Payroll Taxes
In This Chapter
- Withholding federal, state, and local income taxes
- Calculating Social Security and Medicare withholdings
- Understanding federal and state unemployment taxes
- Determining if your company is subject to a disability tax
Benjamin Franklin is widely attributed as saying the only two certainties in life are death and taxes. As you’ll see in this chapter, taxes are an absolute certainty of running any sort of business. Even if you don’t have any employees, it’s very likely that you’ll be subject to payroll taxes in some fashion.
In this chapter, you might be astounded to learn about the number of different payroll taxes you have to pay and keep up with as a business owner. Some will be rather familiar to you if you’ve ever worked as an employee and lamented about the assortment of withholdings taken from your paycheck. However, some taxes are borne solely by employers.
You’ll also see in this chapter that you’ll be paying taxes at the state, federal, and sometimes even local level. We don’t mean sales tax here, that’s a separate discussion in Chapter 18. In this chapter, we explain the whats and whys about the most common taxes assessed on payroll.
Income tax withholding in the United States has been around in some manner since the Civil War, but most of its present structure was formed in the 1950s, including the setting of April 15 as the annual date all personal tax returns must be filed.
Withholding is a mechanism by which employers may have to set aside a prescribed amount of each employee’s check for federal income tax withholding. (We say may because various factors can determine whether an employee has federal income taxes withheld from their paycheck.) Most states also assess a state income tax, and some jurisdictions, such as cities and counties, assess local income taxes as well.
In a perfect world, the amount withheld from each employee’s check would exactly match their tax liability by the end of the year. However, that’s rarely the case, and employees often end up withholding more than necessary, resulting in large income tax refunds the following year.
Federal Withholding
Federal withholding amounts are determined annually by the Internal Revenue Service (IRS) and vary based on income level and marital/household status. The IRS typically issues new withholding tables for the upcoming calendar year each December in a document known as Publication 15, or Circular E. This document provides instructions for knowing whether someone who works for you should be considered an employee, the definition of wages and other compensation, directions for determining how much to withhold from employee paychecks, and information on how to deposit taxes you’ve withheld. In essence, Circular E contains everything you need to know to determine payroll tax withholding by hand, if you choose to do so.
Unlike the other payroll taxes we’ll cover, federal income taxes tend to be highly personalized. To start, there are two different sets of withholding tables. One covers unmarried individuals (referred to as single), as well as unmarried people who have one or more dependents (referred to as head of household). A second table covers married couples.
Another personal aspect to federal tax withholding is the number of allowances you and your employees opt for. The value of an allowance changes each year due to inflation, but for the 2016 tax year, each allowance an employee claims reduces their taxable income for withholding purposes by $4,050. This enables employees to match their withholding to their expected income tax liability. (However, allowances simply control withholding from one’s paycheck. If you claim too many allowances, you might end up with a large income tax bill when April 15 rolls around.) The IRS requires all employees to submit a Form W-4 indicating the number of allowances claimed.
State Withholding
If you and your employees are isolated to Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming, you can skip this section. None of these states levies a state income tax. In addition, Tennessee and New Hampshire do have a state income tax, but both exempt wages.
So anyone living in the other 41 states must calculate, remit, and report state income tax withholdings in addition to federal income taxes. Most states have a similar tax structure to the federal tables, but be sure to investigate the requirements with your state’s Department of Revenue.
Local Withholding
The U.S. Census Bureau reports that as of 2013, the United States contained 19,508 incorporated areas (cities, towns, townships) and 3,194 counties for a collective total of 22,702 jurisdictions. Specific information about local taxes is difficult to find, but a 2011 article published by the Tax Foundation indicated that nearly 5,000 cities and counties across the United States assess a local income tax. These numbers change regularly, and the totals are updated infrequently.
Suffice it to say, there’s a roughly 1 in 5 chance you live in a local jurisdiction that assesses a local income tax.
Social Security and Medicare
The U.S. Social Security and Medicare programs are administered by the federal government, and taxes for these programs are collected by the IRS.
The Social Security Administration (SSA) was founded in 1935 and pays retirement, disability, and survivors benefits to U.S. citizens. Taxes have been collected under this program since January 1937, and regular monthly benefits have been distributed since January 1940. The SSA reports that the first payout under the program was a single lump sum of 17¢ in January 1937. Further, as of calendar 2009, the most recent year available, 55 million Americans received monthly Social Security benefits.
