Payroll Tax Primer for Small Business Owners

If your business has employees, it owes payroll taxes to the Internal Revenue Service. You even have to pay some payroll taxes, like Social Security, for yourself if you are a self-employed sole proprietor.  Paying these taxes is a fundamental responsibility of employers, so it is a subject small business owners must understand.

Employees vs. Independent Contractors

How you define your workers, either as waged employees or independent contractors, has a major impact on your payroll tax situation. Independent contractors are also commonly called freelancers or gig workers.

You are responsible for the payroll taxes of employees, while independent contractors pay their own taxes.

According to the IRS, you can categorize a worker as an independent contractor if you cannot control how they work, only the results of the work. A plumber you called to fix your pipes one time would be an independent contractor, while a salesperson whose working hours you decide should probably be categorized as an employee.

“Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done,” the IRS says (emphasis theirs). “This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.”

The IRS assumes a worker is an employee, so you must have copious documentation, like a detailed, signed contract, to prove that a worker is an independent contractor.

Additionally, some states might have worker definitions that are more stringent than the federal government, such as California’s recent AB 5 legislation. Therefore, it’s best to thoroughly research labor laws and consult with a local tax professional before bringing on someone as an independent contractor.

Payroll Taxes You Must Pay

As a small business owner, you are responsible for paying several types of payroll taxes. These taxes are based on the taxable income, meaning wages, bonuses, and gifts for your taxable employees (i.e., not independent contractors).

Federal Payroll Taxes

With federal payroll taxes, you withhold income from your employee every paycheck and remit the amount as tax to the IRS on a quarterly basis. In filling out tax forms, your employee has some say in how much income you should withhold.

You can withhold tax based on income bracket or by a percentage of income. Withholding based on the employee’s income bracket is a simpler method and is popular with small businesses.

State and Local Payroll Taxes

Similar to the IRS, many states, cities, and counties require employers to withhold payroll taxes from their employees. Some states, like Texas and Florida, do not have state income tax. Check the website for the city and municipality where your business is located to find out the details of your tax liabilities. The Small Business Administration has resources, too.   

Social Security and Medicare

The Federal Insurance Contributions Act (FICA) requires employers to pay taxes that fund Social Security and Medicare, as well as withhold tax from employees for these programs. The employer and employee each pay half of the FICA tax, meaning each party pays a flat rate of 6.2% for Social Security and 1.45% for Medicare. In total, the FICA tax is 15.3%.

Unless your employee opts for you not to, the employer is responsible for withholding the employee’s FICA taxes and remitting them to the IRS. The withholding occurs along with paying the employer’s half of the FICA taxes.

 FUTA

The Federal Unemployment Tax Act (FUTA) is a tax employers pay to fund federal unemployment benefits. The FUTA tax is 6% for the first $7,000 of income earned by each employee every year. This is a tax on employers—it is not withheld from a worker’s paycheck.

However, most small businesses are eligible for the maximum of the FUTA tax credit, which reduces the tax rate to 0.6%. With the credit, the FUTA tax liability for employers would be $42 per employee earning $7,000 or more annually.

How to Pay Payroll Taxes

Every paycheck, you need to calculate how much money you need to pay in tax along with how much of your employees’ income you need to withhold. In order to determine what amount to withhold, you will need your employee’s W-4 and the relevant forms from the IRS that list tax rates based on income brackets or percentages. You can submit the taxes to the government online.

It is best practice to remit withholdings and taxes to the IRS every pay period.

The tax system is pretty complicated for employers. To make it easier, you can use payroll software like Gusto. It is also well worth it to seek out an accountant or tax professional to take over your payroll taxes throughout the year.

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The information provided in this post does not, and is not intended to, constitute tax advice; instead, all information, content, and materials available in this post are for general informational purposes only. Readers of this post should contact their tax professional to obtain advice with respect to any particular tax matter.