A Handy Payroll Tax Guide That Keeps Everyone Employed
No matter what end of a business you work on, whether as the owner, an employee or a self-employed sole proprietor, you deal with payroll taxes. If you just landed your first job or just started your own business, you need to learn the ins and outs of payroll taxes.
What Is Payroll Tax?
While a payroll tax does get paid to the Internal Revenue Service (IRS), it does not get deposited in the same account as personal or business income taxes. Payroll taxes get withheld from an employee's pay by the employer. Rather than keeping the funds or depositing it into a privately held account, such as IRA contributions, the employer pays it to the government. Proper tax management matters so you keep your business out of trouble..
Payroll Tax Guide: For the Employer
The IRS sets the calculations for the tax. The tax applies to an employee’s wages, salaries, and tips. In the US, this goes into three separate accounts - federal income tax withheld, Medicare and Social Security. Although not part of the payroll tax calculations, the employer must also pay money to the government for federal unemployment programs. This is separate from corporation tax which is covered separately outside the confines of this payroll tax guide.
Payroll Tax Guide: For the Self-Employed
A self-employed individual pays their self-employment taxes to the government, but does not have to pay for the unemployment programs. These are the same as payroll taxes, but referred to by a different name due to their association with self-employment.
Different Rates
The self-employment tax rate differs from the payroll tax rate. This tax rate is 15.3 percent. The government divides it into two parts. The Social Security portion of 12.4 percent provides for the retirement account and disability insurance.
The Medicare account gets 2.9 percent from the paycheck. If the individual earns more than $200,000 per year, the Medicare tax increases by 0.9 percent. Other differences exist between a payroll tax and self-employment taxes and requirements that get covered outside the payroll tax guide.
Payroll Tax Guide: For the Employee
As an employee, this payroll tax guide explains the amounts you see on your pay stub when these taxes get withheld from your paycheck. The federal income tax withheld enables you to pay your federal income tax that is due each April, a little bit at a time. It makes it simpler to withhold since you cannot access it until you file your taxes. This saves a lot of people from spending the money on another item and coming up short in April. You get to choose the amount you want deducted each pay period. If you have enough deductions, you can end up getting a nice portion of this back.
The other two “pots” of money – Medicare and Social Security - you eventually get back, too. Upon retirement, the former provides you with medical insurance coverage and the latter provides you with a retirement income. Essentially, the amount withheld each pay period provides for your income taxes and retirement.
As an employee, you can find this information contained in an itemized form on your pay stub. It shows the amount withheld not only for federal taxes, but also state and municipal taxes. The employer must also withhold workers’ compensation taxes. This pays for insurance that pays for an employee’s medical costs if they are injured on the job or become ill while on the job due to exposure to something in the work environment.
Localities do not always withhold or require local payroll taxes, but when they do, it is to fund local infrastructure and programs, including first responders, road maintenance and parks and recreation.
While the employer must fund unemployment insurance, qualified employees who leave their position can obtain the funds when their job ends. The rates of unemployment insurance vary by federal and state and by industry. A few states require the employee to contribute to the costs of their disability and unemployment insurance.
Facts and Figures
The payroll taxes that cover Medicare and Social Security contributions, constitute what is commonly referred to as the Federal Insurance Contributions Act (FICA) tax. It breaks down as follows for up to a maximum salary of $137,700.
An employee pays 7.65 percent from their paycheck.
The Social Security account gets 6.2 percent of this.
The Medicare account gets 1.45 percent of this.
Medicare does not cap the salary. Any person earning more than $200,000 or $250,000 for jointly filing married couples pays an additional 0.9 percent.
The Social Security Payroll Tax goes into two government-owned trust funds:
the Old-Age and Survivors Insurance Trust Fund (OASI),
the Disability Insurance Trust Fund.
No single organization or individual manages this money. A coalition of six individuals manages these trust funds:
the Secretary of the Treasury,
the Secretary of Labor,
the Secretary of Health and Human Services,
the Commissioner of Social Security,
two public trustees manage these trust funds.
Why Payroll Taxes Matter to a Business
So, here is the deal. The government requires these payroll taxes so that every wage earner has a nest egg they can rely on when they reach retirement age. They require worker’s compensation taxes to protect employees who do not receive work benefits or whose injuries or illness would exceed the coverage of existing medical insurance.
Your business will get into serious trouble with the IRS if you try to flout these regulations. Congress, when it created the US Treasury’s rulemaking ability, gave the Treasury department the same law-making power as itself. While Treasury can only make rules in regards to matters under its purview, this extends to a number of fiscal issues. The IRS has the power to make all rules regarding taxation.
In addition to its rulemaking abilities, the IRS also has investigative powers. In fact, it was the IRS, not the Federal Bureau of Investigation (FBI) that finally took down the storied mobster Al Capone, who once ruled Chicago. The IRS got Capone on charges of tax evasion.
This should scare you. It should scare the pee out of you.
How the IRS Works
The IRS refers to its investigative division using the seemingly innocuous term, “Examinations.” It sounds a bit like they might give you a pop quiz, doesn’t it?
Their pop quizzes include requiring you to include in an investigation every tax return and piece of financial paper for the past seven years. If that sounds massive, it is. It requires boxes and boxes and boxes, as my mama liked to say.
Payroll Tax specialists
Sometimes, the IRS has to investigate your standard fare business that somehow forgot it owed payroll taxes. They have specialists trained for exactly this purpose. The law is exceedingly complicated and at the highest levels, there are only a handful of examiners, as they refer to them, who conduct this work. Those individuals work cases within regions of the US. A person working the central region, for example, might work a case one week in Chicago, IL, but two weeks later conduct an investigation in San Antonio, TX. They get to see the country one tax return at a time.
