax, it is not subject to payroll taxes.

Payroll Tax Compliance

The penalties for not paying payroll taxes on time vary depending on the circumstances. A business may be responsible for any shortfalls if it incorrectly withholds deductions from its employees’ pay. Moreover, errors in deductions or failure to remit withheld funds to the appropriate agencies on time can also result in fines and other penalties.

IRS penalties increase the longer late payments extend past the due date:

• 1 to 5 calendar days: 2% of the unpaid deposit
• 6 to 15 calendar days: 5% of unpaid deposit
• More than 15 calendar days: 10% of unpaid deposit
• More than 10 days after the date of the first notice or letter or the day of notice for immediate payment: 15% of the unpaid deposit

Additional compliance considerations:

• The IRS also charges interest on penalties.
• The IRS might see failure to pay as tax evasion, resulting in potential criminal penalties.
• Penalties at the state and local levels vary.

Payroll Tax Filing Services

While managing payroll tax filings on your own may sound like a good way to save money, it can ultimately cost you more in the long run if you miss deadlines, fail to calculate withholdings correctly, or don’t make tax deposits on time.

Using payroll software can help you avoid manual calculation errors and automate the payroll process. Whoever uses the software to process your payroll should be proficient with the technology and knowledgeable about payroll requirements.

For more peace of mind, consider outsourcing your payroll tax filings to an accounting firm, bookkeeper, or payroll solutions provider who understands all aspects of the payroll process and uses reliable payroll software to ensure accuracy and efficiency.

CorpNet is Here to Help!

CorpNet is focused on helping entrepreneurs start their businesses and stay in compliance. We know payroll taxes can be one more item on a long list of growing start-up requirements.

We want to help you succeed, so we offer payroll tax registration services in all 50 states. Let us handle the details while you put your time and energy into finding and hiring the staff you need to grow your business and reach your goals.