Employment Taxes 101: An Owner's Guide to Payroll Taxes
Employers are required to deposit employment taxes and report these taxes on a quarterly basis in most cases. Employment taxes include withholding from employees' paychecks to cover income taxes—federal and where applicable state and local—as well as the employees' share of Social Security and Medicare taxes (FICA). They also include the employers' share of FICA as well as federal and state unemployment taxes. The failure to properly withhold and deposit taxes can result in significant penalties for employers.
What are employment taxes?
Employment taxes are federal and state taxes related to employee's taxable compensation. They include:
- Income tax withholding based on information provided by employees on Form W-4. This tax is paid exclusively by employees.
- FICA. This is comprised of Social Security and Medicare taxes and is paid equally by employers and employees. The Social Security portion is referred to as Old Age, Survivors, and Disability Insurance, or OASDI and provides benefits to retirees, spouses and former spouses, as well as dependent children in some cases, and disabled individuals under retirement age. The Medicare portion allows those age 65 and older (plus certain other individuals) to qualify for Part A Medicare coverage with no additional cost, plus coverage through Parts B, C, and D for an additional premium.
- FUTA, which is federal unemployment tax paid exclusively by employers.
- State unemployment tax is paid by employers, although a few states require some employee contributions.
What should employers know about employer tax responsibilities?
Employers have several mandatory tasks in handling payroll taxes:
- Figure income tax withholding and other employment taxes.
- Deposit all employment taxes according to a set deposit schedule (with an exception for a very small employer).
- Report quarterly about their employment taxes covering income tax withholding and FICA (with an annual report for a small employer) and report annually to employees and the Social Security Administration about employee's tax payments. They also have annual FUTA reporting. And there is state-level reporting.
Note: An employer may also be required to withhold other amounts from employees' paychecks, such as salary elective deferral amounts for employee contributions to 401(k) plans and flexible spending accounts or for garnishment to cover child support. These additional withholding amounts do not figure into employment taxes; they are merely an additional employer responsibility.
Mandatory Employer Payroll Taxes
Payroll taxes are required to be handled by employers who can be penalized if not done properly. There are a variety of payroll taxes, some paid by employers, some by employees, and some by both. But in all cases, it's up to employers to deposit them.
Federal Income Tax
Income tax withholding from employees' paychecks is designed to cover what they will owe in federal income tax for the year. This includes employees' income taxes as well as Social Security and Medicare taxes. For certain employees, it also includes an additional Medicare tax (explained later).
All states, other than Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming which have no income tax and New Hampshire and Tennessee (through 2020) which do not tax wages, require employers to withhold state income tax from employees' paychecks. Some cities, including New York City and Philadelphia, also have income taxes, which means additional wage withholding.
In a handful of locations, other withholding is required to cover:
- Short-term disability
- Paid family leave
- Unemployment benefits
Social Security Tax (FICA)
Social Security and Medicare taxes, which make up FICA, are imposed on both employers and employees to pay for Social Security benefits and Medicare benefits. Employees and employers each pay 6.2% of compensation up to an annual wage base limit ($137,700 in 2020) for the Social Security portion, plus 1.45% of all compensation for the Medicare portion.
Federal Unemployment Tax Act (FUTA)
The federal government doesn't pay unemployment benefits but does help states pay them to employees who've been involuntarily terminated from their jobs. To fund this assistance to the states, there's FUTA, which is a tax created by the Federal Unemployment Tax Act. The tax applies only to the first $7,000 of wages of each employee. The basic FUTA rate is 6%, but employers can receive a credit for state unemployment tax of up to 5.4%, bringing the net federal rate down to 0.6%, or a maximum FUTA payment of $42 per employee.
However, the credit is reduced if a state borrows from the federal government to cover its unemployment benefits liability and hasn't repaid the funds. Then such state becomes a "credit reduction state" and the credit reduction (listed on Schedule A of Form 940) means the employer pays more FUTA than usual.
State Unemployment Tax
States have the responsibility of paying unemployment benefits to eligible workers who are involuntarily terminated (those laid off other than for gross misconduct or who are furloughed). To fund this liability, states impose unemployment tax on employers. The tax is figured more like insurance because the rate that employers pay is based on their claims experience. The more claims made by former employees, the higher the tax rate on such employers. Each year, the state informs an employer of its tax rate, which can never be below a minimum amount.
Additional Medicare Tax
When an employee's compensation from an employer exceeds $200,000, the employer must withhold an additional amount for the additional Medicare tax. This tax is 0.9% of earned income over a threshold amount ($250,000 for joint filers, $200,000 for singles, and $125,000 for married persons filing separately). This tax is paid solely by the employee; the employer merely has the responsibility of withholding it. The $200,000 withholding threshold applies regardless of the employee's marital or tax filing status.
Understanding Payroll Tax Responsibilities
Employers' payroll tax responsibilities are extensive. They include figuring income tax withholding (federal and where applicable state and local), depositing payroll taxes, and filing various returns explained later to report payroll activities.
How to Calculate Employer Payroll Taxes
Payroll taxes are figured according to an employee's Form W-4. This form tells the employer the employee's marital status and whether additional withholding should be made to cover certain personal taxes to which an employee may be entitled that reduce his or her income taxes. If no W-4 is provided, then an employer withholds as if the employee were single with no other adjustments.
