Lesson 7 - How to manage payroll so you withhold the correct amount from employees
Hi, I'm Janene. I've started my real estate business, and I'm sure it's going be a success. In the last lesson, I learned about the differences between employees and contractors. Now, I need to know how to manage payroll. I've been doing all the reading I can, but there's a lot of material here. What I really need is an overview of my responsibilities and where I can look for more specific information. Can you help me?
We sure can, Janene.
Welcome, everyone, to How to Manage Payroll so You Withhold the Correct Amount from Employees. In this lesson... we'll discuss your responsibilities as an employer to identify wages that are subject to employment taxes; we'll explain the difference between an accountable plan and a non-accountable plan; and we'll show you how to calculate your payroll taxes using the appropriate method.
In the first part of this lesson, we'll discuss the employment tax rules for wages and other types of compensation.
What are wages?
But what exactly are wages? And does all compensation count as wages?
Wages that are subject to federal employment taxes include all payments you give an employee for services performed. These payments may be in cash or in other forms. Salaries, vacation pay, bonuses, commissions, and certain fringe benefits are some examples of amounts that you include in wages for employment tax purposes.
Not all employee compensation is considered wages
However, not all employee compensation is considered wages. For example, if you pay the cost of an accident or a health insurance plan for your employees, these payments are not wages and therefore are not subject to tax.
That seems pretty clear.
Accountable and Non-Accountable plans
But what about those accountable and non-accountable plans you mentioned at the beginning of the lesson. What are they?
Let's start with accountable plans. An accountable plan is a reimbursement or allowance arrangement between you and your employee that meets all three of the following rules: One, your employee must pay for deductible expenses while performing services as your employee. Two, your employee must account to you for those expenses within a reasonable time, and Three, your employee must return to you any advanced amounts that are more than the actual expenses within a reasonable period. What counts as a reasonable period? What counts as a reasonable period depends on the facts and circumstances. Generally, it's considered reasonable that if your employee received any advances within 30 days of the time they incur the expenses, that employee adequately accounts for the expenses within 60 days after the time the expenses were paid and the employee then returns any excess amount within 120 days from the date the expenses were paid.
So then what would be a non-accountable plan?
You have a non-accountable plan if an employee is not required to, or does not have to, account for expenses in a timely manner. It is also a non-accountable plan if you advance an amount of money to your employee for business expenses and that employee is not required to or does not return any amounts not used for business expenses. It makes no difference if they were supposed to account for the money and didn't, or if you didn't require them to account for it at all. Basically, if you give your employee money for travel or business expenses and they never account for it or return any of it, you have a non-accountable plan.
IRS Publication 15, Employer's Tax Guide, has more information on accountable and non-accountable plans.
So I understand the differences between an accountable and non-accountable plan, but how do I calculate payroll?
There are very specific rules for specific types of workers.
Because you only need that information if you have those type of workers, please choose one of the following as it pertains to your business: Do your employees receive tips? Is your business a non-profit organization? Do you employ farm workers?
Choose one of the following:
When you have employees who receive tips
Many employees receive tips. Tips are taxable income and the tips employees get from customers are generally subject to withholding. By the 10th of each month the employees must report to you the tips they received in the prior month. For example, if workers received tips in April, they would report them to you by May 10th. This includes cash tips as well as tips charged on credit cards or to accounts. If the 10th day falls on a Saturday, Sunday, or legal holiday, the employee has until the next business day that is not a Saturday, Sunday, or legal holiday. Also, if the total month's tips are less than 20 dollars, then even though they would remain taxable to the employee, they would not need to be reported to you. If your employees receive tips... Form 4070, Employee's Report of Tips to Employer, is a great tool to give them to assist in their reporting requirements. Form 4070 can be found in IRS Publication 1244, Employee's Daily Record of Tips and Report to Employer. In addition to Form 4070, there is also a daily log employees can complete as well as helpful instructions for recording and reporting tip income. For more information, see IRS Publication 531, Reporting Tip Income.
