Demystifying Payroll Taxes and Their Effect on Businesses

Payroll taxes have long been a mystery to most business owners. What are they?  What are my responsibilities?  Why are the IRS and the state constantly writing to me about filing and paying?

In the long list of responsibilities business owners face daily, their responsibility to file and pay payroll taxes sometimes falls to the bottom of the list.  This is a dangerous oversight because the consequences are costly.

According to the Center for Budget and Policy Priorities the 2019 payroll taxes were $1.24 trillion, which is $35.9% of all IRS revenue.  Therefore, the IRS has a vested interest in pursuing employers who renege on their responsibility.

It is worth understanding the components of payroll taxes. The Federal Insurance Contribution Act (FICA) comprises the two main parts of the federal payroll taxes: Social Security and Medicare.  The burden of these taxes is borne equally by the employee and employer: each party pays 6.2% each for Social Security and 1.45% for Medicaid, totaling 12.4% for Social Security and 2.9% for Medicaid.   

The funds collected through social security pay benefits to retirees and people with disabilities, as well as providing survivor benefits for families of deceased workers.  The medicare tax funds the hospital insurance part of medicare.

Social security contribution, also known as Old-Age Survivors Disability Insurance (OASDI), is imposed on employees’ wages up to a stated amount known as the annual limit.  The annual limit is adjusted each year with changes to the national average wage index. The 2020 annual limit is $137,000.  The OASDI rate for self-employment income is 12.4%.

Medicare tax, also known as Medicare Hospital Insurance (HI), does not stop at an income limit like social security contributions. However the rate increases once employees are above a certain limit.  Married employees with income over $250,000 and single employees with income over $200,000 pay an additional 0.9% resulting in a Medicare tax of 3.8% (2.9% + 0.9%).

Another part of the payroll tax is FUTA (Federal Unemployment Tax Act) which imposes a 0.9% tax on the first $7,000 of every employee’s income, up to $42 per employee per year.  The employers only contribute to FUTA.  Most of these revenues fund part of the administration of the State Unemployment Insurance Fund.

The IRS is vigilant in pursuing the trust fund part of the payroll tax.  This part of the tax is the taxes the employer collects from the employee to remit to the IRS: income taxes, social security and medicare taxes.  The employer collects these taxes from the employee and holds them in trust until remitted to the IRS.  These funds do not belong to the employer and because the IRS depends on the taxes to fund specific areas they are tenacious in their effort to recover these funds.

For the employers who fail to pay the trust fund taxes, the IRS will impose a trust fund recovery penalty.  The penalty is equal to the amount of the tax withheld.  Therefore, if an employer owes $12,000 for the trust fund part of the payroll taxes, the trust fund penalty will be equal to $12,000, making the total liability $24,000.  While some may think the penalty is imposed only on the business, it may also be imposed on the owners, shareholders and anyone who makes decisions and/or has control of the business finances.

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