Payroll Withholding Requirements
by Peter F. Voehringer, CPA
Since small businesses are generally regarded as the backbone of the United States' economy, it should not be surprising that the timely payment of their taxes is important to the U.S. government. As many IRS representatives will concur, the quickest way for these businesses to be shut down is failing to remit payroll taxes. As such, the typical small business (as well as its employees) should be concerned with three types of employment taxes: Social Security taxes, unemployment taxes and wage withholding taxes. In addition to self-employment taxes and estimated tax payments, self-employed individuals should be concerned with these three types of taxes if they also qualify as employers. This article details the responsibilities of the employer and the employee in reporting and paying the wage withholding taxes.
Prior to World War II, individuals paid their federal income tax entirely in the subsequent year. Since the tax applied only to upper level wage earners, it was not burdensome on most taxpayers. As the war progressed, the federal government's need for additional revenue grew substantially.
Thus, increasing numbers of persons became subject to the tax which resulted in the federal government expanding the tax base to include individuals with relatively small incomes. Still in need of improved cash flow, the federal government approved a solution in 1943, which marked the beginning of the present income tax withholding system.
Under the original system, employers were required to withhold and remit to the government 20 percent of each employee's wages, net of certain deductions. Since this rate approximated the lowest income tax rate at this time, most low and middle income taxpayers owed little, if anything, when they filed their annual returns.
Withholding on wages remained at a rate approximating the lowest marginal rates until the introduction of graduated withholding under the Tax Adjustment Act of 1966. Graduated withholding rates were an important extension of the "current payment" principle. By approximating the graduated income tax rates, the government simplified the tax payment problem for most wage earners and accelerated the flow of collections to the U.S. Treasury.
The graduated withholding system introduced in 1966 is essentially the same system in effect today.
Responsibility of Employer
In general, every employer must deduct and withhold income tax on the amount of wages that are actually or constructively paid to any employee. Regardless of the timing of payments for employee's services, the frequency of the payments or the amounts paid to the employee, the income tax applies. Any individual, corporation, partnership, trust, estate, joint-stock company, association, syndicate or other unincorporated organization, group or entity that pays remuneration for services is subject to the withholding rules. While many people believe the withholding requirements only apply to individuals engaged in a trade or business, the requirements also apply to organizations that are exempt from tax, such as religious, charitable and educational organizations.
The Internal Revenue Code places the responsibility for withholding and remitting the correct amounts on the employer. While the code allows some penalty-free corrections for inadvertent mistakes which are timely resolved, the employer can be subject to penalties and interest for failure to deduct, withhold and timely remit income taxes from employees.
On or before the employee's employment commencement date, an employee must furnish the employer with a signed Form W-4 Withholding Exemption Certificate, indicating the number of withholding exemptions that he or she intends to claim. If the employee fails to submit a certificate or submits an invalid certificate, the number of withholding exemptions is considered to be zero. Properly submitted withholding certificates remain in effect until a subsequent certificate is filed.
The computation of the amount of tax that is withheld from the wages of each employee is determined based on the employee's payroll period. Withholding taxes are normally computed based on the daily, weekly, biweekly, semimonthly, monthly, quarterly, semiannual or annual payroll period which the employer uses.
The amount of tax that is withheld from an employee's wages is determined in part by the number of withholding exemptions and allowances claimed by the employee. Withholding exemptions generally correspond to the exemptions that an employee is entitled to claim in computing his or her annual income tax.
Payroll taxes, such as Federal Insurance Contributions Act (commonly known as FICA, **which includes medicare and social security**) taxes and withheld income taxes, are reported together by employers on the same form. Generally, employers who withhold income and social security taxes file Form 941, Employer's Quarterly Federal Tax Return.
Exceptions to this rule include:
- Employers with $1,000 or less liability for withheld income tax, social security and Medicare tax per year file Form 944, Employers Annual Employment Tax Return;
- Individuals who employ domestic workers and domestic farm-workers to perform services must file Schedule H with their individual tax return;
- Employers of agricultural workers must report withheld taxes on Form 943, Employer's Tax Return for Agricultural Workers; and
- Nonpayroll taxes are reported on Form 945, Annual Return of Withheld
Federal Income Tax (includes taxes withheld on gambling winnings, retirement pay for service in the Armed Forces, pensions, annuities and IRAs).