Some employees receive allocated tips. These are tips you assign to an employee in addition to the tips the employee reported to you for the year. Do this only if your business is a restaurant, cocktail lounge or similar business that must allocate tips to employees, if the tips that are employee-reported are less than 8 percent of their share of the food and drink sales for the business, and if you are not participating in the Attributed Tip Income Program. No income, Social Security, or Medicare taxes are withheld on allocated tips. Show the allocated tips separately in box 8 on Form W 2. Do not include allocated tips in box 1 with wages and reported tips. IRS Publication 531, Reporting Tip Income, can give you more details on allocated tips. Calculating allocated tips can be a difficult process. But the IRS can help make it easier. If your employees receive tips, you can participate in the Tip Rate Determination and Education program. The IRS has several tip agreements to help employers and employees understand and meet their tip reporting responsibilities. All are voluntary. The two most common agreements are the Tip Rate Determination Agreement, or TRDA, and the Tip Reporting Alternative Commitment, or TRAC. Again, see IRS Publication 531 for more information.
Non-Profit Organization Employees
Although many non-profit organizations are exempt from income tax, their employees are not. You must still withhold income tax from the pay of your employees; however, there are special rules for Social Security taxes, Medicare taxes, and federal unemployment taxes for employees of non-profit organizations. For more information, see the "Employees of Exempt Organizations" section of IRS Publication 15A, Employer's Supplemental Tax Guide.
To report income tax withheld as well as employer and employee Social Security and Medicare taxes on farm workers... use Form 943, Employer's Annual Federal Tax Return for Agricultural Employees. Form 943 is also used to report taxes on wages of household employees in a private home on a farm operated for profit. If you employ both farm and nonfarm workers, you must treat employment taxes for the farm workers differently than employment taxes for the nonfarm workers. See IRS Publication 51, Agricultural Employer's Tax Guide and IRS Publication 225, Farmer's Tax Guide, for more information.
How do withholdings work?
How do withholdings work? And how do I know if I'm withholding the correct amount?
To ensure that you are withholding the correct amount, you'll first need to know the total amount of compensation and benefits included in each employee's wages for the pay period. Then, you'll need to calculate the amount of income tax to withhold from each employee. How do I do that? The two most common methods are the wage bracket method and the percentage method.
Wage Bracket Method
Under the wage bracket method, you simply locate in IRS Publication 15 the proper table for your payroll period and the employee's marital status as shown on the employee's Form W 4. Then, look at the employee's Form W 4 for the number of withholding allowances claimed. Using the number of allowances claimed on the Form W 4 and the amount of wages paid, follow the column and row to find the amount of tax to withhold. For withholding computations for employees claiming more than ten withholding allowances, you will need to refer to the special wage bracket instructions in IRS Publication 15.
How would I calculate withholding by the percentage method?
If the employee's wages are greater than the amounts in the last wage bracket of the wage tables or if you do not want to use the wage bracket tables, you can use the percentage method. This method works for any number of withholding allowances the employee claims on any amount of wages.
To calculate withholding by the percentage method, you will again use IRS Publication 15. Using the percentage method table, multiply one withholding allowance for your payroll period by the number of allowances the employee claims on the Form W 4. Then, subtract that amount from the employee's wages. Next, find the amount to withhold from the tables for the percentage method of withholding. As with the wage bracket method, those tables are found in IRS Publication 15. Understanding wages for employment tax purposes is not easy. Remember to start with IRS Publication 15 to help answer most of your questions related to compensation.
Withholding Employee's Share of Social Security & Medicare
What other withholdings do I need to know about?
You are also responsible for withholding the employee's share of Social Security and Medicare taxes. The Form W 4 information does not change the amount of Social Security and Medicare taxes. Simply multiply the total wage by the applicable employee Social Security and Medicare tax percentages. You can find the current employee rate for Social Security on their Website at www.ssa.gov. As an employer, you also pay a matching amount. In addition, each year the amount of wages subject to Social Security withholding changes. You do not have to withhold any more Social Security taxes once the employee's wages you have paid reach that limit. This is known as the wage base limit, and this limit is published annually in IRS Publication 15.