The collective Social Security and Medicare tax withheld from employee paychecks is often referred to as the FICA tax. The acronym stands for Federal Insurance Contributions Act, the legislation that authorized the tax. The FICA tax itself is actually a combination of two tax rates, with two distinct thresholds.
Ostensibly, this tax is shared on a 50/50 basis between the employee and the employer. However, self-employed taxpayers must pay both halves of the tax.
Social Security Withholding
The tax rate for Social Security withholding has remained mostly constant at 6.2 percent of the wage base since the early 1990s. However, both the employee and employer must pay this tax, so the collective rate is 12.4 percent of the wage base.
For calendar year 2015, the wage base is $118,500, which means employees must pay Social Security tax of 6.2 percent on the first $118,500 they earn during the year. Employers must match this, so for 2015, the collective tax can be as much as $14,694 for employees who are at or above the wage threshold.
A self-employed taxpayer earning above the wage threshold owes the entire $14,694, although offsets are sometimes available.
The wage base increases by a small percentage each year to reflect inflation.
BOTTOM LINE
During the 2011 and 2012 tax years, Congress temporarily lowered the Social Security tax rate to 4.2 percent for employees (the employer rate remained at 6.2 percent), so the collective employer/employee total was 10.4 percent. That legislative provision, the 2010 Tax Relief Act, expired without renewal and the tax rates returned to 6.2 percent for both employee and employers in 2013 and beyond.
Medicare Withholding
A Medicare tax is withheld from employee checks in the same fashion as Social Security, however there’s no wage base, so all wages are taxed for Medicare.
For the 2015 calendar year, the Medicare tax is 1.45 percent of all wages an employee earns. The employer matches this, so all wages are subject to a total of 2.9 percent for Medicare tax.
Certain high-income earners are now subject to an additional Medicare tax of 0.9 percent above designated thresholds, but these amounts are calculated and paid on one’s personal income tax return and not subject to payroll withholding.
Anyone who earns more than the FICA withholding base should pay particular attention when changing jobs in a given year. It’s possible to have excess FICA withheld because your second employer won’t take into account the amount your previous employer withheld. If you find yourself subject to excess FICA withholding, you can recover the difference when you file your annual personal income tax return by claiming a tax credit for the excess.
Unemployment Taxes
Your business pays and files returns for two different types of unemployment taxes, federal and state.
Unemployment insurance is designed to be a safety net for employees who have had their employment terminated by their employer. If an employee willingly leaves a job, he or she is not eligible to receive unemployment insurance (also called unemployment compensation). However, when a corporation implements a mass layoff, typically all those employees are eligible for unemployment insurance. Note, however, that an employee terminated for misconduct or some other justifiable cause likely doesn’t qualify to receive unemployment insurance.
Unemployment insurance does not usually provide full-wage replacement. It’s intended to be a financial stop-gap while terminated employees seek new employment.
Unemployment insurance is administered by each state, but you also pay a federal unemployment tax.
Federal Unemployment Taxes
Federal unemployment taxes need to be paid in addition to state unemployment taxes. You might wonder why Uncle Sam wants to charge you for an insurance program administered by each of the 50 states. There are several reasons for this:
- The federal government helps subsidize the cost of running each state’s unemployment insurance program.
- Congress sometimes mandates that states extend the period of time they offer benefits to long-term unemployed citizens. The federal tax helps fund these congressional mandates.
- The need for benefits in a given state sometimes outstrips the unemployment taxes collected. In such cases, a state can borrow money from the federal unemployment tax program to fund benefits. Any such borrowings must be paid back by the state.
The Federal Unemployment Tax is often referred to as FUTA. In this case, the A in the acronym refers to the legislation that enabled the tax, the Federal Unemployment Tax Act.
This tax applies to the first $7,000 earned by each employee in a given calendar or fiscal year. Ostensibly, the tax is 6.2 percent of the first $7,000 of each employee’s wages, or $434 per employee, per year. However, employers are allowed to claim a credit of up to 5.4 percent of the $7,000 based on the unemployment tax they pay to their state. This reduces the federal unemployment burden for most employers to 0.8 percent of the first $7,000 of wages, or usually $56 per employee, per year. This assumes an employee is on your payroll long enough to earn $7,000.
FUTA is based on the first $7,000 an employee earns in a year, so for most employees, the $7,000 meter starts at January 1. For any new hires during the year, the $7,000 starts accumulating as of the hire date.
