What is payroll tax?
What you need to know as a small business owner
When it comes to running a business, there are certain responsibilities that you have to account for. And for small business owners like you, you’re often the one who performs these responsibilities. One of these is running payroll, which is an essential part of paying employees accurately and on-time. But payroll isn’t just about paying employees. It’s much more than that, including handling payroll taxes. So, in this article, we’ll take a look at payroll taxes: from what they are to who pays them to the process of paying them. To start, let’s dive into what payroll taxes are.
What are payroll taxes?
When it comes to your business, paying employees is an integral part of the payroll equation. But payroll is not only distributing wages. It's the entire process of running payroll, from paying employees to tax filing, calculating and taking out payroll deductions for local, state, and federal taxes, Social Security, Medicare, unemployment insurance, and any voluntary employee deductions. The payroll management process also includes maintaining employee pay stubs as well as records of every transaction your business makes.
When it comes to taxes on payroll, there are two types – income tax and payroll tax. Income tax are taxes that only the employee pays for that you as the business owner collect and send to the appropriate tax entities. These taxes use income tax withholding based on information provided by your employees on Form W-4. This could include federal, state, and local income taxes, depending on where your business operates. The state and local income tax rates use an employee's taxable income to factor in how much income tax they can expect to pay. While employees pay these taxes, your business is required to remit payment to the Internal Revenue Service (IRS) and other tax authorities. It’s important to understand income tax to better understand payroll tax, which we’ll talk about next.
In contrast to income tax, payroll tax are taxes that the employer mostly pays for. While employees do pay an employee portion of payroll taxes, employers pay the majority of it. The federal government uses payroll taxes for specific purposes, while income taxes go to the U.S. Treasury’s general fund or, in the case of state income tax, the state's general fund.
When it comes to federal payroll taxes, these include FICA, FUTA, and SUTA tax. Let’s learn about what these acronyms mean and take a closer look at each in the next section.
What’s my business’s responsibility?
As you now know, a small business like yours is responsible for payroll taxes. And while your company isn’t responsible for all the payroll tax, it does shoulder most of the costs. Payroll taxes can be specific and payroll tax rates are set by the government, so there's no way to skirt these business taxes. Let's look at the most common payroll taxes you can expect to pay:
Federal Insurance Contributions Act (FICA) tax
The federal government passed FICA in 1935. The employer and employee split responsibility for the FICA tax, each paying half of the total amount. The law mandates that employers withhold the total percentage from paychecks to fund this tax. The FICA tax is the primary funding vehicle for Medicare and Social Security benefits; it helps support retirees, the disabled, and children who qualify. While many will receive these benefits once they’re retired, employees fund the programs while they’re working. And employers like you are also responsible for contributing. Both the employee and employer pay 7.65% of the employee's gross income to fund the Medicare and Social Security programs, amounting to a total tax rate of 15.3%.
When you withhold these payroll taxes from your employees' wages and make tax payments to the IRS, the taxes then get distributed to both the Social Security Administration and the federal government’s Medicare trust. Those programs then disburse the funds appropriately to those who qualify for Medicare programs and Social Security benefits. The Social Security tax is sometimes referred to as the Old Age, Survivors, and Disability Insurance (OASDI) tax.
There are a few limits on FICA taxes. As of the 2021 tax year, the gross annual pay cap for the Social Security portion was $142,800. That means that any additional wages above this Social Security wage base aren’t subject to withholding Social Security taxes. You don’t have to pay any employer taxes on wages above that amount. However, when it comes to Medicare taxes, there’s no cap, so all of an employee’s annual wages are subject to Medicare tax.
While businesses are typically responsible for paying FICA taxes, there are certain exemptions that make some payments not subject to FICA taxes. These exemptions include:
- Children under age 18 who are employed by their parents
- Qualified retirement plan contributions from employers
- Service performed by students employed by a school, college, or university
- Some church and qualified church-controlled organization wages
- Some state and local government salaries
Employees who are exempt from FICA don’t have to pay FICA taxes. However, they also don’t receive benefits from the FICA system. Again, these are typically rare cases where businesses are exempt from paying the FICA tax.
Federal Unemployment Tax Act (FUTA) tax
The next tax that an employer is responsible for is the FUTA tax. The FUTA was passed in 1939. It is a federal law that raises revenue to administer unemployment insurance and job service programs in every state. The fund created from FUTA covers employees who qualify for unemployment benefits. As an employer, you’ll need to pay the FUTA tax if you’ve paid $1,500 or more in wages during any calendar quarter, and you’re responsible for the 6% FUTA tax on up to $7,000 of wages for each employee per year. However, depending on the state your company operates in, the IRS could give you a credit of up to 5.4% when you file your Form 940 stating that you pay into the state unemployment fund. So, if the IRS credited your business the full 5.4%, that would limit your effective FUTA tax rate to .06%.