Employers relying on outside payroll service providers, such as Paychex, can leave the calculations to them. Some employers who do payroll in-house use software or rely on tables provided by the IRS in Circular E to calculate payroll taxes.
What forms are required when calculating and submitting payroll taxes?
There are no special forms used to calculate payroll taxes. And no special forms are needed when depositing payroll taxes. However, there are required forms to be filed which report these activities.
Overview of Tax Returns and Deposits
Employers have the responsibility to file employment-related tax returns and deposit employment taxes according to set deadlines. If they fail to do so, they may be subject to failure to file and failure to pay penalties. What's more, "responsible persons" in the company who fail to deposit trust fund taxes—amounts withheld from employees' paychecks—may be subject to a 100% personal liability. This trust fund recovery penalty is triggered when a person with the authority to make payment decisions willfully fails to deposit the taxes. The possibility of these penalties means employers must get things right.
Employers must file a variety of tax returns related to employment taxes. On the federal level, they include:
- Form 940, which is an employer's annual FUTA tax return.
- Form 941, which is an employer's quarterly tax return reporting withholding and the employer's share of FICA. For 2020, it's also used to claim a credit for employment taxes to cover payments by small and mid-sized businesses of mandatory sick leave and mandatory family leave, due to the COVID-19 pandemic. If employment taxes are not sufficient to cover these required payments to employees, then employers can file Form 7200 to obtain an advance credit of employment taxes.
- Form 943 is the employer's annual return for agricultural employees.
- Form 944 for small employers eligible to pay employment taxes annually rather than depositing them according to a schedule.
- Form 945 is a federal income tax return used to report nonpayroll payments, including pension distributions.
Employers must also report withholding to employees and the Social Security Administration. For this purpose, they must file:
- Form W-2 with employees.
- Form W-3 with the Social Security Administration. This is a transmittal form that summarizes all W-2s; copies of all W-2s are included with the W-3.
Employer Tax Deposits
All payroll taxes must be deposited with the government in a timely manner. The IRS sets the tax deposit deadline for employers. These deadlines depend on the amount of deposits:
- Semi-weekly schedules are for the largest employers.
- Monthly schedules are used by the majority of employers.
Some payments may be made with the either Form 941 or Form 944, depending on certain criteria. Refer to pages 25 -26, Depositing Taxes in IRS Publication 15, for further details.
Note: Due to the COVID-19 pandemic, employers can elect to defer the deposit and payment of the employer's share of Social Security taxes that would otherwise be made during the period beginning on March 27, 2020, through December 31, 2020. If so, then 50% of the deferred amount must be deposited no later than December 31, 2021, and the other 50% by December 31, 2022. If deposits are made by these dates, they are treated as timely and no late payment penalty results.
Filing Employer Tax Returns
Employers must file returns by set deadlines (explained below). Usually, employer tax returns are filed electronically through an authorized e-file Provider or software you purchase for this purpose.
How often do I have to file taxes?
Most employers' returns are filed annually. However, the employer's federal return (Form 941) is filed quarterly.
States have their own filing schedules for their returns. Check with your state tax/revenue/finance department.
How much should I withhold?
It's up to the employer to figure the correct amount of withholding based on an employee's Form W-4. A revised Form W-4 went into effect for 2020, but existing employees are not required to submit new forms; employers can calculate withholding based on the old versions on file with them.
All employees are required to complete a Form W-4, Employee's Withholding Certificate to provide the employer with information needed to compute withholding.
For new employees, employers must require them to complete Form I-9 to verify they are legally eligible to work in the U.S. And it's also advisable for employers to have employees complete Form 8850, which is a form employers must submit to the state workforce agency to determine whether the new employee falls within a targeted group that entitles the employer to a work opportunity tax credit.
Once I've calculated my business employment taxes, how do I submit them?
Payroll taxes must be deposited electronically through the Federal Electronic Tax Payment System, or EFTPS. Small employers who are permitted to pay their employment tax when filing their annual employer tax return can opt to use EFTPS.
For state employment taxes, check with your state to determine how to deposit employment taxes.
How do I handle independent contractors or self-employed individuals?
Independent contractors and self-employed individuals are not employees. However, employers should review the status of the worker to ensure that the individual is properly classified as an independent contractor. Businesses that engage them are not responsible for any employment taxes on payments made to them. These workers pay self-employment (SE) tax on their net earnings from self-employment (their profits from their business activities), which is essentially the employee and employer share of FICA. If a self-employed person also has wages from a job, the wages are coordinated with the SE tax so that the wage-base ceiling can be properly applied.
If total payments to such worker in the year are $600 or more, the business must file an annual information return—Form 1099-NEC—to report the payments to the worker and to the IRS.
Employer payroll responsibilities may seem overwhelming. The rules are continually changing, as evidenced in 2020 by a Form W-4, a higher wage base limit for Social Security taxes, mandatory payments of certain benefits offset by employment taxes, and a deposit deferral option. To ensure that you do things correctly, consider outsourcing payroll to a payroll service provider such as Paychex.