Employer's Tax and Legal Obligations

When hiring a worker you assume tax and legal obligations. For example, social security and Medicare taxes must be withheld from each employee's gross pay, employment tax returns must be filed timely, and employment taxes must be paid to the government.

State law requires employers to carry workers' compensation insurance for employees. Workers' compensation insurance covers work-related injuries of employees. It provides wage replacement and medical benefits for an employee injured on the job..

For employment tax purposes, no distinction is made between classes of employees; hourly workers, managers, and supervisory personnel are all employees.

Officers and Directors of a Corporation:

An officer of a corporation is generally an employee. However, an officer who performs no services or only minor services, and neither receives nor is entitled to receive any pay, is not considered an employee.

A director of a corporation is not an employee with respect to services performed as a director.

Sole Proprietors and Partners:

Sole proprietors and general partners are classified as self-employed persons for federal tax purposes and not employees of the business.

Self-employed persons are not subject to any federal or state withholding taxes and do not receive Form W-2 annually. Sole proprietors report gross receipts and business expenses on Schedule C (or Schedule F for farmers). Net income or loss is carried from Schedule C to Form 1040..

Partners report income or loss on Schedule E.

Self-employment taxes (Social Security and Medicare taxes) are paid by self-employed persons and are reported on Form SE.

Withholding Taxes:

The following federal taxes are required to be withheld from an employee's gross pay:

  • Federal income taxes (unless the employee chooses exempt status on Form W-4).
  • Social Security Taxes
  • Medicare Taxes

Social security and Medicare taxes (referred to as FICA taxes) are paid by both the employer and the employee. Each pays one-half the social security rate, 6.2% (.062) and one-half the Medicare rate, 1.45% (.0145).

Self-employed persons pay both halves of both taxes, 12.4% for social security and 2.9% for Medicare, for a total rate of 15.3%.

Social Security Annual Wages Base:

The annual wage base represents the maximum amount of earned income subject to Social Security taxes. (The IRS refers to the annual social security wages base as the contribution and benefit base.)

The annual wage base generally changes each year with changes in the national average wage index. However, the annual wage base for 2015 and 2016 have remained unchanged at $118,500. For example, for 2016 an individual with earned income (i.e. wages, self-employment income) equal to or larger than $118,500 would contribute a maximum of $7,347 to social security.

Medicare Tax:

There is no limitation on earned income subject to Medicare tax. Every dollar of earned income, from the first dollar, is subject to Medicare tax. This has been the case since 1994.

Federal Unemployment Tax (FUTA):

FUTA stands for - Federal Unemployment Tax Act.

FUTA, along with state unemployment systems, provides for payments of unemployment compensation to workers who have lost their jobs. Most employers pay both a Federal and a state unemployment tax.

Federal unemployment taxes are an employer-only tax. Therefore, this tax is not withheld from an employee's pay. The FUTA rate is generally 0.6% (.006), which includes a credit of 5.4% of state unemployment tax you paid.

The 0.6% rate is applied only up to the first $7,000 of each employee's gross pay, or $42 maximum per employee.

Credit Reduction States:

When a state's unemployment insurance funds are depleted, the state draws (borrows) from a designated federal loan account. For example, the outstanding loan balance for California as of July 14, 2016, according to the Department of Labor, was $3.2 billion.

If the loans are not repaid within two years, part of the 5.4% FUTA tax credit is reduced, increasing the effective FUTA tax rate for that state to repay its loans. This simply means, credit reduction state employers end up paying a higher FUTA tax than employers in states that are not credit reduction states.

Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return:

Form 940 is filed annually by the employer. Although Form 940 covers a calendar year, you may have to deposit your FUTA tax before you file the return (which is due by February 1, of the following year).

When You Must Deposit FUTA Taxes:

If your FUTA tax liability is MORE than $500 for the calendar year, you must deposit at least one-quarterly payment. In other words, your are only required to make a deposit if your FUTA tax liability accumulates to more than $500 (i.e. $501 or more) during any quarter.

If your FUTA tax liability is less than $500 in any quarter, you simply carry the amount over to the next quarter and add it to the FUTA liability of that quarter. Once the accumulated FUTA tax liability reaches $501 or more in any quarter, a deposit must be made. You make the deposit by the last day of the month after the end of the quarter the amount accumulated to over $500.

If your undeposited FUTA tax is MORE than $500 on ... Deposit your tax by...
March 31 April 30
June 30 July 31
September 30 October 31
December 31 January 31

Fourth Quarter FUTA Tax Liability $500 or Less:

If your FUTA tax liability is $500 or less for the entire calendar year, you can either make a deposit by February 1 of the following year or pay the tax with your Form 940 by February 1 of the following year.

For example, if your FUTA tax liability totals $500 for the entire calendar year of 2016, you can either deposit the tax by February 1, 2017 or pay it with your Form 940 by February 1, 2017.

