Withholding payroll taxes is a duty employers are tasked with by the federal government. Getting it wrong can result in some tough penalties by the IRS and can cause hardship for your employees as well. Understanding what and how much to withhold is key to staying in compliance with the law, and out of the Internal Revenue Service’s crosshairs.
Employers have the obligation of withholding various state and federal (and in some cases, local) taxes from their employees paycheck and handing the money over to appropriate government agencies. Employers also must pay taxes themselves based on how much their workers are paid.
The taxes employers are typically required to withhold from employee paychecks and pay themselves include federal, state and local income taxes, Social Security and Medicare taxes, unemployment taxes and disability insurance taxes. Business owners may also be liable for payroll tax withholding on the income they derive from their businesses.
Workers Subject to Payroll Taxes
While you might think that anyone who does work for you counts as an employee, tax code just isn’t that simple. The IRS has definitions of employees and not everyone who comes in and does a little work for you may classify as an employee. In general, workers are classified as your employees if they meet a common-law test that defines them as employees rather than independent contractors. Here’s a 20-point test for determining whether workers are employees and subject to withholding:
1. Instructions: Are your workers required to follow your lead on when, where and how they perform their duties? If so, they’re probably employees and not independent contractors.
2. Training: If you provide your workers with a substantial amount of training, they’re more likely to be classified as employees, as independent contractors are expected to already know how to perform their work, making substantial training from you unneccessary.
3. Integration: The more vital your workers’ contributions to your business are, the more likely it is that they’ll be classified as employees.
4. Personally rendered service: Do your workers perform the tasks you give them on their own, or do they have the option to farm it out to others? Independent contractors can substitute other people’s work to complete the tasks you assign them, employees usually can’t.
5. Assistants. Workers who can independently hire assistants are more likely to be independent contractors.
6. Continuing relationship. Workers who regularly perform work for you over a period of time or at regular intervals are more likely to be classified as employees.
7. Work hours: If you set your workers hours, they’re more likely to be classified as employees, as worker who set their own hours are more likely to be classified as independent contractors.
8. Full time. If you require your workers to work on a full-time basis, they’re more likely to be classified as employees than independent contractors, who have more leeway to determine who they work for and when.
9. Work performed on your property: Workers who perform their assignements on your premises or at a location designated by you are more likely to be classified as employees, as independent contractors often work out of their own places of business.
10. Order or sequence set: If you determine in what order your workers perform their assignments, chances are that they are employees rather than independent contractors.
11. Reports: If you require your workers to keep you up-to-date with regular reports, chances are the government will classify them as employees.
12. Per hour vs. per job: Workers who are paid by the hour or based on time are more likely to be classified as employees, whereas workers who are paid on a per job basis are more likely to be considered independent contractors.
13. Expenses: If you cover your workers’ business and travel expenses, they’re more likely to be classified as employees, as independent contractors are usually expected to pay for their own expenses in performing their work.
14. Tools and supplies: Workers who supply their own tools and equipment are more likely to be considered independent contractors.
15. Investment: The larger the worker’s personal investment in the facilities and tools they use in the performance of their assigned tasks, the more likely it is that they’re independent contractors. Workers who have little or no investment in their work tools and equipment are more likely to be employees.
16. Profit or loss: The more likely it is that your workers will make an individual profit or take a loss as a result of their work for you, the more likely it is that they are independent contractors, whereas employees compensation is more settled.
17. Multiple employers: If your workers supply services to you some of the time and services to another business for some of the time, chances are that they are classified as contractors, whereas employees are more likely to exclusively offer their services to you.
18. Services available to the public: Workers who offer their services to the general public by means such as business cards or other advertising are more likely to be classified as independent contractors. Employees are more likely to offer their services exclusively to your company.
19. Firing: If you can fire your workers at any time, they’re more likely to be classified as employees. Firing independent contractors is more likely to be governed by contractual agreements.
20. Quitting: Similar to firing, if your workers can quit at anytime without incurring penalties, they’re more likely to be classified as employees, whereas contractors are often subject to penalties if they quit during the middle of an assigned project or are unable to complete it.
If your employees have a strong majority of these factors leaning one way or the other, chances are they should be classified accordingly. If you’re still unsure about their status, you can consult with a tax professional or get a determination from the IRS.
Correctly designating your workers and withholding taxes accordingly is important as you can be hit with substantial state and federal penalties if you’re not correctly withholding taxes, including interest on the amount owed.
Once you’ve determined your workers’ status, you must then determine whether the compensation they receive is taxable under the various types of withholding employees are required to make. Pretty much any monetary compensation to employees, such as wages, commissions, salaries are subject to withholding. This also includes prizes and bonuses and vacation and sick leave compensation.
Some benefits may not be subject to withholding taxes, however. These exceptions include:
- Health benefits.
- Contributions to retirement plans.
- Onsite gym facilities provided to employees.
- Metro and parking passes up to $230 per month.
- Small benefits such as occasional parties or tickets to athletic and entertainment events.
- Workers compensation and some life insurance.
- Dependent care assistance up to $5,000 per employee.
- Moving expenses provided to employees.
Business and mileage expenses provided to employees are considered in most cases to be non-taxable income.
Income subject to withholding may be subject to caps. For example, Social Security and Medicare taxes are only taken out of the first $106,408 of income, and caps on unemployment and disability insurance withholdings may also apply.
Determining How Much to Withhold
Once you’ve determined what compensation withholding is required from, you then must determine how much to withhold. This amount can vary based on your employees’ salary, and the amount of exemptions they can claim such as marital status or number of dependents.
Employees are required to fill out W-2 forms concerning their exemption information, and using this data employers can use tax tables available from the IRS and state tax agencies to determine how much to withhold for state and federal income taxes.
With regard to Social Security and Medicare Taxes, employers must withhold 6.2 percent of an employee’s salary for Social Security and 1.45 percent for Medicare and the employers must chip in the same amount. (A temporary tax decrease has lowered the employees’ share of SS taxes to 4.2 percent). The withholdings for Social Security apply to the first $106,480 of the employees’ income, and exemptions claimed on income tax do not apply. No caps exist for Medicare withholdings.
Employers must pay state and federal unemployment insurance taxes, however, these taxes are paid by employers and not withheld from employees’ checks.
In California, Hawaii, New Jersey, New York, Puerto Rico, and Rhode Island, employers must also withhold disability insurance taxes from employee paychecks. Rates vary from state to state.
Paying The Taxes
Once you hire your first employee, you’ll need to register with the IRS and probably also state tax agencies. The IRS will assign you an employer identification number, which you’ll use on all official correspondence. You’ll need to remit the taxes withheld from employee paychecks to the government at least once per month, and keep careful records of these transactions. The IRS and state agenices will inform you of your tax obligations and supply you with the appropriate forms you can use to determine and submit your tax obligations.
Getting your tax withholdings done correctly and remitting the money to the government in a timely fashion is important because civil and criminal penalties can be assessed if you don’t. Businesses that fail to properly remit taxes can be forced to pay the taxes from their own funds and can also be assessed interest on those amounts. Each instance of falsified or incomplete documentation can also be hit with a fine. For severe violations, the IRS may pursue criminal charges against you.