Small Business Payroll Taxes: How to Calculate and How to Withhold

It’s gratifying that your small business puts people to work, but managing the process that pays their wages is a top financial challenge. Still, managing payroll—and payroll taxes in particular—is important and necessary. Mishandling payroll taxes may lead you to lose employees or even face legal trouble, so it’s crucial to understand your obligations, best practices to minimize costs and where to turn for help and insights.

What are Business Payroll Taxes?

Basic payroll taxes include income taxes, Federal Insurance Contributions Act, better known as FICA, and Federal Unemployment Tax Act, or FUTA. All permanent employees must fill out U.S. Internal Revenue Service (IRS) Form W-4, telling an employer how much payroll tax to withhold from their paychecks based on filing status and dependents.

Employees should have the opportunity to update their W-4s annually to ensure that appropriate amounts are withheld.

• Federal income tax withholding is determined using the information employees have shared on Form W-4 and the withholding tables in IRS Form 15, Employer’s Tax Guide.
• State income, local and other taxes, as applicable, are determined by a state Form W-4 or by the federal form. Note that not all states have an income tax.
• FICA encompasses Social Security and Medicare contributions.
• FUTA collects funds subsequently allocated to states and paid to eligible unemployed workers.
• Disability insurance taxes must be paid by employers in California, Hawaii, New Jersey, New York, Rhode Island and Puerto Rico.

Keep in mind that the IRS uses the term "employment tax" rather than the more general term “payroll tax”.

What are the Payroll Tax Rates for 2020?

FICA is a shared responsibility; the current tax rate for social security is 6.2% for the employer and 6.2% for the employee, or 12.4% total on up to $137,700 of employee earnings. The amount paid into employees’ Social Security accounts during their working careers determines the Social Security benefit they receive as retirees—or the benefit families receive should the earner pass away.

Medicare is funded by a 1.45% payment from the employer and a 1.45% deduction from the employee, or 2.9% of total earnings. If employees earn more than a threshold amount based on filing status, they must pay an additional 0.9% percent.

FUTA is paid solely by employers; this tax cannot be deducted from employees' wages. The 2020 FUTA tax rate of 6% is applied to the first $7,000 employees earn. Businesses use IRS Form 940 to report FUTA tax paid and, if they paid state unemployment taxes in full and on time, may be eligible for up to a 5.4% federal tax credit.

Failing to make federal tax payments on time opens your company up to serious fines and penalties, so it is critical to meet your obligations by accurately calculating the amount of payroll taxes you owe and paying them by IRS deadlines.

What are Your Payroll Tax Obligations as a Small Business?

Federal payroll taxes are “pay-as-you-go,” which means taxes must be paid as income is received throughout the year. Employees have state, local and federal taxes withheld from their checks every pay period.

As a business owner, you must keep records of employment taxes for at least four years and make them available to the IRS on request. Your records should include the items below.

What are Taxable Workers?

Typically, taxable workers are employees your company directs and controls in the execution of their work. Employees in all states are subject to payroll taxes, and employers must deduct all applicable taxes from employee paychecks and remit the employer and employee portions regularly.

U.S. citizens employed in a U.S. possession or territory generally are subject to payroll taxes, except for some exempt service providers.

Contract employees pay their own taxes based on income you report on IRS Form 1099.

What are Taxable Wages?

Taxable wages include compensation for work performed and comprise salary, tips, bonuses, in-kind payments, sales commissions and gifts. Employers use IRS Form W-2 to report these amounts to employees and IRS Form W-3 to report Form W-2 to the Social Security Administration.

For those who may have laid off employees, remember that severance payments are considered wages and are subject to Social Security and Medicare taxes, income tax withholding and FUTA.

What if I Can’t Pay My Payroll Taxes or I Pay Them Late?

The IRS expects all payroll taxes to be deposited on specific dates each year, either monthly or biweekly, and imposes penalties if employers miss those deadlines—up to 10% if payments are more than 16 days late.

One of the tax law’s harshest penalties is referred to as the "100 percent penalty." If you are responsible for remitting a company’s federal taxes—which have been withheld from employees' paychecks—and fail to do so, you can be held personally liable for 100 percent of the unpaid amount. If you find yourself short of funds, there are better ways to cope with cash flow problems than by shorting Uncle Sam.

Can a Small Business Do Its Own Payroll?

Larger companies typically have dedicated staff to handle payroll. Small and midsize companies generally can’t afford that. So how are they managing?

Some turn to online payroll software and payroll services to handle the entire process, including calculating wages and taxes and paying employees by direct deposit or check. These services generally charge a monthly fee.