What about the Medicare tax withholding?
The employee tax rate for Medicare tax is an additional percent and, again, that rate can be found at www.ssa.gov. There is no wage limit for Medicare taxes so all wages are subject to withholding and, just like Social Security taxes, you as the employer must pay a matching amount. Generally, you compute all payroll deductions on the gross pay of each employee. However, as your business grows, there may be portions of an employee's pay, such as certain contributions to retirement plans that are not subject to some or all of these taxes. You can learn about these plans in the lesson "How to Set Up a Retirement Plan for You and Your Employees."
Would taxes have to be collected on tip income, too?
As an employer, you must collect income tax, employee Social Security tax, and employee Medicare tax on the tip income your employees report to you. You can collect these taxes from wages or from other funds your employee makes available. If the employee receives regular wages and reports tips, calculate income tax as if the tips were supplemental wages or a part of regular wages. If you have not withheld income tax from the regular wages because the wages were too low, add the tips to the regular wages and withhold income tax based on the total.
But if you withheld income tax from the regular wages, then you have two options available: You can withhold a flat 25 percent or you can add the tips and regular wages for the most recent payroll period and calculate the income tax withholding as if the total were a single payment. Then, subtract the tax already withheld from the regular wages and withhold the remaining tax from the tips.
What if the employee's income is below the 25 percent income tax bracket?
If the employee's income is below the 25 percent income tax bracket, calculating their tax using the 25 percent flat rate may mean that you are withholding a lot more tax than is necessary. This could cause a hardship for the employee, so try to consider this before using the flat 25 percent withholding method.
What if the employee's regular wages aren't enough for me to withhold all the tax owed? What do I do then?
There may be times when an employee's regular wages may not be enough for you to withhold all the tax owed on the regular pay plus reported tips. If this happens, the employee can give you money until the close of the calendar year to pay the rest of the taxes. If there is not enough money to cover all the taxes, withhold taxes in this order: all taxes on regular pay; then, Social Security and Medicare taxes on reported tips; and finally, income taxes on reported tips. Collect any taxes that remain unpaid from the employee's next paycheck. If taxes remain uncollected at the end of the year the employee may be subject to a penalty.
Does it matter if the worker is full or part-time? What if he or she has another job?
When it comes to withholding taxes, there is no difference between full or part-time employees and it does not matter if the worker has another job. You are not responsible for knowing when the employee's total wages reach the wage base. You are only responsible for knowing when the employee meets the wage base for the wages you have paid. There are exceptions, however, when you take over an existing business. If you acquire an existing business, you may include the wages paid by the previous employer to your employee's wages when you calculate their annual wage base limit for Social Security tax purposes. IRS Publication 15 has more information on this topic in the section "Successor Employers."
What about unemployment taxes? What do I have to do with this?
Let's take a few minutes to talk about the Federal Unemployment Tax Act, or FUTA. FUTA directs the states and the federal government to make and to run the unemployment tax program, which provides unemployment payments to workers who have lost their jobs. The various states create the actual employment insurance systems and the federal government approves the state laws and pays the administrative costs of the state programs. Because this is a joint program between the state and federal governments, you are first subject to the state tax. Then, this tax becomes a credit against the federal tax. In your state, you may even be exempt from the tax, but you still have to pay the federal tax. Conversely, you may not owe FUTA tax but you still need to pay the state. Unlike other payroll taxes, this tax is the sole responsibility of the employer. It is not deducted from the employee's paycheck.
You are an employer for FUTA tax purposes and must file and pay the tax if in the current year or last year you paid wages of 15 hundred dollars or more in any calendar quarter to employees or had one or more employees at any time in each of the 20 or more weeks. The 20 weeks do not have to be full or consecutive weeks. Count all regular, temporary, and part-time employees, including employees on vacation or sick leave. Not all employee wages are subject to FUTA tax: there are exceptions for certain employers as well as certain types of employees. For more information, refer to the table "Special Rules for Various Types of Services and Payments" in IRS Publication 15.
