Payroll tax compliance is a vital task for growing business. Business creates payroll liability every month while paying the salary to employees. The payroll tax has several elements which we would understand in this article. We would also understand the difference between payroll tax and payroll liability and payroll reporting requirement as per US laws.
Payroll liability and payroll taxes:
To understand payroll Tax and Payroll liability, we categories payroll into six parts:
- FICA Payroll taxes
- Federal Income Tax and State Income Tax
- Unemployment Tax
- Withholding taxes or payroll deductions
- Employer’s contribution towards payroll taxes
- Employer’s payroll responsibility in form of reporting and tax payment
Payroll Tax and Income Tax:
Please take note that there are two types of taxes. Payroll taxes known as FICA tax and Income tax levied on employee’s salary.
Employee and employer contribute towards payroll taxes. On the other side, income tax has been deducted from the salary of the employee as per the declaration given by him in Form W-4. Once you receive declaration,you need to go to IRS website and use IRS withholding calculator to understand tax liability of the employee.
The unemployment tax has two types:
It’s Federal Unemployment Tax having the rate of 6%. The maximum wage ceiling for FUTA is $7000. If an employee earns more than $7000, an amount exceeding $7000 will not be taxed.
Certain states levied an unemployment tax on employee’s salary. An employer needs to pay this unemployment tax from his pocket to government. SUTA rate varies from state to state.
FICA Payroll Taxes:
FICA is the Federal Insurance Contribution Act.
FICA covers the following taxes: social security and Medicare taxes.
Social Security Tax:
The rate of social security tax is 6.2%. The wage ceiling is $128400 (For 2018). Anything earned by employee above $127200 is not covered under social security tax.
It has the rate of 1.45% without any wage ceiling.
Additional Medicare Tax:
It is required to be deducted at the rate of 0.9% when an employee earns over $2, 00,000. Please note, employer is not required to contribute towards additional Medicare Tax.
Payroll Withholding taxes (Payroll Deduction):
Following taxes are required to be withheld (deduct) from the gross pay of the employee:
- 6.2% social security tax
- 1.42% Medicare tax
- Additional Medicare tax at 0.9% when applicable.
- Federal Income tax withholding
- State Income tax withholding
- Other local tax withholding if any.
Voluntary payroll deductions:
Saving is good habit and employee can save for the future by voluntary payroll deductions. Following are voluntary payroll deductions:
- Insurance premium ( life insurance and health insurance)
- 401(K) plan – retirement plan contribution
- Employee stock purchase plan
- Flexible spending accounts
Voluntary payroll deductions have two types- pretax and post-tax. It depends on the type of deduction. With pre-tax deduction, you need to deduct the amount based on gross wages. With post tax deduction, you need to deduct the amount based on net wages. Visit IRS site for further info.
Example of Payroll withholding:
Rossy is working at Mizzle, Inc and receiving $5000 as salary. The company is required to withhold 5 % in federal income taxes and 5% in state income taxes. The company is also required to pay 1% state unemployment tax and 6% Federal unemployment tax. Let’s calculate net pay of Jan 18, 2018.
Gross pay = $5000
Federal income tax = $250
State income tax = $250
Social security Tax (6.2%) =$310
Medicare Tax (1.45%) = $72.5
Total payroll withholding is $882.5
Net Pay = ($5000 – $250-$250-$310-$72.5) = $4117.5
Additionally, the company is required to contribute towards social security tax, medicare tax, and unemployment tax.
Employer’s contribution towards payroll taxes:
The employer is required to contribute towards following taxes:
- 6.2% social security tax
- 1.45% Medicare tax
- State Unemployment Tax ( SUTA)
- Federal Unemployment Tax (FUTA)
Gross pay = $5000
Social security Tax (6.2%) =$310
Medicare Tax (1.45%)= $72.5
State unemployment tax (SUTA) (1%) =$50
Federal Unemployment Tax (FUTA) (6%) = $300
Total employer’s contribution is $732.5
Wages expense for Employer:
The employer can claim wages and contribution towards payroll tax as the tax deduction while filing the tax return.