Employers must keep accurate records of employment taxes for a minimum of four years after the later of the due date of the return or the date the tax is paid. Although the employer is not required to adopt any particular method of accounting or form of recordkeeping system, it must adopt a method or system that will enable the Internal Revenue Service to ascertain the amount of the employer's tax liability, if any. If the employer is exempt from any employment tax, the employer must maintain adequate records to establish its exemption. The records must include the following information:
- Each employee's name, address and Social Security number;
- The total amount and date of each wage payment and the period of time the payment cover;
- The amount of each wage payment subject to withholding;
- The amount of the withheld tax and the date it was collected;
- The reason why the total wage payment is less than the taxable amount, if applicable;
- Copies of statements furnished by employees relating to nonresident alien status, residence in Puerto Rico or the Virgin Islands or residence or physical presence in a foreign country;
- The fair market value and date of any noncash compensation paid to a retail commission salesperson if no income tax was withheld;
- Information concerning direct payments by an employer under an accident and health plan;
- Withholding exemption certificates (Form W-4) by each employee;
- Any voluntary withholding agreement;
- The dates and amount of payment in each calendar quarter that an employee performed services which were not in the course of the employer's business;
- Copies of any statements furnished by employees reporting tips; and
- Copies of requests by employees to have withholding computed on the employee's cumulative wages.
The Internal Revenue Code imposes civil penalties for various types of noncompliance with the rules relating to the reporting and payment of employment and withholding taxes. Criminal penalties may be imposed for the failure to pay any tax or file a return depending on the "willfulness" or intentional violation of the party committing the act.
In the case of a business that has not remitted its payroll taxes, the IRS can extend these penalties to certain individuals (e.g., a "responsible" person, such as a corporate officer). The code defines a responsible person as one who is "required to collect, truthfully account for and pay over" the withheld taxes to the government. Factors to determine responsibility include day-to-day management, stock ownership, authority to sign checks and holder of corporate office. Since no one factor is controlling, the surrounding facts and circumstances must be examined in determining responsible status.
Although a person may be responsible to collect, account for or pay over the required taxes, the person may still escape liability under Section 6672 of the code. The penalty only applies if the failure for collecting, accounting for or paying over the taxes is willful. The term "willfully" means that the act of failing to collect, account for and pay over the taxes was voluntary, consciously and intentionally done, as opposed to an accidental failure. The willfulness requirement is satisfied merely by showing that the responsible person made the deliberate choice to pay the withheld taxes to other creditors instead of paying the government.
With the relatively new Taxpayer Bill of Rights 2, each person who paid the penalty is entitled to recover from other persons who are liable for the penalty an amount equal to the excess of the amount of paid by such person over such person's proportionate share of the penalty. Such a proceeding is a federal cause of action and must be entirely separate from any proceeding involving the IRS's collection from any responsible party.
** Employers should also be aware that IRS will impose penalties if wages are deemed upon audit that the employer didn't report as wages. This is often the case when the employer believes he is paying contract labor, and it frequently is impossible to recover this tax from former employees, while the penalties are nonrecoverable.
As each individual must pay the federal income tax on earned or received income during the year, the employee should try not to have too much or too little income tax withheld. If too little tax is withheld, the employee will owe tax at the end of the year and possibly owe interest and penalty.
If too much tax is withheld, the employee provides an interest free loan to the government until a refund is received.
Check and Correct Withholding
It is a good idea to check and see if enough, but not too much, tax is withheld for the current year. There is a good chance too little tax is being withheld if:
- the employee has more than one job at a time,
- the employee's spouse also works or
- the employee has income not subject to withholding.
There is a good chance an employee is having too much tax withheld if:
- the employee got a big refund for the previous year and the income, adjustments, deductions and credits will remain the same this year,
- the employee got a big refund last year, the income, adjustments and deductions will remain about the same as last year, but he or she qualifies for one or more tax credits this year or
- the employee's income will remain about the same as last year, but the adjustments, deductions or credits will increase significantly.
The earlier in the year an employee checks his or her withholding, the more likely the correct amount of tax will be withheld.
If the employee determine that too much or too little tax is being withheld, the employer should be given an updated Form W-4 showing a change in filing status, in the number of withholding allowances or an additional amount to be withheld.
With any tax legislation changing tax rates, amount of credits available and many line items on the individual's tax return, a review of the estimated liability should be done before the end of the current year to see if current withholding is too high or low. In order to properly estimate an accurate withholding in conjunction with one of the various tax credits, one needs to obtain IRS Publication 919 and complete one of the appropriate worksheets contained therein.
Although taxpayers often feel that government agencies are unresponsive to the taxpayers' needs, the Internal Revenue Service has improved its customer service centers. To order free publications and forms, call 1-800/TAX-FORM.
By accessing the IRS's Web site at www.irs.gov, one can download forms, instructions and publications; see answers to frequently asked questions; and search publications on-line by topic or keyword. The IRS also provides an information help line by calling 1-800/829-1040.
Many taxpayers overlook the importance of a properly completed Form W-4 and are shocked when additional taxes are due with their personal tax returns or believe that they must have made a mistake in the tax return preparation if they are getting a large refund. Due to the ever changing tax laws and changes in the personal or financial situations of the taxpayers, taxpayers should check their withholding at least annually to prevent owing too much tax at the end of the year or losing the use of that money until you get your refund. A good time to check your withholding is right after preparing your tax return for the previous year since you will have a better guide to whether your withholding is too little, too much or about right.
About the Author
Peter F. Voehringer, CPA, is an accountant with DelBrocco & Associates in Memphis , Tenn.
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