For household workers, you are subject to FUTA tax only if you paid total cash wages of 1 thousand dollars or more for all household employees in any calendar quarter in the current or prior year. A household worker is an employee who performs household work in a private home, local college club, or local fraternity or sorority chapter.
For farm workers, you are subject to FUTA tax on the wages you pay to farm workers if you paid cash wages of 20 thousand or more to farm workers during any calendar quarter in the current or prior year or if you employed ten or more farm workers at least some or part of a day, whether or not at the same time, during any 20 or more different weeks in the current or prior year.
How is the FUTA tax calculated?
Currently, the FUTA tax rate is 6 percent. FUTA tax is figured on the first 7 thousand dollars in wages paid to each employee during the year. The tax is imposed on you as the employer; do not collect it or deduct it from your employee's wages. You can take a tax credit of up to 5.4 percent against FUTA tax for amounts you paid into state unemployment funds, resulting in a net tax rate of .6 percent. But you can only take this credit in full if the taxes are paid to the state by the time you need to file your Form 940 FUTA tax return. See IRS Publications 15 and 15A for more information on the FUTA tax as well as the current rate. Remember, this tax is the sole responsibility of the employer. It is not deducted from the employee's paycheck.
Can I have an example?
Sure. Let's say late last year you hired Frank and paid him 35 hundred dollars in wages before the year ended. All of the 35 hundred was subject to the FUTA tax at a rate of 6 percent. Assuming you are eligible for the maximum FUTA state tax credit, and all the required state contributions were paid on time, your tax on Frank's wages would have been 21 dollars. Then, let's say a few months into the beginning of this year, Frank's total wages for this year reached 7 thousand dollars. None of the wages you pay him after that are subject to the FUTA tax for the rest of the year. Let's say, though, that Frank quits his job and Nancy replaces him. The first 7 thousand dollars you pay Nancy this year is also subject to the FUTA tax. Why is that? Remember... the first 7 thousand dollars you pay each employee each year is subject to the FUTA tax. The FUTA tax you would pay is 42 dollars for Frank's wages and 42 dollars for Nancy's wages. Your total FUTA tax, this year, is 84 dollars.
What about due dates for paying the FUTA tax?
The due date for the first quarter is April 30th; the due date for the second quarter is July 31st. The due date for the third quarter is October 31st, and the due date for the fourth quarter is January 31st. Small business employers file Form 940, Employer's Annual Federal Unemployment Tax Return, to report FUTA tax. If your liability for the fourth quarter, plus any amount not deposited from an earlier quarter, is over 5 hundred dollars, deposit the entire amount by the due date of Form 940, January 31st. If it is 5 hundred dollars or less, you can either make a deposit or pay the tax with your Form 940 by January 31st. Some states may require that you file state unemployment taxes at various times throughout the year, but the federal unemployment tax return is filed annually. The due date for the Form 940 is January 31st. If you have deposited all of your FUTA tax on time, however, you are given until February 10th to file. As with all due dates, if the date falls on a Saturday, Sunday, or a federal holiday, you can file on the next business day.
As you've learned with employment taxes, FUTA tax also has rules on when you must deposit taxes. If, at the end of any calendar quarter you owe, but have not yet deposited, more than 5 hundred dollars in FUTA tax, you must deposit the FUTA tax by the last day of the first month after the quarter ends. If the accumulated tax at the end of any of the first three quarters is 5 hundred dollars or less, you do not have to deposit the amount; instead, you may carry it forward and add it to the liability calculated in the next quarter to see if you must make a deposit. Remember, all this information is in IRS Publication 15.
Thank you. This lesson has been a big help.
We're glad to be of assistance, Janene.
But before we end, let's look at what we've covered in this lesson. We identified wages that are subject to employment taxes, learned about accountable and non-accountable plans, and discussed how to calculate your payroll. We've also defined wages subject to FUTA tax; figured the FUTA tax due; and described the deposit requirements for this tax. Thank you for joining us for this lesson. Best wishes on your business.