In above example, payroll expense is $5000 + $732.5 = $5732.5
Sum of Payroll withholding and employer’s contribution towards taxes is the payroll liability for the employer. He needs to deposit this amount to the government at the due date.
In the example, payroll liability is $1615 – the sum of $732.5 (Employer’s contribution) and $882.5 (Payroll withholding).
Self-Employment Tax (SE Tax):
This tax is applicable for self-employed person.
As per IRS, self-employed person means proprietor, a partner in business or an independent contractor.
SE is a combination of social security tax (12.4%) and Medicare tax (2.9%). So the tax rate is 15.3%.
When you work as an employee, you contribute the half amount of social security and medicare tax, and your employer contributes another half amount of taxes. But as self-employed, you need to contribute the total amount towards taxes. As self-employed, you need to deduct SE from your gross pay and pay to the government.
Please note, wage ceiling will remain the same for social security tax and Medicare tax as mentioned above in the post.
Calculation of SE tax:
Use the formula below to calculate your self-employment tax
SE tax = Self-employed taxable income *92.35%*15.3 %
Let say your self-employed income is $100000. Your SE tax will be $14129.55 by using above formula.
In above, the half amount ($7064.775) will go to other taxes in tax form and another half ($7064.775) will be considered as an adjustment.
Employer’s responsibility towards Payroll:
Payment to employees:
You can choose the right payment schedule as per the nature of your business and payment method of pay – fixed or monthly.
You have following options to make payment to employees:
- Weekly – Best when you are paying employees on hourly rate.
- Bi weekly – Best when you have hourly and Fixed pay employees
- Monthly – Best option when you have most of fixed pay employees.
Depositing payroll taxes:
Once you have paid salary after deducting tax, next task is to pay taxes to government.
The employer is required to deposit payroll taxes (social security tax, medicare tax and income tax) at the monthly or semi-monthly basis. If the employer is failed to deposit payroll tax on time, he is liable to the penalty of 15%.
FUTA tax is required to be deposited on a quarterly basis when tax due exceeds $500.
Mode of payment of taxes:
The tax must be paid by mode of electronic fund transfer. You can deposit your tax by following this link
Reporting of payroll tax:
The following returns should be submitted to comply with US payroll tax regulation.
- Form 941 – Employer’s quarterly federal tax return. This forms covers amount you have deducted for social security tax, Medicare tax and income tax. This needs to file four times a year.
- Form 940 – Employer’s Annual Federal Unemployment tax return ( FUTA)
- Form W-2 -Wage and tax statement. This form includes detailed information about pay and deductions and you need to give it to the employee at year end so that he can file his taxes.
- Form 945 – Annual Return of Withheld Federal Income Tax
- Returns for state and local taxes as per requirement of the state.
- 1099-MISC– You are required to prepare and give this form to contractor showing payment you have made to him in the year. (We have published a detailed post about 1099. Read it here.)
No matter the size of business, if you are having more than 100 transactions a year, you should start using cloud accounting software for your business.
For payroll, you have the following option:
- Use the inbuilt payroll feature given in cloud accounting software
- Purchase add-on for the payroll function
- Use separate software for payroll
Some popular payroll software in the market are:
- Quickbooks payroll addon
If you are not ready to purchase any software yet, you can use a free IRS payroll calculator or Gusto’s free tools for payroll.
So these are the important things you need to know about payroll tax and your payroll liability as a business owner.
Taking first step is always hard in any work. However, once you understand payroll tax, choose and setup payroll software and run first payrun, it will be piece of cake to do payroll.
Of course, when organization grows, you can outsource payroll function or hire someone to do payroll. Till then, run payroll regularly, submit forms at a time and stay tension free!