Small Business Tips

Payroll tax basics for business owners

MileIQ Team

Any time you hire an employee, you become an unpaid tax collector for the government. You must withhold and pay both federal and state taxes for the worker. These taxes are called “payroll taxes” or “employment taxes.”  

It’s crucial to stay current when paying payroll taxes. Otherwise, there are substantial penalties for failing to do so.

When do employers have to pay and withhold payroll taxes?

Businesses only have to pay payroll taxes for workers who are employees. For independent contractors and consultants, payment of payroll taxes is their responsibility. To clarify, independent contractors are temporary workers who are in business for themselves.  

Initially, it’s up to the hiring firm to determine whether any person it hires is an employee or an independent contractor (IC). Unfortunately, some employers classify their workers as contractors even though they are employees. This misclassification occurs because independent contractors often cost less than employees.

Yet, a hiring firm’s decision about how to classify a worker is subject to review by various government agencies, including:

  • The IRS
  • The state tax department
  • The state unemployment compensation insurance agency

Bad things happen if the IRS or other government agency determines that a business misclassified an employee as an IC. The company can get ordered to treat the worker as an employee and must pay back taxes and substantial penalties.

Federal payroll taxes

There are three different federal payroll taxes:

  • Social Security and Medicare taxes
  • Income taxes
  • Federal unemployment taxes

Employers must withhold part of these taxes from their employees’ pay. They pay the rest themselves.

Employers must deposit these taxes with the IRS monthly or semi-weekly. They must also file quarterly employment tax returns. But employers with a total employment tax liability of $1,000 or less may file employment tax returns once a year instead of quarterly.  

Social Security and Medicare Taxes (FICA): The employer and employee must each pay Social Security and Medicare (FICA) taxes. The employer must deduct the employee’s share from each wage payment.  

The FICA tax rate for both employer and employee is 7.65% of taxable wages. This is the sum of the 6.2% Social Security tax and 1.45% Medicare tax.  

The Social Security tax (OASDI) is subject to an annual inflation-indexed taxable wage base limit. This limit is $132,900 for 2019.  

There is no wage base limit for the Medicare tax (HI). Employees must pay an additional 0.9% Medicare tax on wages over $200,000, $250,000 for married couples filing jointly.  

Federal Income Tax Withholding (FITW): The employer must withhold federal income tax from each wage payment made to an employee. The amount withheld depends on the employee’s marital status and the number of withholding allowances and exemptions claimed.  

Federal Unemployment Tax (FUTA): An employer must pay federal unemployment tax on the employee’s wages up to an annual FUTA wage base ($7,000 in 2019).

The FUTA tax rate is 6%, but employers obtain a 5.4% credit for timely payment of state unemployment taxes. Thus, the FUTA tax rate is generally 0.6% or $42 per year per employee.  

An employer must pay this tax if it:

  • Pays at least $1,500 in total wages to employees in any three-month period, or
  • Has at least one employee during any day of a week during 20 weeks in a calendar year (the 20 weeks need not be consecutive)

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State payroll taxes

Employers must also pay state payroll taxes. These vary somewhat from state-to-state.

State unemployment compensation  

Federal law requires all states to create an unemployment insurance fund. Employers must pay into this fund for their employees. Employees make no contributions, except in Alaska, New Jersey, Pennsylvania, and Rhode Island, where employers withhold small contributions from their employees’ paychecks.  

Some small employers exempt from paying unemployment taxes: In most states, if your payroll is very small, you won’t have to pay unemployment compensation (UC) taxes.  

In about half of the states, you must pay state UC taxes for employees if you’re paying federal UC taxes, also called FUTA taxes. This means you must pay state UC taxes if:  

  • You pay $1,500 or more to employees during any calendar quarter—that is, any three-month period, or  
  • You have at least one employee during any day of the week for 20 weeks in a calendar year (the 20 weeks need not be consecutive)  

Other states have payroll or service requirements that are stricter than FUTA requirements. For example, California employers must pay unemployment compensation taxes if they pay one or more employees $100 or more per quarter. Michigan employers must pay unemployment compensation taxes for any employee paid $1,000 or more in a calendar year.

Several states provide the broadest possible UC coverage by requiring employers to pay UC taxes for all employees.  

Unemployment Tax Rate: The unemployment compensation tax rate varies from state to state. It depends partly on the age of the business, the industry, and how many claims are by the company’s employees.  

Employers who maintain a stable payroll and file and pay their unemployment taxes on time will pay the lowest rate. Employers with high turnovers or large fluctuations in their payroll, and those who don’t file or pay their taxes on time, must pay more.  

As a general rule, the unemployment tax rate is somewhere between 2% to 5% of wages, up to the maximum amount of wages that are taxable under the state’s unemployment compensation law.  

What about state income taxes?  

All states except Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have income taxes. New Hampshire and Tennessee impose income taxes only on interest and dividend income.  

If you do business in a state that imposes state income taxes, you must withhold the applicable tax from your employees’ paychecks and pay it over to the state taxing authority.  

It’s straightforward to determine whether you need to withhold state income taxes for a worker: If you are withholding federal income taxes, then you must withhold state income taxes as well. Contact your state tax department for the appropriate forms.  

You can find a link to your state’s income tax office at www.taxadmin.org/state-tax-agencies.  

State disability insurance  

Five states have disability insurance that provides employees with coverage for injuries or illnesses that are not related to work. These states are California, Hawaii, New Jersey, New York, and Rhode Island. Puerto Rico also has a disability insurance program.  

In these states, employees make disability insurance contributions. These are withheld from their paychecks by their employers. Employers must also make contributions in Hawaii, New Jersey, and New York.  

The disability insurance coverage requirements are the same as for employment compensation insurance. If you pay employment compensation for a worker, you must withhold and pay disability insurance premiums as well.  

How to pay payroll taxes

Payroll taxes can get complicated. You must figure out how much to withhold, do the necessary record keeping, and fill out the required forms.  

Many business owners seek outside help. Many use an accountant or payroll tax service to deal with these taxes. Your bank may also provide payroll tax services.  

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