This article is intended for U.S. business owners only.
Many small business owners think payroll processing is simple. Well, it’s only simple if you've set up payroll for your business properly at the very beginning. And that’s a big if.
Some of the largest financial risks entrepreneurs suffer are penalties and interest assessed for incorrect payroll tax remittance and reporting. It’s definitely worthwhile to understand what’s involved before getting started.
Here are the top things you need to know before starting out, based on frequently asked questions and best practices for payroll.
1. What counts as payroll?
The most common forms of payroll are wages and salaries paid to employees for services performed in a business. Wages also include: tips, bonuses, commissions, and fringe benefits such as employer provided cell phones or automobiles.
2. Who are employees?
Improper classification of workers can cause substantial financial consequences and is one of the most important parts of payroll to understand.
It can be tempting to classify all part-time, seasonal, short-term and occasional workers as independent contractors rather than employees to save money on payroll taxes. It’s not a good idea. Descriptions are not what matter.
What is important is how the IRS and your state classify workers, which is unique to each situation and considers about 20 different items. The most important are whether you (the employer) have the right to control what work will be done, how it will be done, and where it will be done. Other items include whether you provide tools, equipment, workspace, insurance, vacation, and other benefits.
If you classify workers as contractors and the IRS later decides they are employees, you can be liable for unpaid payroll taxes, fines, penalties, and interest fees. The payroll forms you need to file to pay contractors are quite different than the forms you need for full-time employees, so make sure you know how to properly pay independent contractors versus your full-time employees.
3. Does it matter where employees live?
Absolutely! An employee’s permanent residence is considered his or her tax “home” and determines what taxes he or she has to pay in that state. Employers withhold the same amount of federal taxes no matter where the employee lives or works.
State and local income taxes are usually determined by considering the employee’s home (resident) location as well as their work location. In most cases, employers have a withholding responsibility to the location where their employees actually work, which can either be their resident or nonresident state.
Here’s where things get tricky. Depending on where the employee lives, employers can withhold the employee’s state income tax for his/her home state. Special income tax arrangements (reciprocity agreements) can also be in place for bordering states.
4. What taxes have to be withheld from employee paychecks?
In most cases employers are required to withhold the following taxes (although there are some exceptions):
- Federal income tax
- Social security tax
- Medicare tax
- State and local tax
- Plus, any additional taxes that can vary by state (e.g. disability insurance)
5. What payroll taxes have to be paid?
All employee withheld taxes plus any employer contributions (as required) must be paid to the agency responsible for collecting them (either the IRS, State Department of Revenue/Taxation, State Department for Labor, or Employment Services).
Additionally, employers must match the amount of Social Security and Medicare taxes withheld from employee paychecks and pay those, too.
Employers also have to pay Federal and State unemployment insurance contributions from their own funds.
6. What are the payroll tax rates?
Federal income tax withholding is determined by an employee’s W-4 form. For 2021, the social security tax is 6.2% on the first $142,800 of wages. The Medicare tax is 1.45% on the first $200,000 of wages and an additional 0.9% for anything over that (with different thresholds applying for joint and married filing separately). Note that there are matching employer and employee portions for both Social Security and Medicare taxes (but not the Additional Medicare Taxes, this is employee-paid only).
State, city, local and municipal tax rates are different for each state. Most states have their own forms for employees to fill out to determine State withholding, while other states use the federal W-4 form.
The Federal unemployment tax for 2021 is 6.0% on the first $7,000 you pay to each employee. Most employers can take a credit against their Federal unemployment tax for amounts paid toward State unemployment tax. The credit may be as much as 5.4% of the taxable wages, making the Federal unemployment rate 0.6% after the credit. The maximum credit can be claimed if the State unemployment tax has been paid in full for the year, as long as the taxable wages were the same as Federal unemployment taxable wages.
State unemployment tax rates depend on a variety of factors that differ by state. These can include business type, type of industry, length of time an employer has had an active account, and the number of unemployment claims charged to the employer’s business.
7. When do payroll taxes have to be paid?
The frequency of federal tax payments depends on the employer’s tax liability (amount due). Generally, towards the end of each year, IRS mails notices to employers informing the schedule they should use for depositing payroll taxes for the upcoming calendar year. The determination is based on the 12-month look-back period, ending June 30th of the previous year (the four prior quarters). Most employers are required to make either semi-weekly or monthly deposits.
State and local payroll tax due dates are different for each state, and employers have to refer to their state tax laws to determine the deposit schedule.
The due date of the payroll tax liability is determined by the date on which wages were paid to employees. It’s important to note that this can differ from when the wages were earned (when work was performed). When determining the due date for your liabilities, always use the check date you had paid your employees.
Calculating payroll taxes is a task that can overwhelm even the most experienced business owners, which is where Wave Payroll can lend a helping hand.
As well, if you’re a business owner in Arizona, California, Florida, Georgia, Illinois, Indiana, Minnesota, New York, North Carolina, Tennessee, Texas, Virginia, Washington, or Wisconsin, there’s an option to have your payroll tax payments and filings done for you.
8. How are payroll taxes paid?
All Federal withholding and unemployment taxes must be paid electronically either through Electronic Federal Tax Payment System (EFTPS) or by wire or ACH credit. Paper checks are no longer accepted. If the date on which employers are required to make a federal tax deposit falls on a non-business day, then employers have until the close of the next business day (any day other than a Saturday, Sunday, or legal holiday) to make a timely deposit.
Some states also require electronic payments. Your business must register for an account with each tax collection agency in the state for which you have to pay.
Employers can be assessed penalties for failing to make payroll tax deposits on time. In general, the timeliness of a deposit is determined by the date it’s received. You don’t want to be late with your deposits.
9. Are any employees ever exempt from payroll taxes?
The specific rules and regulations vary by tax and jurisdiction and can depend on the legal entity of the business, age, and the relationship of the employee and their immigration status to name a few.
10. How does the business owner get paid?
This is such a complex topic that we decided it needed something more than a few paragraphs. Check out this quick video we’ve put together that should answer all your questions.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.