Generally, your business is responsible for paying the FUTA tax each quarter. The exception to this rule is for those small businesses whose FUTA tax liability is $500 or less each quarter. If your business meets this requirement, you’ll carry over any FUTA tax liability into the next quarter until the cumulative liability is more than $500. Again, exempt businesses include any company that pays less than $1,500 to an employee per quarter or businesses that are exempt from income tax under section 501(c)(3) of the Internal Revenue Code (typically nonprofit businesses).
State Unemployment Tax Act (SUTA) tax
Much like the FUTA tax, there’s also a SUTA tax, sometimes also known as State Unemployment Insurance (SUI). This tax varies from state to state, but each state has a fund that supports unemployed workers. Each state sets their own rates and conditions, including the taxable wage base and the range for these unemployment taxes. States determine these rates using a variety of factors, and businesses in some industries may face higher rates due to higher turnover rates in those industries. States may also change these rates annually.
Those businesses who pay the SUTA tax on time may be eligible to receive a federal tax credit from the IRS. On the other hand, not paying the SUTA tax on time can be costly for your business, with fines and penalty fees. It’s important to note that while employers are responsible for this tax, some states require additional withholding from employees to help fund this tax. Therefore, depending on the state in which your company operates, you may have to withhold an additional amount from employees to cover the SUTA tax.
Additional Medicare Tax
One other payroll tax that your business should know about is the Additional Medicare Tax. As you know, employees and employers fund the regular Medicare tax, with each party paying 1.45% of the employee’s earnings. But there’s an additional tax for those who earn above a certain income level (which depends on filing status). Those who are high earners are subject to the 0.9% additional Medicare tax on the income they make above the threshold amount. The calculations for these threshold amounts is based on the following filing statuses:
- For those who are single, head of household, or a qualifying widow or widower, the amount is $200,000.
- For those who are married and filing jointly, the amount is $250,000.
- For those who are married and filing separately, the amount is $125,000.
Now that you know more about each type of payroll tax, let’s look at how you calculate and submit these taxes appropriately and without penalty.
Tax returns and forms
When you run payroll, you have the responsibility to pay all applicable payroll taxes and submit the right documentation. If you don’t submit the necessary forms or if you pay late, your business could be subject to fines and penalties. The possibility of these fines and penalties are one reason your small business should ensure it has a payroll system in place to pay your payroll taxes – accurately and on-time.
So, when it comes to employment taxes, your business could be responsible for filing the following federal tax forms:
Form 940: As you’ve seen, this form allows companies to report their annual FUTA taxes. Chances are, your small business needs to fill out and submit this form.
Form 941: This form is the Employer’s Quarterly Federal Tax Return. While employees typically file tax returns annually, most businesses must file tax returns quarterly. On this form, your business will report income taxes, Social Security taxes, and Medicare taxes, as well as the amount of tax they’ve withheld from employee wages.
Form 943: This form is the Employer’s Annual Federal Tax Return for Agricultural Employees.
As the name implies, this only applies to those who employ farm workers. This form is necessary for those employers who satisfy either of the following requirements:
- You pay cash wages to an employee of $150 or more in a year for farm work.
- The total you pay for cash and non-cash farm work to all your employees is $2,500 or more during the year.
If your business meets either of these requirements, you’ll need to fill out Form 943. In addition, income and FICA taxes should be withheld from your employees, and your business will also pay your share of FICA taxes.
Form 945: This form is the Annual Return of Withheld Federal Income Tax. Businesses use this form to report federal income tax that’s been withheld from several different types of payments. Most commonly, small businesses use this form to report backup withholding from non-employees. Payments to non-employees are normally reported to the IRS using a version of Form 1099. These payments usually do not require employers to withhold income tax from independent contractors. The exception is when the IRS notifies you to start taking backup withholding from their paychecks.
In this article, we talked about the importance of payroll taxes and the types of payroll taxes you can expect to pay as a small business. But as you can see, payroll tax can become a complicated issue for your business very quickly. So, to make it one less thing you have to think about, consider working with a third party payroll manager or use payroll management software. Either one of these choices helps your business not only stay up-to-date on the latest changes to payroll taxes, but can also free you up to do what you love, and what you do best – operating your business.
Ready to work with a payroll partner who can help you with payroll tax?
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