The Enforcers
There is a nifty sub-division of the Service that deals with businesses that combine illegal enterprises and businesses. These folks dress like the SWAT team and actually do at times have to go flying through windows to swarm some drug dealers’ den of inequity.
You probably think they will never come after you. Think again. Dudley-do-right jokes aside, these folks went into law enforcement because they care that the government has the money it needs to run on, that employers do not jip their employees and that bad people do not deal drugs or launder money.
How People Mess Up Payroll Taxes
Believe it or not, a multitude of folks try to get by the payroll taxes. Employers do this in a number of complicated ways. The most essential and probably easiest to prove is when a company says it uses independent contractors instead of employees. You see, independent contractors are self-employed. That means that they pay their own taxes.
Independent Contractors vs. Employees
You are probably sitting there thinking, “Wait. The payroll taxes come out of the person’s pay, so it does not cost them anything.” Ah. But they do not want to pay the money for a staff accountant or even to outsource having to have that calculated and having someone handle the paperwork. They also want to avoid paying worker’s compensation insurance which does come out of their pocket, just as business insurance does.
A bevy of rules exist regarding how to determine whether someone is an independent contractor or an employee. When the IRS gets wind of a business that is suspected of flouting these rules, their first inquiries involve how people are paid and what their work requirements involve. Here is an example:
A business owner can set hours and require an employee to work a specific schedule. The employee must work from 8 am to 5 pm, if this is the schedule set for them by the employer. A business owner can only set a final deadline for a project assigned to an independent contractor. They cannot demand or set hours for the independent contractor to conduct work nor can they demand that it take place on-site in their office or storefront.
An employer can mandate that employee follow a specific procedure for completing a task. They can only assign a task to an independent contractor and specify what the end product must look like. They cannot fill in the how it gets accomplished.
An employer can place on their company’s computer tracking or blocking software that lets them know what applications an employee uses. They have the right to open and read all e-mail correspondence on the employee’s work email account. A business owner has none of these rights in regards to an independent contractor.
Independent Contractors Are Self-Employed
The contractor typically brings their own equipment and uses its own communications tools. Since they are a sole proprietor of their own business, they own their equipment and all rights to it and their privacy. If a business owner attempts to access the independent contractor’s computer, cell phone, email, etc. they will have instituted an illegal wiretap. The IRS can involve the FBI who prosecute such wiretaps.
These basic key differences determine whether the company should be paying the payroll taxes or not. If a company claims it only contracts with independent contractors, but requires them to be on-site at their business between the hours of 8 to 5, for example, or any hours, the IRS catches them. If they have remotely viewed another individual’s or group’s computers, cell phones, email, etc. using any method, they have crossed the line. They are treating their independent contractors like employees which means they should have paid payroll taxes on them.
The IRS Audit
The IRS determines when the business first contracted with an independent contractor, then conducts an examination, better known with great dread in the US as an audit. We won't cover audit specifics in this payroll tax guide. That is a whole other article. At the close of the audit, the IRS examiner prepares the bill for the client, as the IRS refers to those being investigated.
The bill includes all back taxes due from the date of the first independent contractor hired who was not treated as a contractor but as an employee. This will be immediately due. It can amount to hundreds of thousands of dollars or more, depending on the length of time in business and the number of employees.
The upshot is that each business who wants to hire help needs to be exceedingly careful. It is not enough to simply call people independent contractors and have them complete the appropriate paperwork. You must ensure you treat them completely and, in every way, as independent contractors or face a massive bill from the IRS.
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Now, you might think, “Oh, I just won’t pay it.” It is not like a lien against your home that the city issues. The IRS will come after you with all it has and it has a lot. The Service rightly strikes greater fear in the hearts of most Americans because it has both rulemaking, promulgating and enforcement powers that other agencies only dream of having.
It is widely but quietly considered the most powerful law enforcement agency in the country. Unlike the FBI or state or local law enforcement agencies, it makes its own rules. You must follow them. It enforces them through both a paperwork division and a SWAT-like division. It can take you to court and claim all that you own. It will sell it to pay your debt to the government, which is ultimately, actually a debt to all the people who ever worked for that business because that money goes into accounts that pay for their retirement and medical care in old age.
Sometimes, the people who do this do it on purpose. There is no accident. Sometimes, it is a mom-and-pop organization that just did not realize they had done it wrong. Sometimes, it is the baddest of the bad – the gangsters like Capone who had evaded every attempt by local, state and other federal law enforcement – who the IRS, often working in concert with the FBI on joint operations, take down. From businesses who just feel put out by the paperwork of employees to drug cartels and money laundering gangsters, the IRS investigates them. This is the work of payroll examiners and why you need to pay attention to your payroll taxes.
Payroll Tax Guide: Final Thoughts
So, before you grouse about the money taken out of your paycheck, remember that it is taking care of you a few years down the line. It will be there regardless of whether you start an IRA or investment account, so long as you work. Before you grouse about needing to hire or outsource to a CPA, remember, it will cost so much less than an attorney to help you navigate the morass of paperwork and the excruciating length of an audit.
If I seem to know just a little too much about this, worry not. I have never gotten in trouble with them. I know these things because I once dated one of these examiners. Knowing that I someday planned to go into business for myself, he created a mantra of knowledge, oft-repeated. He and his friends never talked about work. They were and are not allowed.
I have witnessed the huge boxes, sealed with tape, myself. I also interned with the IRS the summer between high school and college – in payroll and records, no less. We used to have viewings of the drug and gun hauls. It was sadly, in a time before selfies. (Man, that would be fun.)
Because I want your business to do well and I want you all to succeed, go read the IRS website sections on payroll taxes. Follow the rules.