For small businesses that decide to handle payroll themselves instead of using a service, someone needs to “own” the payroll process, as it requires a considerable amount of work and expertise to set up and to manage. In many cases, this task will fall to a bookkeeper, either in-house or contract.

However you choose to proceed, make sure your in-house financial expert or service provider stays up-to-date on changing laws.

4 Steps In the Payroll Process

The payroll process includes a few steps, which must be documented and repeated every pay period:

1. Record salaries. No hours are collected to run payroll each week for salaried employees, so record salaries, determine pay frequency and collect hours.
2. Collect documentation of hours worked. That could be from timecards, a manual spreadsheet or time-tracking software.
3. Calculate earnings and deductions. Withholding is based on how employees filled out their federal and state W-4 forms. (See “How to Calculate Withholding,” below.) The IRS’ Income Tax Withholding Assistant calculates federal income tax deductions each pay period and is helpful if you don’t use an automated payroll system.
4. Pay your employees. Employee payments methods include cash, paper check, direct deposit or paycard. Paycards function similarly to debit cards; on payday, funds are loaded on to the card, which employees can use to make purchases or withdrawals from an ATM.

How to Calculate Withholding

The IRS Form W-4 that employees fill out during onboarding has a worksheet to help them determine withholding. Additionally, employees may use the IRS’ Tax Withholding Estimator to perform W-4 checkups each year. That’s important to do especially if tax laws change or they experience a change in circumstances, such as the birth of a child or the loss of a spouse’s job.

Too little withholding could lead to unexpected tax bills or penalties, too much takes money out of their pockets unnecessarily.

State income tax is separate from federal taxation. States may require employees to fill out state W-4s; however, IRS W-4 can be used to calculate state and/or local income tax withholding in lieu of other forms being available. Note that nine states have no income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming—and again, consider local income tax.

4 Steps to Calculating FICA Payroll Taxes

Calculating FICA payroll taxes includes four steps:

1. Calculate Social Security withholding. Multiply each employee’s gross pay for the pay period by the Social Security tax rate (6.2%).
2. Calculate Medicare withholding. Multiply each employee’s gross pay by the Medicare tax rate (1.45%). If employee earnings exceed threshold amounts, deduct an additional 0.9%.
3. Subtract those amounts—FICA—from the employee’s gross pay.
4. Match those amounts with the employer contribution and remit the total FICA tax to the federal government using Form 941.

You must enroll in the Electronic Federal Tax Payment System (EFTPS) to make your payment.

Federal vs. State Taxes

This table summarizes the federal and state payroll tax obligations for employers and employees.

Depositing and Reporting Your Employment Taxes

All federal tax deposits—income tax, FICA and FUTA—must be made using electronic funds transfer (EFTPS).

Federal income tax and FICA: There are two deposit schedules, monthly and semi-weekly, and before the beginning of each calendar year, businesses must determine the one they’re required to use. This is determined by the total tax liability reported on Form 941. Note that schedules for depositing and reporting taxes are not the same.

Businesses that reported $50,000 or less in tax liability for the previous four quarters must deposit taxes monthly. Companies that reported more than $50,000 in taxes for the previous four quarters must deposit semi-weekly (twice per month). According to the IRS, employers on either schedule can report their deposits quarterly or annually by filing Form 941 or Form 944.

FUTA: Deposit FUTA payments quarterly, by the last day of the first month that follows the end of that quarter. For example, if the quarter ends March 31, deposit funds no later than April 30. Report payments on Form 940.

Employment Tax Reporting Due Dates

The following deadlines are for filing tax information for your permanent employees.

By January 31:

• File Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. If you deposited all of the FUTA tax when due, the IRS gives you 10 additional calendar days to file.
• File Copy A of all paper Forms W-2, Wage and Tax Statement, with Form W-3, Transmittal of Wage and Tax Statements, or file electronic Forms W-2 with the Social Security Administration (SSA) to report wages, tips and other compensation paid to employees.

By April 30, July 31, October 31, and January 31 (for the fourth quarter of the previous calendar year):

• File Form 941, Employer’s Quarterly Federal Tax Return. If you deposited all taxes when due, you have 10 additional calendar days to file the return.

Managing Payroll Taxes with Payroll Software

Payroll software providers can simplify the process by offering a payroll calculation engine and reporting. But they also provide a full service, and they will deposit and pay all payroll-related taxes for you to reduce risks of penalties and fines. They also allow you to print checks locally, provide support for multi-state employees, and handle year-end tax filings for your employees and contractors.