Form 941, Employer's Quarterly Federal Tax Return:

Form 941 is filed quarterly with the IRS to report the number of employees who received wages, tips, and other compensation for the pay period, the total amount of wages, tips, and other compensation paid for the period, federal income tax withheld, social security and Medicare taxes, and taxable wages and tips subject to additional Medicare tax withholding.

Using a payroll service to handle your payroll processing needs is a smart move! You'll free up tons of time that can be used for more profitable activities and protect your cash by avoiding costly non-compliance penalties.

State Unemployment Taxes:

Like FUTA tax, state unemployment tax is generally an employer-only tax as well. However, there are three states that withhold SUTA taxes from an employee's wages - Alaska, New Jersey, and Pennsylvania.

The state return for unemployment taxes is generally filed monthly to report gross wages paid for the period. The amount of unemployment tax due is calculated on this form. The tax is generally assessed on the first $7,000 of each employee's gross pay.

The tax rate (referred to as your experience rate) can go up or down depending on the number of successful unemployment claims filed against the business. Low turnover will result in a lower experience rate and vice versa.

Employment Forms When Hiring an Employee

Form W-4, Employee's Withholding Allowance Certificate:

Form W-4 is completed by each newly hired employee so that the employer knows the amount of federal income tax to withhold from the employee's pay.

The amount of federal income taxes withheld is generally based on the number of allowances claimed. An employee may also designate a specific amount to be withheld on one of the lines on Form W-4.

An employee may complete a new W-4 each year or anytime his personal or financial situation has changed.

Form I-9, Employment Eligibility and Verification:

Form I-9 is a U.S. Citizenship and Immigration Services form. The purpose of Form I-9 is to document the verification of the identity and employment authorization of each employee (both citizen and non-citizen) hired to work in the United States and in the Commonwealth of the Northern Mariana Islands.

The employer is responsible for retaining completed I-9 forms. Employers may be fined if the form is not complete.

note Form I-9 is not required for unpaid volunteers or for contractors. However, a company could still find itself liable if it contracts work to a company knowing that the contractor employs unauthorized workers.

Employers and employee's are responsible for completing and signing the appropriate section(s) of Form I-9. An employer should not complete Form I-9 until after the individual has accepted employment.

Newly hired employees must complete Section 1 of Form I-9 no later than the first day of employment.

Employers must complete Section 2 of Form I-9 by examining evidence of identity and employment authorization within 3 business days of the employee's first day of employment. For example, if an employee begins working on Monday, you must complete Section 2 by Thursday of that week.

noteIf you hire an employee for less than 3 business days, Section 2 must be completed no later than the first day of employment.

Employers cannot specify which document(s) employees may present from the List of Acceptable Documents, found on the last page of Form I-9.

Workers' Compensation

If you have employees, you are required by each state to carry workers' compensation insurance to cover the costs associated with job-related injuries of employees.

Workers' compensation insurance is a no-fault system. This means, a worker does not have to prove that some one else caused the injury. Even if the worker caused his own job-related injury he may receive workers' compensation benefits.

note Sole Proprietors:
A sole proprietor is not treated as an employee for workers' compensation purposes and therefore, is not eligible for coverage. However, some states allow sole proprietors to opt in to a similar program. Check with your state.

Workers' Compensation insurance premiums vary depending on the degree of risk associated with each employee's job. Jobs that pose a higher degree of risk for physical injury, such as handling chemicals, will require a higher premium than jobs with a lower risk, such as office workers.

Independent Contractors

People in various professions and trades offering their services to the public are generally not employees. For example, doctors, attorneys, accountants, electricians, house painters, and plumbers.

The general rule is that, a worker is an independent contractor if you, the recipient of the service, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.

For example, an accountant would be an employee if you control what work is to be done, when it is to be done, and where it is to be done

On the other hand, a bookkeeper who offers her services to the general public for a fee and who sets her own work schedule and controls where and how her work is to be performed, would be an independent contractor.

Taxes and Independent Contractors:

You are not generally required to withhold federal income taxes from payments made to independent contractors. However, if you do not receive a tax identification (TIN) number from the contractor, you may be required to withhold backup withholding.

Backup Withholding:

If an independent contractor does not provide you with his tax identification number (TIN) and if you paid that individual $600 or more during the year, you are required to withhold federal income taxes (referred to as backup withholding) from payments made to that individual. The backup withholding rate is 28% of the amount paid and is paid to the U.S. Treasury Department..

How to Request a Taxpayer Identification Number:

If you hire a independent contractor, give the individual Form W-9, Request for Taxpayer Identification Number and Certification. Have that individual complete the form and return it to you. Keep this form on file as evidence that you were not required to withhold backup withholding for that contractor..

Form 1099-MISC:

Include the gross amount paid to an independent contractor and the amount of backup withholding, if any, on Form 1099-MISC. If backup withholding was required, it is paid to the U.S. Treasury.

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