Any other wages employees earn are exempt from the FUTA tax.
State Unemployment Taxes
State unemployment taxes are commonly referred to as SUTA (State Unemployment Tax Act). Each state is responsible for paying unemployment benefits to citizens who have had their job terminated by an employer. The criteria for qualifying for unemployment varies by state, and employees terminated for cause, such as fraud, not performing job duties, etc. might not be eligible for unemployment.
For the most part, states have a wide degree of latitude in how they fund and administer unemployment programs. Accordingly, the rules and regulations for state unemployment vary widely. Unlike FUTA, which is assessed on the first $7,000 of an employee’s wages, some states, such as Washington, assess a state unemployment on as much as the first $41,300 for calendar year 2014. Conversely, Arizona and California had the lowest wage base in 2014 of $7,000. Other states fall somewhere in between.
Another difference between FUTA and SUTA is that each employer might have to pay a different percentage of the wage base. This is often based on several criteria.
For example, brand-new businesses are often subjected to a new employer tax rate that’s higher than the average paid by most businesses. Over time, if the business doesn’t have any former employees who file for unemployment, the tax rate is lowered. For calendar year 2014, Vermont had the lowest new-employer rate of 1 percent of its wage base, while Hawaii had the highest rate of 4.6 percent.
Also, businesses that have had many employees file for unemployment insurance are often subjected to a maximum unemployment tax rate. In 2014, Massachusetts had the highest maximum rate of 12.27 percent of the wage base; the lowest rate in 2014, 5.4 percent, was assessed by Alaska, Florida, Georgia, Mississippi, Nebraska, Nevada, New Mexico, and Oregon.
In addition, businesses that, over time, do not have any employees file for state unemployment benefits may see their wage rate drop to as low as 0 percent. This is true in states such as Iowa, Missouri, Nebraska, North Carolina, and South Dakota. In calendar year 2014, Pennsylvania had the highest minimum tax rate of 2.8 percent of the wage base.
ACCOUNTING HACK
At this point, your head might be spinning from the vagaries of each taxing authority’s requirements. Most accounting software offers fee-based payroll processing services that range from streamlining payroll by providing prebuilt tax calculations so you don’t have to perform any manual calculations, to full-service payroll options that calculate all the withholdings and prepare all the tax forms (see Chapter 18). You also can outsource your payroll processing to your software provider or a third-party payroll processing company.
As you can see, the states are all over the place when it comes to determining how much to charge for state unemployment taxes. Accordingly, we can’t provide specific guidance for each state, but in general, we can say this about SUTA:
Every employer in a state pays an unemployment tax based on a certain threshold of each employee’s wages, referred to as a wage base.
The percentage of the wage base each employer pays for its employees is based on a state’s experience with that employer. States typically only change the wage base and/or tax rate for an employer once a year, but sometimes mid-year changes are implemented during periods of high unemployment. Each state is expected to keep its unemployment insurance fund solvent, so changes in demand for unemployment benefits may result in sudden and dramatic changes in the tax.
Unemployment taxes are typically remitted to the states by way of a quarterly unemployment tax return. This return usually includes a list of every employee the company has in a given state, along with their total wages. The unemployment return has a space to show the amount of exempt wages (those employees earned above the wage base) along with a net taxable amount. The tax rate is applied to this next taxable amount.
The unemployment insurance programs are typically administered by a Department of Labor in each state, but some states might have different names for their programs or departments.
Temporary Disability Insurance
If you live in California, Hawaii, New Jersey, New York, or Rhode Island, you might be subject to an additional tax levy to fund temporary disability insurance (TDI).
Much like unemployment insurance provides partial income replacement for employees who are terminated by employers, TDI is intended to provide similar protection for health-related issues. Employees who miss work for more than a few days due to illness, injury, or pregnancy-related issues may be able to recover a portion of their lost wages under this program.
The Least You Need to Know
- Employers are required to withhold income, Social Security, and Medicare taxes from employee wages and remit those amounts to the federal and state governments.
- In jurisdictions where income tax is incurred at the local level, employers are required to withhold and submit city, county, or township taxes.
- Employees who had too much (or not enough) tax withheld can settle up on their annual income tax returns.
- Unemployment insurance is required to be paid at both the federal and state level.
- Additional payroll taxes such as disability insurance are required in some states.