Payroll taxes are all taxes that are collected, by federal, state, and local governments, based on salaries and wages paid to employees. These taxes must be withheld from wages by all businesses that have employees. These taxes are remitted on a monthly or semi-weekly basis, depending on the quantity owed. Businesses are also required to make regularly scheduled reports to the Internal Revenue Service (IRS) and to state and local taxing agencies about the amount of taxes owed and paid. Businesses are not required to withhold payroll taxes on wages paid to independent contractors. Self-employed persons are responsible for paying their own payroll or income taxes directly to the appropriate taxing entity.
Many small businesses fall behind in paying these taxes or filing the associated reports at some time during their existence. Such an error is, however, very costly because significant interest and penalties apply for late payment or nonpayment of payroll taxes. In fact, the Trust Fund Recovery Penalty allows the IRS to hold a small business owner or accountant personally liable for 100 percent of the amount owed, even in cases where the business has gone bankrupt.
TYPES OF PAYROLL TAXES
Three main types of taxes fall under the category of payroll taxes:
- The regular income tax that must be withheld from employees' paychecks. Employees can adjust their income tax withholding by filing Form W-4 with their employer and designating the number of withholding allowances they wish to claim. Ideally, the total income tax withheld should come close to equaling their overall tax liability at the end of the year. By adjusting their withholding allowances properly, employees can avoid owing large amounts in taxes or providing the government with an interest-free loan.
- Federal Insurance Contribution Act (FICA) taxes. This tax includes contributions to two federal programs, Social Security and Medicare. The tax rate for FICA taxes does not often change but the earnings on which those taxes are applied changes from year to year. In 2006, full FICA taxes of 7.65 percent were due on the first $94,200 earned. Only the Medicare portion of the FICA tax, 1.45 percent, was due on earnings over $94,200. Employers are required to match the FICA amount withheld for every employee, so that the total FICA contribution is 15.3 percent on the first $94,200 earned. Self-employed persons are required to pay both the employer and employee portions of the FICA tax.
- Federal Unemployment Tax (FUTA, the "a" stands for the word Act in the original name of the act). This tax is approximately 1 percent of the first $7,000 in wages paid to an employee and is paid in full by the employer. Technically, the federal unemployment insurance payroll tax is 6.2 percent of the first $7,000 of an employee's wages. However, employers in states with their own unemployment insurance tax programs receive a 5.4 percent credit toward their federal tax payment, reducing their tax rate to 0.8 percent. Since all states have federally approved programs, the effective FUTA rate is 0.8 percent.
- State Unemployment Taxes. Unemployment Insurance (UI) is a federal-state program jointly financed through federal and state employer payroll taxes. The federal portion is the FUTA. The state unemployment tax differs from state to state, the rate being determined by each state separately and within the state for each employer separately. The UI program is based on experience-ratings. This means that within a given state, firms that lay off a higher percentage of workers and whose employees collect a higher amount of UI benefits pay higher tax rates than firms that lay off fewer workers. The national average state tax rate in 2003 was 2.1 percent. This rate was paid on the first $7,000 to $9,000 of earnings depending on the state. In 2004, the states had a range of maximum UI tax rates from 5.4 percent to almost 11 percent.
- Local Payroll Taxes. Cities and municipalities may impose a payroll tax. These taxes are usually paid by both the employee and employer and vary in range widely.
PAYROLL TAX REMITTANCE AND REPORTING
In addition to withholding payroll taxes for employees, employers must remit these taxes to the IRS in a timely manner. The regular income taxes and the portion of the FICA taxes that are withheld from employees' wages must be remitted to the IRS monthly, along with a Federal Tax Deposit Coupon (Form 810-9B). If the total withheld is less than $500, however, the business is allowed to make the payments quarterly. In 1996, the IRS began requiring businesses that owed more than $47 million in payroll taxes annually to make their monthly payments via telephone or computer through the Electronic Federal Tax Payment System. The threshold for electronic filing was scheduled to drop to $50,000 in annual payroll taxes by January 1, 1997, but the deadline was pushed back to June 30, 1998. In addition, two bills were introduced in Congress that would make electronic payments of payroll taxes voluntary for small businesses with few employees.
Employers must also file four different reports regarding payroll taxes. The first report, Form 941, is the Employer's Quarterly Federal Tax Return. This report details the number of employees the business had, the amount of wages they were paid, and the amount of taxes that were withheld for the quarter. The other three reports are filed annually. Form W-2—the Annual Statement of Taxes Withheld—must be sent to all employees before January 31 of the following year. It details how much each employee received in wages and how much was withheld for taxes over the course of the year. Copies of the W-2 forms for all employees also must be sent to the Social Security Administration. The third report, Form W-3, must be sent to the IRS by February 28 of the following year. It provides a formal reconciliation of the quarterly tax payments made on Form 941 and the annual totals reported on Form W-2 for all employees. The final report is the Federal Unemployment Tax Return, Form 940, which outlines the total FUTA taxes owed and paid for the year.
