Payroll Tax: Definition, Categories, Reporting & Penalties

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All business owners are responsible for withholding taxes from their employees' wages or paychecks. These payroll taxes appear on pay stubs and fall into two major categories: FICA and Medicare taxes. Payroll taxes represent a significant portion of the total tax-generated income of the United States and are used to fund Social Security benefits and Medicare.

In other words, payroll taxes are withheld from workers' wages in order to ensure the government can give financial support upon retirement. In order to benefit from these government programs later in life, workers have to pay into the programs. Before payroll legislation was first passed in 1935, employees were responsible for submitting these tax payments to the IRS, and the result was a severe lack of compliance. Now, the onus for withholding and submitting these taxes lies on employers.

To encourage employers to remain compliant, the IRS maintains a strict timeline for receiving payments and applies financial penalties to employers who fail to submit them on time. It's important to take payroll taxes seriously and to understand your obligations as an employer at federal, state and local levels. If accounting is not your strong suit, consider using a payroll software tool that includes a tax reporting and payment option.

Income, Employment and Payroll Taxes

Payroll taxes are commonly confused with other taxes, like the federal income tax, federal unemployment tax or employment taxes in general. Payroll taxes are considered a type of employment tax but are separate from income taxes. Employees are responsible for paying income taxes at the federal, state and local levels, but employers bear the responsibility of sending payroll taxes to the IRS.

Employers are also responsible for paying unemployment taxes per the Federal Unemployment Tax Act, and they only withhold the additional Medicare tax for employees who make over $200,000 annually. Each of these employment taxes is subject to specific rules and regulations established by the IRS regarding reporting the taxes and depositing payments.

Federal Insurance Contributions Act

The Federal Insurance Contributions Act, or FICA, dictates that 12.4% of an employee's wages should go toward funding Social Security benefits. Half of the amount is to be "paid" by employees, but in practical terms, it's simply withheld from employees' wages; they do not need to worry about making any payments.

Because they only pay half, the employees' actual tax rate decreases to 6.2% for the Social Security tax. The employer takes on the responsibility of withholding the correct amount and sending it to the IRS on a quarterly basis along with the employer's own half of the FICA contribution.

Medicare Payroll Tax

Another 2.9% of an employee's wages is withheld to fund Medicare, the "old age" health insurance provided to people age 65 or older who have contributed to its funding via taxes. As with FICA, half is paid by the employer, and half is paid by the employee.

Although the federal government collects a total of 15.3% on payroll taxes, only 7.65% is actually withheld from an employee's paycheck. The other 7.65% is paid by the employer.

Self-Employment Tax

For the self-employed, all payroll taxes are bundled together into the self-employment tax at a rate of 15.3%. This essentially requires self-employed individuals to pay for both halves of the typical payroll tax, acting as both the employer and employee. As with payroll taxes, the self-employment tax payment is expected to be made quarterly.

State Payroll Taxes

Some states impose additional payroll taxes to fund statewide social programs. For example, employers in the state of California need to withhold an additional percentage (currently 1%) of employees' wages for the State Disability Insurance program. On a federal level, disability benefits are paid through the Social Security Administration, which is funded by FICA taxes. Therefore, California's state disability program is funded through the same means: wage withholding.

To find out if your business is responsible for reporting and paying any state payroll taxes, contact your state's department of labor or equivalent agency. Some cities, including San Francisco and Newark, also have local taxes that must be withheld by employers, so contact your city government for more information as well.

Filing and Depositing Federal Payroll Taxes

The IRS expects all business owners to file their payroll taxes on a quarterly basis, with due dates falling on January 31 (for the last quarter of the previous year), April 30, July 31 and October 31.

How often you actually deposit payroll tax payments varies, and you can choose to change your payment schedule if needed at the beginning of the calendar year. A monthly deposit schedule requires you to send payment to the IRS for payroll taxes by the 15th of the next month. A semiweekly deposit schedule requires deposits to occur every other Wednesday or Friday, depending on when you distributed paychecks to your employees. Note that all federal payroll taxes have to be paid using an electronic funds transfer.

Penalties for Incorrectly Reporting Payroll Taxes

The IRS not only actively tries to identify and collect tax debts but also applies penalties for failing to report or pay payroll taxes in order to encourage all business owners to send in their taxes on time. Yes, even small-business owners can face hefty consequences for failing to comply with payroll tax deadlines and regulations. You don't have to run a large business to be on the IRS's radar.

The financial penalty you'll face depends on how late you submit payment. Being just one to five days past the deadline gives you a 2% penalty fee, which grows to 5% for payments six to 15 days late and doubles to 10% for anything more than 16 days late. The penalty grows again to 15% for failing to send payment 10 days after receiving a bill from the IRS. None of these penalties takes into account the interest rate you'll also owe on the payments, which can be anywhere from 3% to 6%.

If you still don't pay, the IRS can place a tax lien on your business, essentially holding your property as collateral until you fulfill your debt. Take care to deposit the money as directed by the IRS using electronic transfer funds only because you'll face a penalty again if you try to pay but do it incorrectly.

Software to Simplify Your Payroll

You know it's important to file and deposit employer payroll taxes according to the IRS's strict guidelines, but maybe your small business only has a couple of employees, none of whom is a tax accountant. Do you need to hire someone else just to oversee these payroll taxes? Thankfully, no.

As with most modern-day small-business problems, there's a software solution. Before you get too worried about payroll taxes, try using payroll software like Gusto, Wagepoint or QuickBooks Online. You can even find a payroll tool that integrates directly with your current accounting software to save time.

Above all, look for payroll software that specifically handles payroll tax reports and deposits at federal, state and local levels. You want to rest easy knowing that your payroll taxes are automatically handled and that no surprise bills will arrive from the IRS. Payroll tax is not a suggestion — it's the law!