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A Primer on Payroll Taxes for the Small Business Owner
by Mark Minassian, CPA

The responsibility for collecting and paying payroll taxes is often overlooked by new business owners. Many employers do not budget for payroll taxes when hiring new employees and subsequently get caught with cash shortfalls, which can lead to unpaid payroll taxes and trouble with the Internal Revenue Service. Understanding the employer’s responsibility in this area is essential to running a successful business.

Withholdings and FICA Taxes

Individuals classified as employees must have payroll taxes withheld from their paychecks. These include federal taxes, Social Security taxes, Medicare taxes and state and city taxes (if applicable). Social Security and Medicare taxes are commonly referred to as FICA taxes, named for the Federal Insurance Contributions Act of 1939 that authorized these taxes to be collected. The employer is responsible for remitting the payroll taxes to the IRS and to the state and local taxing agencies on either a quarterly, monthly or weekly basis, depending upon the amount of total taxes withheld.

The Social Security tax rate is 6.2% and is withheld on the first $113,700 of wages paid to an employee during 2013. The wage limit is based on a national wage index and usually increases each year. The Medicare tax rate is 1.45% and applies to all wages paid to all employees. There is no wage limit on the Medicare tax.

For every dollar of Social Security and Medicare tax that is withheld from an employee, the employer must match and pay that amount to the IRS. These matched amounts are paid to the IRS along with the other withholdings and are allowed as a tax deduction to the employer.

Unemployment Taxes

Employers must also contribute to the federal unemployment tax fund on behalf of their employees. The Federal Unemployment Tax Act (FUTA) imposes the tax on the first $7,000 of wages paid to each employee. The employer pays this amount; it is not withheld from the employee. The tax is paid to the IRS either once a quarter or in one lump sum at the end of the year if the total tax for all employees is less than $500.

Employers must also pay unemployment taxes to their state unemployment fund. These tax rates vary by state (ranging from 0.5% to 10%) and are usually paid on a quarterly basis. And like the FUTA tax, these amounts are paid by the employer and are not withheld from the employee (except in Alaska).

The FUTA tax rate is 6.0% per employee. However, if an employer contributes to a state unemployment fund on a timely basis, the FUTA rate is reduced to 0.6% per employee. The state unemployment tax rate fluctuates depending on the industry the company is in, how long the company has been in existence and the number of former employees who have filed unemployment claims.

Managing Cash Flow

Many new business owners do not factor in the cost of payroll taxes when hiring an employee. When they do not account for the company’s share of the FICA and unemployment taxes, they often end up with unexpected cash flow problems.

TIP: A good rule of thumb for employers to follow is to add 15% to the cost of any employee’s pay to cover payroll taxes. For example, if an employer wants to pay an employee $20 per hour, the total cost to pay that employee will be approximately $23 per hour once payroll taxes are factored in.

Employers are not required to keep the withheld payroll taxes in a separate bank account. As a result, these funds usually remain in the company’s checking account and are commingled with the rest of the company’s cash. When companies run into cash shortages, they may be tempted to pay other creditors instead of their payroll taxes. The IRS will assess interest and serious penalties for nonpayment of these taxes. Penalties may be levied against any individual in a company who has the responsibility of collecting and paying the payroll taxes, whether an owner, officer or employee. Furthermore, noncompliance with payroll tax laws can lead to tax liens and business seizures.

Staying in Compliance

Payroll tax compliance is one of the most important aspects of running a business. Larger companies should consider using a payroll service to handle their payroll. Many accountants will also process payroll for their clients. The cost of outsourcing payroll is far outweighed by the benefits of being in compliance with the tax laws and having more time to devote to other areas of the business.

Whether a company processes its own payroll or uses a payroll service, understanding the responsibility for payroll taxes is an important key to running a successful business.

Disclaimer:  Any tax advice contained in this article is not intended or written to be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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