Most states—as well as some large cities—have their own income tax that businesses must withhold from employees' wages and report to the appropriate authorities. States may also have other payroll taxes that must be collected from employees, as well as unemployment taxes that must be paid by the company. The payment schedules and reporting procedures for state and local payroll taxes are usually consistent with those applied to federal payroll taxes.
EXCEPTIONS TO PAYROLL TAX RULES
There are certain situations in which small businesses can avoid owing payroll taxes. For example, special rules apply to sole proprietorships and husband-and-wife partnerships that pay their minor (under 18) children for work performed in the business. These small businesses receive an exemption from withholding FICA taxes from their children's paychecks, and are also not required to pay the employer portion of the FICA taxes. In this way, the parent and child each save 7.65 percent, for a total of 15.3 percent. In addition, the child's wages can still be deducted from the parents' income taxes as a business expense. Children employed in small family businesses also usually qualify for an exemption from the FUTA tax until they reach age 21.
There is no limit on how much children can earn and still receive the FICA tax exemption. However, it is important that the wages paid to the child are reasonable for the job performed, and that the hours worked by the child are carefully documented, so it will be clear to the IRS that the child has not been paid for little or no real work performed. In addition, parents should note that their child's financial aid for college may be reduced if they earn more than $1,750 per year.
Small businesses also are not required to withhold payroll taxes for persons who are employed as independent contractors. Using independent contractors rather than hiring employees may be an attractive option for some small businesses. By avoiding responsibility for payroll taxes and all the associated paperwork, as well as avoiding the need to pay benefits, businesses may find that using an independent contractor costs between 20 and 30 percent less than hiring an employee. But misclassifying an employee as an independent contractor can lead to costly consequences for a small business. The IRS examines such relationships very carefully, and in cases where an independent contractor must be reclassified as an employee, the business may be liable for back taxes plus a special penalty of 12 to 35 percent of the total tax bill.
The IRS uses a 20-step test to determine whether someone is an employee or an independent contractor. True independent contractors, according to the IRS definition, are in business for themselves with the intention of making a profit and are not under the direct control of the client company. To protect their companies from potential problems, small business owners should make sure that independent contractors are paid by the job rather than by the hour, set their own hours and rules, work on their own premises using their own equipment, sign a specific contract for each project, and make themselves available to multiple clients. Rather than withholding taxes, small businesses simply file an annual informational return—Form 1099, Statement of Miscellaneous Income—detailing the total amount paid to each contractor. No reporting is required for contractors that were paid less than $600 over the course of a year.
TRUST FUND RECOVERY PENALTY
Small businesses often find themselves faced with a cash flow crisis, one they believe will ease in a matter of days or weeks. The business owner who, when faced with this cash flow problem, decides to pay vendors before paying for payroll tax obligations is making a grave error. A typical scenario may play out as follows. For short-term survival, the business owner or executive decides to meet current creditors' requirements and oblige the IRS to become a creditor. The hope is that in the medium term the business will be able to pay the IRS the delinquent taxes plus interest and penalties. Often, however, the business becomes insolvent and declares bankruptcy. In order to address this problem and avoid significant erosion of tax revenue, in 1954 Congress enacted a penalty—equal to the unpaid payroll taxes—against all responsible persons who willfully fail to collect and turn over the money.
This penalty for the failure to withhold or remit payroll taxes, known as the Trust Fund Recovery Penalty (TFRP), is included under Section 6672 of the Internal Revenue Code. It allows the IRS to hold individuals associated with a business personally liable for 100 percent of the unpaid amount when the business fails to meet its payroll tax obligations. The TFRP applies to employee funds that the employer holds in trust for the IRS—all of the regular income tax withheld and the employee half of the FICA tax—but not to the employer portions of payroll taxes. The penalty is particularly severe because the IRS considers an employer who fails to pay to be violating a trust. The TFRP can be applied in addition to civil and criminal penalties, including the seizure of business assets and forced closure of the business. And since it is a penalty rather than a tax, the TFRP is not erased by bankruptcy.
In order to apply the TFRP to an individual, the IRS must prove the person's responsibility (that he or she had the power to make the decision about whether or not to pay) and willfulness (that he or she knowingly failed to act rather than made an honest mistake) for the business's failure to remit payroll taxes. In making its determination about who to hold responsible, the IRS looks at who made the financial decisions in the business, who signed the checks, and who had the duty of tax reporting. Under these rules, a small business owner can be found personally liable even if a staff member or outside accountant was directly responsible for payroll tax compliance. In cases where both the business and the owner go bankrupt, the company's accountant may be tagged as the responsible party and held personally liable.
Because the law regarding payroll tax noncompliance is so sweeping, small business owners should pay particular attention to the trust fund taxes. It is vital to keep the taxes that are covered by the TFRP current, even when the business is experiencing cash flow problems. If it appears as if the small business is heading for bankruptcy, these taxes should be paid prior to filing, when management can still designate where the IRS should apply payments. After the company files for bankruptcy it loses this option, and the IRS will apply any payments elsewhere since they can collect the TFRP from individuals associated with the company. Not paying the IRS may solve a company's short-term cash flow problems but it will cause serious problems for the person or persons responsible in the long term.
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