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Payroll vs. income taxes: From deductions to filing

What is taxable, who is responsible, and how can you get it right?

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COVID-19 has changed how small businesses operate, from applying for relief such as the Paycheck Protection Program (PPP) to updating payroll processes. Payroll—comprised of complex processes including garnishments and unemployment claimspayroll taxes, and classifying workers—doesn’t have to be confusing. By understanding payroll changespayroll technology, and the ebb and flow of time and attendance, you can improve and simplify your payroll processes. WeWork Business Solutions, powered by VensureHR makes professional services simple, so you can revitalize your small business during this time.

Editor’s note: The following article does not reflect or refer to the Presidential Executive Order passed on August 8, 2020, regarding the deferral of payroll taxes. The information here focuses on base payroll tax details and will not address deferred payments.  

Both payroll tax and income tax are deducted from an employee’s paycheck. But there are a few items that set these two tax types apart. 

The term payroll taxes, or employment taxes, is made up of Social Security and Medicare taxes and calculated on the wages or salaries of employees. This includes all taxes associated with withholding, filing, and remitting. These processes are complicated on their own, but they can take on a new level of complexity for business owners when bundled together in the payroll process. 

Income tax, simply stated, is a tax on the employee’s salary paid for by the employee. Any funds an employee earns at a job or from self-employment, bank interest, or property gains would be subject to this tax. 

What is payroll tax? 

Some people may consider themselves business owners when they launch a website, activate their online payment button, or publish a graphic on their social media business platform announcing they are open for business. To the Internal Revenue Service (IRS), however, a business is only considered a business after being assigned an employer identification number (EIN). This number, also referred to as a Federal Tax Identification Number, is used to identify a business as an official entity. (Not sure if you need an EIN? The IRS offers a short quiz to find out!)

As a business owner with an EIN, you’re responsible for the company’s payroll taxes, or employment taxes. That means it’s your job to deduct a portion of each employee’s wages to pay taxes on their behalf, and to pay payroll taxes on each employee from the company revenue. 

Payroll tax is mandated by the Federal Insurance Contributions Act (FICA). The funds from these two programs serve as the second largest source of revenue for the U.S. government. Payroll tax is an employer-employee tax, meaning that both parties split the tax down the middle, paying 6.2 percent each. 

To avoid numerous penalties, the government requires employers to make regular tax payments. This process includes submitting proper paperwork and filing accurate reports and supplemental data. Not only do the federal and state taxes have to be paid and reported to the proper agency, but it has to be done on time and with the right forms. Employers are also required to maintain payroll tax records for both federal and state. 

Note: The IRS has varied reporting deadlines for specific forms. 

Business owners have four options for submitting federal tax payments—however, electronic submission is preferred. Other options include ACH payment initiated by your financial institution, tax professional or payroll service payment initiation, or a same-day tax wire (rare). An exception to the electronic filing preference is made for small business owners. Small businesses with less than $2,500 per quarter of federal tax liability have the option to mail check payments with the quarterly return.

Some business owners don’t have employees—however, this doesn’t exempt them from paying payroll taxes, as the owner is still expected to take a salary. This payment is based on the self-employment tax, which is calculated by combining Medicare and Social Security to get a tax rate of 15.3 percent, and applies only if you fall into one of the below categories: 

  • Have annual net earnings of $400 or more
  • Are a church employee with an income equal to or more than $108.28

Payroll tax filing requirements

Tax deposit schedules for employment taxes depend on the size of the tax liability outlined by the IRS, communicated in the fourth quarter of each calendar year. The IRS will inform you of the proper schedule of payment (annual, quarterly, monthly, or semi-weekly) based on the income and FICA taxes reported for a specific period. Monthly and semi-weekly are the most common options for most employers. 

Annual deposits: Annual deposits are part of an “opt-in” program (submit Form 944) that you must apply for. To be considered, the business must have an estimated tax employment liability of $1,000 or less for the calendar year and must not be an agricultural or household employer. 

Quarterly deposits: Quarterly deposits are suitable for businesses where current or preceding quarter taxes are less than $2,000. 

Monthly deposits: Monthly deposits must be submitted prior to the 15th day of the following month. For example, February payments are due prior to March 15. 

Semi-weekly deposits: Semi-weekly deposits for wages paid on Wednesday through Friday are due by the following Wednesday. Wages paid on Saturday through Tuesday are due by the following Friday. (Business days are considered any day other than Saturday, Sunday, or federally recognized holidays.)

What is income tax?

Income tax is an umbrella term that refers to the employee taxes a business is responsible for paying on the employee’s behalf, which are deducted automatically from the employee’s paycheck. It includes federal, state, and local income taxes, and is applicable to employees in every state, except the seven states exempt from local income taxes. Most states incur additional state income tax, and some localities also apply a local income tax. The income tax amount for these line items is based on a few factors, including the employee’s W-4 and identified filing status. 

At the base level, these are the federal and state taxes that apply to an employee’s taxable wages:

  • Federal income taxes: These taxes are calculated by referencing specific information on the employee’s W-4 form. The total federal income tax deducted is dependent on an employee’s gross wages, filing status, and list of exemptions. Some states mandate additional withholdings to cover short-term disability, the Family and Medical Leave Act (FMLA), and unemployment benefits
  • Local income taxes (where applicable): According to usa.gov, 43 different states and various localities within those states require residents to pay a personal income tax. 

Income tax vs. payroll tax

Payroll tax, paid by the employer and the employee, consists of Social Security tax and Medicare tax, both of which base the tax percentage on the employee’s gross wages. Social Security tax, for example, aids in funding retirement benefits, dependents of retired persons, and disabled persons and their dependents. Medicare funds are released to beneficiaries after they reach 65 years of age. Payroll tax is often taxed at a flat rate. 

Graphic courtesy of Vensure.

Income tax, however, is based on how much money an employee makes when all sources of income are combined. The actual tax percentage also depends on a variety of other factors including tax brackets, deductions, and potential credits. Tax credits are a one-for-one reduction in owed income taxes. Examples of tax credits include environmental improvements to an employee residence, like solar, or child and dependent care or education credits. 

When it comes to tax returns, most of the focus for the filing exercise is spent on income tax, as the process is far more complex. Business owners will report on the amount of payroll tax paid throughout the year to employees. 

From tax withholdings to depositing payroll tax payments to filing returns, there are challenges and regulations that can make the entire payroll tax process seem overwhelming for new business owners. But with guidance, it should soon be just another part of the job. 

This coming tax season, consider learning more about the proper management and filing of your business payroll taxes by exploring the WeWork Business Solutions, powered by VensureHR

Julie Dower is a marketing and communications manager working for Vensure Employer Services, living in Chandler, Arizona. A mother to infant twin girls, she holds a master of science in technical communications from Arizona State University and a master of arts in English from Northern Arizona University.

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