Back to basics: What small employers need to know when withholding taxes for an employee
A guide to payroll taxes and a helpful checklist for employers.
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The Small Business Association reported that in 2018 nearly 60 million people in the U.S. were employees of small businesses. It comes as no surprise that hiring employees and correctly withholding income taxes, Social Security, Medicare, and unemployment taxes from each of their paychecks can be complicated. Small employers, who may not have a payroll department available to them, must diligently follow the rules – as well as their special exceptions and treatment – for withholding, reporting, and depositing employee taxes, among other obligations.
Classify workers as employees or independent contractors
First, employers must identify who qualifies as an employee. Classifying employees for tax purposes can be confusing and the stakes are high. Employers generally must withhold and deposit federal income taxes, Social Security and Medicare taxes (FICA), and unemployment tax (FUTA) on wages paid to an employee. Employers generally don’t have to withhold or deposit any federal taxes on amounts paid to independent contractors. Employers must also issue Form W-2 reporting their annual wages and taxes withheld.
To determine whether an individual is an employee or independent contractor, the IRS has published the common-law rules for making this determination. The facts of each employment situation are different and must be applied to the factors listed in Pub. 15-A, Employer's Supplemental Tax Guide, pages 7 – 11. Special rules apply to ministers and certain employees of exempt organizations.
Special rules apply to businesses owned by spouses and family employees. See Pub. 15, (Circular E), Employer's Tax Guide, for more information.
If a business is selected for an employment tax examination to determine whether it correctly treated workers as independent contractor, the business may qualify for Section 530 relief. For more information, see Pub. 1976, Do You Qualify for Relief under Section 530?
Special rules for international workers
Employers must withhold 30 percent of compensation paid to nonresident alien workers unless that pay is specifically exempted from withholding or subject to graduated withholding (as with certain agricultural workers). Resident alien and undocumented individuals are subject to the same withholding that applies to U.S. citizens who receive the same kind of income. Wages paid to nonresident aliens are reported on Form W-2 and withheld taxes are reported by the employer on Form 941.
Special rules apply to nonresident aliens when completing Form W-4, see Notice 1392, Supplemental Form W-4 Instructions for Nonresident Aliens for certain exceptions to withholding on nonresident alien pay for dependent services. Also, see Pub. 519, U.S. Tax Guide for Aliens, for more information.
If a nonresident alien is exempt from withholding based on a tax treaty, the nonresident alien must file Form 8233 with their employer. The employer must then review the form, sign to accept, and forward it to the IRS within five days of acceptance. If the employee submits Form 8233 claiming exemption under a tax treaty, the wages are reported on Form 1042-S instead of in box 1 of Form W-2. Nonresident aliens are subject to FICA taxes on their wages unless the nonresident alien is an exempt student, teacher, researcher, trainee, or other nonresident alien with an F-1, J-1, M-1, or Q visa.
The employer must pay FUTA tax on nonresident alien wages unless they are an exempt student, teacher, researcher, trainee, or other nonresident alien.
More information on these rules can be found in Pub. 515, Withholding of Tax on Nonresident Aliens and Foreign Entities pages 35 – 38.
Treatment of fringe benefits and supplemental income
Fringe benefits are a form of pay for services performed. For example, an employer providing a business vehicle to an employee to commute to and from work is a fringe benefit. The value of the benefit is taxable and included in the recipient’s pay unless specifically excluded. See Table 2-1 in Pub. 15-B, Employer’s Tax Guide to Fringe Benefits, for various types of fringe benefits and how to treat them for employment tax purposes.
Supplemental income are wage payments made to an employee that aren’t regular wages, such as bonuses, commissions, overtime pay, severance pay, awards, prizes, and other payments that are taxable fringe benefits. Special rules apply to supplemental income withholding depending on whether the wages are combined with regular wages or identified separately from regular wages. A flat 22 percent can be applied to supplemental wages paid which are separately identified and when the employer withholds income tax from the employee’s regular wages. See Chapter 7 of Pub. 15, (Circular E), Employer's Tax Guide, for more rules and examples of withholding on supplemental wages.
Employers who offer retirement account benefits such as matching contributions to IRA and 401(k) accounts will need to report contributions on the employee’s Form W-2. Employers who provide employer-sponsored health plans to their employees are also required to report the value of these payments on Form W-2.
The Tax Cuts and Jobs Act (TCJA) of 2017 changed the Form W-4
The TCJA made sweeping changes to the individual tax brackets and suspended the personal exemption for tax years 2018 through 2025. The IRS issued a new Form W-4 in February 2018 with new instructions to account for these changes.
Under the new instructions for Form W-4, employers were required to begin using the updated withholding amounts no later than February 22, 2018. If an employer failed to use the proper withholding during 2018, they must correct form from the 94x series that corresponds to the incorrect withholding using the IRS procedures described in Correcting Employment Taxes.
The Form W-4 for use in 2019 is available now.
Checklist of employer responsibilities and forms to file, calendar for withholding and depositing income, FICA, and FUTA taxes
- Work eligibility verification (USCIS Form I-9, Employment Eligibility Verification)
- Record employees’ names and Social Security numbers
- Request employees complete Form W-4
- Withhold federal income tax based on employee’s Form W-4
- Withhold employee’s share of Social Security and Medicare taxes
- Deposit withheld income tax, withheld and employer Social Security taxes, and withheld and employer Medicare taxes
- Note: The due date of this deposit depends on the employer’s deposit schedule (monthly or semiweekly)
Quarterly (By April 30, July 31, October 31, and January 31)
- Deposit FUTA tax. If undeposited amount is over $500 for the year, then the employer must deposit at least one quarterly payment using the Electronic Federal Tax Payment System (EFTPS)
- File Form 941 and pay tax with return, if not required to deposit monthly or semiweekly
- If Social Security and Medicare taxes were timely deposited when due, then the due dates for Form 941 are May 10, August 10, November 10, and February 10
- Some taxpayers only file Form 944 and are not required to file Form 941
In addition to the above deadlines, these are required annually:
By January 31st
- File Form 944, if required by IRS notification, and pay tax with return if not required to deposit
- File Form 940 to report any FUTA tax
- But if all FUTA tax was deposited when due, file Form 940 by February 11th
- Furnish each employee with a Form W-2
- Furnish other payees with a Form 1099 (Example: Provide independent contractors with a Form 1099-MISC)
- File Form 945 for any nonpayroll income tax withholding
- File Copy A of Forms W-2 and the transmittal Form W-3 with the Social Security Administration
- File Copy A of Forms 1099-MISC (only if there are payments in box 7) and the transmittal Form 1096
By February 15th
- Ask for Form W-4 from employees claiming exemption from tax withholding. Forms W-4 claiming exemption from withholding for previous year expire
By February 28th
- File paper Forms 1099 (other than Form 1099-MISC with payments in box 7 and Form 1099-H) Copy A and the transmittal Form 1096 with IRS
- File paper Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips with IRS
- Reconcile Form 941 or Form 944 with Form W-2 and Form W-3
By April 1st
Before December 1st
- Request that employees submit an updated Form W-4, if they need to change their withholding for the next year
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