Employment taxes are so named because they apply only to compensation for work. Because employment taxes are flat taxes, for which there are few deductions, they are major burden on poor people, and the major reason why work is the most heavily taxed form of income. Investment income and inheritance are not subject to employment taxes and are usually taxed at a much lower rate than compensation for work. However, starting in 2013, a 3.8% Medicare tax will also be assessed on investment income for high income taxpayers: this is the 1st time that traditional employment taxes have been extended to other forms of income. Employment taxes are also sometimes referred to as payroll taxes because they are generally withheld from payroll. The main part of employment taxes consists of the Social Security tax and the Medicare tax, equal to 15.3% of taxable compensation, where the employer pays ½ of the tax and the employee pays the other half. However, the employer must collect the entire tax and remit it periodically to the IRS. Employment taxes also consists of the federal unemployment tax, which is only assessed on the employer. Self-employed people pay the self-employment tax, but they must pay both the employer and employee portion. However, they can deduct the employer's portion of the tax, so they pay an effective rate of 14.13%. Additionally, they can deduct ½ of their unemployment tax from their gross income.
The Federal Insurance Contributions Act (FICA) set up the Social Security and Medicare system to provide for retirement, disability, and hospital insurance for workers. Employment taxes are the employer's tax obligation in regards to employee compensation, including income tax withholding for federal, state, and local taxes, FICA taxes, and federal and state unemployment taxes. Some states also assess a disability tax.
Employees must pay federal, state, and local income taxes on their income. The employer withholds the tax based on the amount of pay, the employee's filing status, and the number of withholding allowances claimed on Form W-4, Employee's Withholding Allowance Certificate, which the employee submits to the employer.
There are 3 types of taxes that the employer must remit periodically, based on employees' pay:
- taxes withheld from the employee's pay
- FICA taxes: Social Security and Medicare taxes
- federal unemployment tax (FUTA).
A business owner who works as an employee of his own corporation is also liable for payroll taxes. Income taxes assessed on employees apply only to the employee, but must be withheld by the employer and remitted periodically. However, income tax is not withheld from the pay of some statutory employees. FICA taxes consist of 2 equal portions: an employer portion and an employee portion. FUTA is assessed only on the employer. However, in some states, local taxes are paid only by the employees, such as Pennsylvania's unemployment tax and California's state disability insurance.
All businesses that have employees must have an employer identification number (EIN), format: 12-3456789. All business entities except sole proprietorships require an EIN; sole proprietorships only require one if they have employees. Although many states use the federal EIN, some use a separate state EIN.
Severance payments may also be subject to employment taxes, although the law is not clear, as some courts have decided that there is employment tax liability on severance payments, while other jurisdictions have decided otherwise. FICA taxes are generally withheld on deferred compensation when it is earned, not when paid. Some compensation may be subject to FICA and FUTA taxes even if they are not subject to income taxes, such as contributions to a qualified retirement plan or some other fringe benefits. If parents employ their children younger than 18, then the wages are not subject to FICA or FUTA; there is no liability for FUTA taxes until the child reaches 21.
Wage differential payments to employees on active duty for more than 30 days are subject to income tax withholding but not FICA or FUTA withholding. Withholding on such payments can be determined by the IRS withholding tables or it can be aggregated with ordinary pay from which a flat 25% can be withheld, if the compensation is less than $1 million.
Trust Fund Taxes
Taxes withheld from the employees' pay are considered to be trust fund taxes, because the employer is responsible for withholding the tax and remitting it to the tax authorities, so the employer holds the taxes in trust for the tax authorities. Business owners are personally liable for trust fund taxes, even if they are employees of their own corporation. They will also be held liable for the employee's portion of the tax if it cannot be collected from the employee.
Taxes on both Employers and Employees
FICA tax is assessed on both employers and employees. The total FICA rate is 15.3%, but the employer and employee pay ½ of that rate, or 7.65%. Additionally, employees with incomes exceeding $200,000 per year must also pay an additional 0.9% Medicare tax.
The Social Security portion of the FICA tax is assessed only on income up to the Social Security wage base:
Income above the wage base limit is not subject to Social Security taxes, but all earned income is subject to the 2.9% Medicare tax, with ½ of the tax, or 1.45%, assessed on the employer and 1.45% on the employee. However, only the employee is liable for the 0.9% Additional Medicare Tax: there is no employer portion. Nonetheless, the employer must withhold the Additional Medicare Tax.
The amount of payroll taxes that must be withheld is determined for each pay period.
