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Jumping the Hurdle from Owner to Employer: Understanding your Employment Tax Obligations

Statistically, one of the largest hurdles for small business owners is evaluating when it is appropriate to add employees to their organization. Although adding employees can create new opportunities for your business there is always the consideration that an increased cost may be incurred. Most of the time the increased cost is not just the additional salary and benefits but the additional compliance cost at the local, state, and federal level. One of the most important compliance considerations that every small business owner should understand is employment taxes, also known as payroll taxes.

Payroll taxes are normally viewed from both the employee and the employer standpoint. From an employee standpoint, payroll taxes are the deductions from their paycheck that they have no idea what or why they are deducted. From an employer standpoint, payroll taxes are normally the deductions you take from your employee’s paycheck and the payments you remit but aren’t really sure why. In reality, payroll taxes are a multifaceted system that includes federal, state, and sometimes local obligations.

Federal Employment Taxes

Federal Income Tax

Around April 1st of each year, we all panic trying to remember where that W-2, our employer sent us, is located so we can file our annual tax returns. However, as an employer, your responsibilities begin long before April 1st of each year. In fact, an employer is required to provide their employees Form W-2 by January 31st of each year. However, in order to obtain the necessary information to prepare Form W-2, an employer should be accurately withholding and remitting the appropriate amount of income tax from your employee’s paycheck throughout the whole year. The IRS has published guidance on how to calculate the amounts to be withheld, how often the tax should be remitted, and if special instructions apply to your particular employee.

Social Security & Medicare Tax (“FICA”)

FICA Tax is a fancy term for Social Security and Medicare Insurance tax. Most of us think of Social Security and Medicare as those things that we will worry about when we are older adults. However, in order to fund Social Security and Medicare, a tax is imposed on certain wages of employees. FICA tax is split up into two portions, the Social Security and Medicare portion. In addition, each portion is again broken up into two parts.

For purposes of Social Security, a total of 12.4% of certain wages of an employee is remitted to the government. The employer (6.2%) and the employee (6.2%) each pay half of the total amount but the employer is responsible for withholding the employee’s portion from their paycheck. The Social Security portion of FICA tax is limited to the first $128,400 (adjusted annually) of wages paid to that employee.

For purposes of Medicare, a total of 2.9% of certain wages paid to an employee is remitted to the government. The employer (1.45%) and the employee (1.45%) each pay half of the total amount but the employer is responsible for withholding the employee’s portion from their paycheck. In addition, once an employee reaches over $200,000 ($250,000 if married) in wages than the employee is required to pay an additional 0.9% of wages, which is called the “additional Medicare tax.” Unlike Social Security, there is no cap on the wages subject to Medicare tax.

Once you have started withholding wages you will need to determine how often you should be depositing those amounts. The IRS has created a deposit schedule based upon the total amounts that are withheld. For new employer’s, you will default to a monthly depositor rule for the first year of business which means that you are required to deposit the total amounts withheld no later than the 15th day of the following month. Once you are an established business, the IRS uses a lookback period to determine how you should be treated going forward. If you have less than $2,500 in deposits then you can deposit at the same time as you file your tax return (i.e. quarterly). If you have more than $2,500 but less than $50,000 than you become a monthly depositor. If you have more than $50,000 then you become a semi-weekly depositor meaning you are required to deposit by either the following Wednesday or Friday of the week after your payday. In addition to this general rule, if you accumulate over $100,000 in deposits during any period then you are required to deposit by the next business day after accumulation.

In addition to your requirement to withhold, pay, and remit FICA taxes you are also required to report such information to the IRS. The IRS has standardized the process by creating a form that can use for such purposes. IRS Form 941, Employer’s Quarterly Federal Tax Return, is a quarterly return that an employer must submit to the IRS that describes who you are, how many employees you have, how much in wages you’ve paid, and if you are eligible for any credits against your payroll taxes. Once you’ve determined this information, the form helps you calculate how much should have been paid in FICA taxes and if there have been any over or underpayments for that time period.

Federal Unemployment Tax (“FUTA”)

FUTA is the Federal Unemployment Insurance tax. While most individuals are not thinking about unemployment when the economy is humming along, unemployment insurance provides a resource for individuals to get over a short-hump until the next opportunity presents itself. In order to fund the unemployment insurance account, each employer is required to pay unemployment insurance tax for each of its employees. Current guidelines require an employer to pay unemployment insurance tax at a rate of 6% up to the first $7,000 of wages paid to the employee. Even though the tax rate is officially 6%, if an employer meets certain criteria then they can take a credit of up to 5.4% when they file their tax return.

Similar to IRS Form 941, the IRS uses Form 940, Employer’s Annual Federal Unemployment Tax Return to report your unemployment tax payments. Even though the Form is an annual tax return, the deposit schedule is not necessarily annually. In fact, for purposes of FUTA, an employer is required to deposit taxes quarterly if the liability exceeds $500. If the liability is less than $500 for that quarter than that amount is carried forward to the next quarter. Once the tax liability exceeds $500 during the quarter, including carryforward amounts, then the employer is required to make the deposit.

State & Local Employment Taxes

State Income Tax

Similar to Federal income tax withholding, a majority of states have an income tax withholding obligation. It is important to understand the applicable withholding, depositing, and reporting rules for each state where you may have a presence. If you don’t have a presence in a particular state but have employees working within that state, you’ll want to become aware of the applicable rules for that state as it is likely that you would be required to withhold, deposit, and report for that employee. Therefore, it is important to consult with an employment tax attorney or payroll tax professional in order to understand what your obligations may be.

State Unemployment Tax (“SUTA”)

SUTA is the state unemployment insurance program. SUTA can be similar in some ways to FUTA but can be quite different from one state to the next. Each state has created its own guidelines for the administration of its state unemployment insurance program. However, each state sets its applicable determination of the type of wages subject to SUTA, the total wage amount subject to SUTA, and the tax rate charged to the employer. The factors used by each state usually revolve around the total amount in the state’s unemployment trust fund, the amount the employer has paid into the trust account, the amount(s) withdrawn from the employer’s trust account, and the particular industry of the employer. Based on these factors, each employer is assigned a tax rate that they are required to pay unemployment tax on for that particular “year.” For new employers, most states have set a fixed rate that is commonly around 2.7% for up to three years.

Local Income Tax

Local income tax withholding sometimes referred to as LIT, is a withholding tax requirement usually administered at the county, municipality, or city level. Each jurisdiction sets their own criteria for what constitutes wages, how much to withhold, when to deposit, and what forms should be provided. If you have an employee that resides in a jurisdiction with a local tax or have a physical presence in a jurisdiction with a local tax make sure you understand your responsibilities. Local income tax withholding can be quite complicated so consult with an employment tax attorney or payroll tax professional to determine your obligations.

Adding employees is an exciting event! When the time comes for you to take that next step, Robinson Legal would be happy to help to ensure that you take the necessary steps to maintain appropriate compliance. Please feel free to reach out to us at (614) 706-4317 or contact via email at drobinson@robinsonlimited.org.

Candace KamenskyComment