Avoid Liabilities: Perfect Your Understanding of Payroll Tax Withholding

As a small business owner, you know that payroll is one of your largest expenses. You also know that you are required to withhold and pay payroll taxes, but this can be challenging if you’re not sure what to withhold and what portion you must pay. Failing to properly process your payroll taxes can lead to major penalties from both the federal and state governments. 

This guide will help you understand the basics of payroll tax withholding. Discover what to watch for as your business grows, and see how tax laws dictate how and when you must pay. 

Types of Payroll Taxes

First, take a moment to familiarize yourself with the various types of payroll taxes that employers are at least partially responsible for. Some of these are federal, while others vary by state.

Federal Insurance Contributions Act (FICA) and Medicare Tax

Payroll taxes primarily consist of two specific types: Social Security and Medicare tax. Together, these taxes amount to 15.3% of each employee’s taxable income, though employees and employers will share this cost differently for Medicare tax (explained below).

Social Security and Medicare Withholding Rates

The current tax rate for Social Security is 6.2% for the employer and 6.2% for the employee, or 12.4% total. The current rate for Medicare is 1.45% for the employer and 1.45% for the employee, or 2.9% total. Refer to Publication 15 (Circular E), Employer’s Tax Guide https://www.irs.gov/publications/p15 for more information.

Additional Medicare Tax Withholding Rate

Important note: An additional Medicare tax applies only to the employee’s wages that exceed a threshold amount. Employers are responsible for withholding the 0.9% Additional Medicare tax on an individual’s wages paid in excess of $200,000 in a calendar year, regardless of filing status. There’s no employer match for Additional Medicare tax. For more information, see the Instructions for Form 8959 and questions and answers for the Additional Medicare tax.

Wage Base Limits

Only the Social Security tax has a wage base limit. The wage base limit is the maximum wage that’s subject to the tax for that year. For earnings in 2024, this base is $168,600. Refer to “What’s New” in Publication 15 for the current wage limit for Social Security wages. There’s no wage base limit for Medicare tax. All covered wages are subject to Medicare tax.

State Unemployment Taxes (SUTA)

State Unemployment Taxes (SUTA) fund benefits for individuals who have lost their jobs. With the exception of Alaska, New Jersey, and Pennsylvania, employers pay the entirety of SUTA taxes. Rates vary by:

  • State
  • Your industry
  • Your company’s history of former employees filing for unemployment benefits

It’s important to note that some organizations, such as non-profits, may be exempt from SUTA taxes.

Each state regulates its own SUTA taxes, so check with your state’s labor department to determine when and how to file these payroll taxes.

Federal Unemployment Taxes (FUTA)

Only employers pay for FUTA taxes. These taxes fund the administrative costs of your state’s unemployment benefits. Business owners pay 6% of the employee’s taxable wages, or up to $7,000 of eligible income per employee. 

However, if you have paid SUTA taxes on time and filed IRS Form 949, you may qualify for a 5.4% tax credit. This will cut your FUTA rate down to 0.6%. 

Self-Employment Taxes

Unless the business is registered as an S corporation or C corporation, business owners are not regarded as employees in the traditional sense. Employers must therefore pay their own taxes. 

This means that business owners must pay both halves of their FICA taxes (15.3% for Social Security and Medicare). However, you can deduct one-half of these self-employment taxes to only pay tax on 92.35% of your taxable earnings.

Taxes Paid by Employees

What taxes are employees solely responsible for? Employees are responsible for paying both their federal and state income taxes, which is why each employee must fill out a W-4 during the onboarding process. Keep in mind that income tax isn’t generally classified as payroll tax, though it will still come out of each paycheck. 

Remember to factor in state income taxes when calculating payroll withholdings. Some states, like Nevada, Tennessee, and Florida, have no state income tax, which can affect employee deductions.

What Reports to File and Where to File Them

Employers must file the following reports when it comes to payroll taxes.

Form 941: Employer’s Quarterly Federal Tax Return

Form 941 reports wages paid, federal income tax withheld, and the employer/employee portions of Social Security and Medicare taxes. This form is filed quarterly, and the address will vary by state.

Form 940: Employer’s Annual Federal Unemployment (FUTA) Tax Return

Form 940 reports the employer’s annual federal unemployment tax. You can find the address for filing Form 940 on the IRS website.

Form 944: Employer’s Annual Federal Tax Return

If your business is small, the IRS may request that you file your federal tax return annually rather than quarterly. The address for filing this form can also be found on the IRS website.

Form W-2: Wage and Tax Statement

Employers provide this form directly to employees, who will file it with their annual income taxes. 

Form 1099-NEC: Nonemployee Compensation

If you’ve employed a contractor for $600 or more during the year, you must file this form to report payments to both the contractor and the IRS. The filing address is listed on the IRS website.

Don’t forget! W-2 and 1099 forms need to be sent to employees and contractors by January 31st of the next year.

What to Watch for When Liabilities Increase

Tax laws are constantly changing. Small businesses should exercise caution when liabilities increase. Pay attention to these crucial areas:

  • Complying with tax laws
  • Managing cash flow to ensure payment
  • Maintaining accurate records
  • Classifying employees properly
  • Planning for future growth

Monitoring these areas can ensure that you stay compliant with existing tax laws and that you have the working capital to cover your payroll expenses.

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