Example: For the 1st pay period in 2015, your employee earns $20,000. You must withhold 15.3%, or $3060, from the payment. After your employee earns $108,500, she receives another payment of $20,000. Therefore, $10,000 will still be subject to the 15.3% payroll tax, while the remaining $10,000 will only be subject to the 2.9% Medicare tax, since that amount exceeds the Social Security wage base. Any amounts paid to the employee for the remainder of the year is subject to the 2.9% Medicare tax, for which the employer must pay 1.45%. If the employee earns more than $200,000, then an additional 0.9% Medicare tax must be withheld from the employee's pay: only the employee is liable for this tax.
There are some groups exempt from FICA: some state and local government employees covered by state pension plans and some college students who work for their universities. Civilian federal government employees hired prior to 1984 are exempt from Social Security.
Special Rules for Tips
Because employees do not often report their tips, there are special tax rules that apply to businesses with employees who earn much of their income from tips. The US Supreme Court has ruled that when assessing FICA taxes on employers, the IRS can use an aggregated estimate of the employer's share of FICA taxes. To avoid taxing employers any more than needed, the IRS will show some leniency if businesses follow some of the programs that the IRS has developed to increase the reporting of tips:
- Tip Reporting Alternative Commitment (TRAC), which requires employers to educate employees on the tip reporting requirements, to report their tips monthly, and to audit those who underreport
- Tip Rate Termination Agreement (TRPA), where the employer and the employees agree to a voluntary tip rate, which can only be done if 75% sign a Tipped Employee Participation Agreement
- Employer Designed Tip Reporting Alternative Commitment (EmTRAC), is an alternative to the TRAC program for the food and beverage industry
- Gaming Industry Tip Compliance Agreement (GITCA), which applies to any gaming or casino industry.
Unemployment Taxes are Assessed Only on Employers
Both state and federal unemployment taxes are generally paid only by the employer. The Federal Unemployment Tax Act (FUTA) helps fund state unemployment programs and covers the federal portion of unemployment insurance and half the cost for extended unemployment benefits. FUTA is reported annually on Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return.
States also borrow from the fund if their unemployment insurance fund is short, as many have done during the credit crisis from 2007-2010.
The tax rate is 6.0% on the 1st $7000 of gross earnings for each employee per year. Employers can apply the FUTA credit reduction based on the employer's payments into the state unemployment insurance fund, usually equal to 5.4%; thus, the effective federal FUTA tax rate is 6.0% – 5.4% = 0.6%.
However, if states borrowed from the FUTA fund, but have not repaid the loan balance by November 10 of the 2nd year, the FUTA credit is reduced by 0.3% for each year that there is a balance, reducing the credit that the employer can claim for state unemployment insurance taxes by the same amount. The state list can be found on the Department of Labor's website.
Some wages are exempt from FUTA:
- for services performed outside of the US
- paid to a deceased employee or the estate
- paid by a parent to a child younger than 21, paid by a child to a parent, or paid by a spouse to the other
- wages paid:
- by a foreign government or international organization
- by a federal, state, or local government
- by a hospital to interns
- paid to newspaper carriers younger than 18
- paid by a school to a school student
- paid by an organized camp to a student
- by nonprofit organizations
- to Class 2 and Class 3 statutory employees
Most states also assess an unemployment insurance tax on the 1st $7000 of gross wages, but the tax rate depends on the number of claims filed by the business, because some businesses have greater employee turnover than others, so it would be unfair to tax all businesses at the same rate. So higher claims results in a higher tax rate. Moreover, some states also have a much higher wage base on which the unemployment tax applies. For instance, Hawaii and Washington have a wage base that exceeds $38,000. Some states may also have other employer only taxes, such as the Employment Training Tax, which California assesses on the 1st $7000 of wages at a rate of 0.1%.
Depositing Payroll Taxes
Tax authorities are vigilant about the deposition of trust fund taxes; they always investigate when the trust fund taxes are not remitted when due. Employment taxes must be calculated to the penny; rounding to the nearest dollar is not permitted as with income taxes. Payroll taxes should be paid using the Electronic Federal Tax Payment System (EFTPS). EFTPS is free to use and can also be used to pay other federal tax liabilities; it also allows a business owner to verify that payroll taxes have been deposited if it uses a payroll company, as most do. In some cases, if a small business only requires making quarterly deposits, the business could use the payment voucher with Form 940, Form 941, or Form 944. However, all other employers must pay their FICA taxes electronically using EFTPS.
Since EFTPS allows a business to monitor whether payroll taxes have actually been deposited, it is the only method any business owner should consider. If payroll taxes were not deposited by the payroll company or the amount was insufficient, then the business owner will be liable for the full amount of the payroll tax not deposited.
Most businesses do, and should, use a payroll service, but the business owner should select a reputable payroll service that is willing to pay for mistakes that it may make. Most reputable services will do this if they are used as a full-service, which includes depositing the payroll taxes. In any case, the business owner should always monitor that the trust fund taxes have been deposited through the EFTPS system. The payroll service will file the required forms and make the required tax payments.
