Hiring employees creates a number of tax issues for small business owners. Staying on top of the tax withholding and reporting requirements for businesses is key to avoiding potentially expensive problems with the IRS and state revenue agencies.
Perhaps the most significant tax issue small business owners face with regard to employees and taxes are the withholdings they are required to make from employee paychecks. Employers are required to withhold federal income taxes from their employees’ paychecks and pay these withholdings directly to the Internal Revenue Service.
The amount to withhold varies from employee to employee, with variables such as the employee’s salary amount, the number of exemptions claimed by employees and their marital status influencing the amount. To help employers calculate how much to withhold, employees are required to fill out W-4 forms to determine how much should be taken out of their checks for federal income taxes.
In addition to income taxes, employers are also required to withhold employee pay for Social Security and Medicare taxes. These taxes are a little easier to calculate, as they are levied at a flat rate of 6.2 percent for Social Security and 1.45 percent for Medicare. (The SS withholding rate was reduced to 4.2 percent for 2011 and extended by two months into 2012. Employers should keep a watch on the actions of the federal government to see what the rate will be moving forward into 2012.)
If you live in a state with an income tax, you will also be required to withhold state income taxes from your employees paychecks. Income tax rates vary from state to state, and your state’s department of revenue is the best place to find more information about how much tax you need to withhold.
In addition to the taxes you withhold from your employees’ checks, you’re also required to make an employer’s contribution to Social Security and Medicare. The employer’s contribution is currently at 6.2 percent for Medicare and 1.45 percent for Medicare. Businesses must also pay state and federal unemployment taxes. State rates vary, but the federal unemployment tax rate is 6.2 percent of the employees’ income. However, employers who pay their state and federal unemployment taxes on time can take a tax credit of up to 5.4 percent of employee pay, making their effective federal unemployment tax rate .8 percent.
Businesses that employ a large number of workers are required to deposit their FICA taxes by using the Electronic Federal Tax Payment System, an online transfer system. This greatly reduces hassles and paperwork for both you and the federal government.
Small businesses that provide health benefits for their employees should be aware of tax deductions they can take. Beginning in 2010, small businesses were permitted to take a tax credit of 35 percent of the premiums they paid to cover employees. The credit is available to businesses that employ 25 workers or fewer where the average wage is $50,000 or less (Deduction rates are smaller for companies with average annual wages of less than 25 percent). Also, to qualify for the credit, employers must pay at least half the premium for their employees’ coverage.
Here’s a quick rundown of the things you must do to comply with most state and federal tax law if you’re operating a business with employees:
- Once you hire employees, you’ll need to report your new hires to your state’s employment office within 20 days of your employees’ start date.
- Make sure your employees are citizens or foreign nationals approved to work in the U.S. by filling out U.S. Citizenship and Immigration Services Form I-9. You can find a copy of this report on the U.S. Citizenship and Immigration Services website.
- Withhold appropriate income and FICA taxes from your employees’ paychecks and submit the taxes to the IRS. IRS Publication 15 can show you how to submit withholdings and is available on the IRS website.
- Withhold state income taxes and deposit them with your state revenue agency.
- Pay the employer’s share of Social Security and Medicare taxes. Employers pay the same share as employees, currently 7.65 percent of wages up to $106,800 and 1.45 percent of wages above that amount.
- Pay unemployment taxes to the IRS. Employers must pay unemployment taxes if they paid more than $1,500 in wages in a calendar year. Also, don’t forget to pay your state unemployment taxes.
- Make sure that you report your employees wages and your withholdings to the Internal Revenue Service by using IRS form W-2.
By making sure that you comply with government regulations regarding employee tax withholdings and other employee tax issues, you can save yourself considerable headaches and your business money in the form of non-compliance penalties.