To report payroll taxes, there are 3 forms that must be filed:
- Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return is used for the FUTA tax return, if the FUTA tax is more than $500 a year. If the FUTA tax does not exceed $500, then Form 940 can be filed at the end of the year; otherwise, taxes must be deposited more frequently, depending on the total tax. Form 940 is due on January 31 following the reported year or until February 10, if all FUTA taxes were deposited when due.
- Form 941, Employer's QUARTERLY Federal Tax Return is used to report FICA and federal income tax withheld quarterly, due on the last day of the month following the end of the quarter (e.g., April 30 for the 1st quarter). If withheld taxes exceed $1000, even if it is only a corporation with 1 employee, a Form 941 must be filed.
- Form 944, Employer's ANNUAL Federal Tax Return can only be used if the IRS notifies a business to use it, because it is designed for the smallest employers whose annual payroll tax liability does not exceed $1000. These businesses can file and pay the taxes once per year.
For larger employers, the schedule for depositing trust fund taxes depends on the amount of tax collected, so businesses are grouped as monthly schedule depositors and semiweekly schedule depositors. The type of depositor depends on the look-back period, which is the year starting on July 1, 2 years prior to the reporting year through June 30 of the following year. If payroll deposits during the look-back period did not exceed $50,000, then the business is considered a monthly schedule depositor, who must make deposits by the 15th day following the month (e.g. March 15 for February). However, if at least $100,000 of payroll taxes has been accumulated, then these taxes must be deposited by the next business day and the business automatically becomes a semiweekly schedule depositor for the remaining current tax year and the following year. If payroll deposits exceeded $50,000 during the look-back period, then the business is a semiweekly schedule depositor. For such a business, if payday is on Wednesday, Thursday, or Friday, then the taxes must be deposited by the following Wednesday; otherwise, the taxes must be deposited by the following Friday. If the deposit is due on a weekend or holiday, then the due date will be the next business day. Penalties and interest apply if the payroll deposits are not deposited on time.
Employers who have less than a $2500 employment tax liability in any calendar quarter can submit their employment taxes with their quarterly employer tax returns. A business owner who has both employees and household employees can report both FICA and FUTA taxes on Form 941 and Form 940, instead of using Schedule H, Household Employment Taxes for household employees.
Most states also require income tax withholding. However, even if an employee works in another state, the business only has to withhold taxes for its own state. However, if the business operates in more than 1 state, then taxes must be withheld for each employee for each state in which they live and where the business has a nexus. Income tax must be withheld for each state in which the employees work if the business operates in those locations.
If the business owner discovers errors in previously filed Forms 941 or 944, then they can be corrected using Form 941-X, Adjusted Employers Quarterly Federal Tax Return or Claim for Refund, or Form 944-X, Adjusted Employer's Annual Federal Tax Return or Claim for Refund. To correct a Form 940, simply use the same form and check "amended return" at the top of the return.
Failure to collect or pay employment taxes is punishable by fines up to $250,000 and up to 5 years in prison for individuals. Moreover, a trust fund recovery penalty of 100% will be imposed on any employer or any person personally responsible for the remittance of trust fund taxes. The entire tax can be collected from a single person, even if more than 1 person was responsible for the trust fund taxes. However, pursuant to a written request by the taxpayer, the IRS must notify the taxpayer of whom they have determined was responsible for the payroll taxes and whether there was any attempt to collect the penalty from those others.
There are also penalties for late deposits, based on a percentage of the amount due:
- 2%, 1-5 days late
- 5%, 6-15 days late
- 10% for deposits more than 15 days late, deposits made at unauthorized financial institutions or directly to the IRS, or amounts paid to the IRS within 10 days of the 1st notice after asking for the due tax.
- A 15% penalty applies to any amounts paid after 10 days after the 1st IRS notice or when a notice of demand for immediate payment is received, whichever is earlier.
Determining the Responsible Person for the Remittance of Trust Fund Taxes
The 100% penalty is assessed only on people responsible for paying the trust fund taxes. A responsible person is defined as an individual who is responsible for collecting, accounting for, and paying withheld trust fund taxes, and who willfully failed to pay those taxes. In determining whether the person was responsible, the courts have examined whether the person:
- had check signing authority
- was an officer or director of the company
- owned a significant share of the business entity
- managed the day-to-day affairs of the company
- hired and fired employees
- made decisions as to which debts or taxes would be paid
- had control over bank accounts and disbursement records
Even people outside of the company may be designated as responsible people, such as lenders, attorneys, accountants, and executors of estates with a business, if they were managing the financial affairs of the company, were aware of the tax delinquency, but failed to pay the taxes, and where they had the authority to do so.