So, you want to learn
by Bean Counter's Dave Marshall

Lesson 4
Payroll Taxes and Withholdings

Introduction Lesson 1 Lesson 2 Lesson 3 Lesson 4 Lesson 5 Lesson 6 Lesson 7 Lesson 8
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IRS Payroll Tax and Withholdings Deposit Rules

As most of you are probably already aware, the IRS requires employers to deduct social security and medicare from their employee's wages and to match what is deducted from their employee's pay for social security and medicare. Social security is deducted from an employee's earnings at the current rate (2005) of 6.2 % and medicare is deducted at the current rate (2005) of 1.45% or a combined rate of 7.65 %. The employer is also required to pay (match) 6.2% and 1.45% of an employee's earnings.

In our Lesson 3 examples, we deducted these amounts when calculating our employee's pay. Taking the deductions is only half the battle. The other half of the battle is monitoring, filing the proper forms, and depositing these deductions.

The IRS requires an employer to pay or deposit these taxes "as you go". Since these taxes are deducted from an employee's earnings (reduce the amount directly paid to the employee) the employee has incurred an unpaid liability to the IRS on behalf of his employees. Additionally the employer has also incurred a liability to the IRS for his employer's share. These amounts can build up fast and become substantial liabilities if not paid at regular intervals. Unfortunately, many businesses have had to shut their doors because they didn't timely deposit these taxes and tried to operate using these funds to pay their other bills.

Note:This is very expensive financing because the IRS charges penalties and interest for not depositing or depositing these taxes late. In addition, owners and employees may be held personally liable for the business not making these required deposits.

If your business is having a tough time making these deposits this situation should be considered a red flag and decisions and corrective actions are probably necessary in order prevent your business from having to shut its doors.

IRS Publication 15 provides detailed instructions and guidance on payroll taxes and tax deposit requirements. I've tried to simplify and summarize some of the main rules and requirements in order to give you the "basics in a nutshell". As I stated in an earlier lesson, I do recommend you download or obtain a copy of IRS Publication 15 and use it as a reference for determining the proper handling of payroll taxes and withholdings.

Normally, a business must periodically deposit income tax, social security and medicare withheld from employee's wages along with the employer's matching contribution for social security and medicare (reduced by any advance Earned Income Credit (EIC) payments) in an authorized financial institution or use the Electronic Federal Tax Deposit System.

A payroll tax deposit is comprised of the federal income taxes withheld from your employee’s wages and both the employee and employer portions of social security and medicare taxes.

In cases where the amount of taxes owed for a quarter are less than $2,500 (reduced by any advance Earned Income Credit (EIC) payments) the amount owed for the entire quarter can be paid in full when the quarterly tax report is due. Businesses subject to the monthly depositing requirements may also make their final payment with the quarterly report instead of depositing the funds.

Businesses that have quite a few employees normally are required to make periodic deposits of payroll taxes and withholdings based on a determination made at the beginning of each new calendar year. The two methods of making deposits are (1) Monthly and (2) Semi-Weekly. The determination involves determining what the liability was for what the IRS refers to as the look back period. If this liability is less than or equal to $50,000 the Monthly Schedule Deposit Rules are used; otherwise, the Semi-Weekly Deposit Rules are used.

New businesses start out using the Monthly Deposit Rules.

What makes up the look back period ? The look back period is made up of four quarters. Two quarters from your prior year and two quarters from 2 years prior to your current year. The quarters are July 1- September 30 and October 1 - Dec 31 from 2 years prior and January 1 - March 31 and April 1 - June 30 of your prior year.

Let's use an example to illustrate what makes up the look back period. We'll assume our current year is 2005. The quarters that make up our look back period are:

Prior Year:
First Two Quarters
January 1 - March 31, 2004
April 1 - June 30, 2004

Two Years Prior
Last Two Quarters
July 1 - September 30, 2003
October 1 - December 31, 2003

2003 2004
July 1

Sept 30

Oct 1

Dec 31

Jan 1

Mar 31

Apr 1

Jun 30

If reported taxes and withholdings during these four quarters are less than or equal to $50,000, for calendar year 2005 the Monthly Deposit Rules apply; otherwise, the Semi-Weekly Deposit Rules are used. Note: Advanced Earned Income Credit Payments are not used as a reduction of taxes for this calculation.

When are these required deposits made ?
If your business qualifies for the Monthly Deposit Rules, the deposit for taxes on wages paid during a month must be made by the 15th of the following month. In other words, taxes on wages paid in January must be deposited by February 15, taxes on wages paid during February by March 15, and so on.

For those that must adhere to the Semi-Weekly Deposit Rules, they basically have 3 banking days at the end of two IRS stated periods to make their deposit.
The two periods are:
(1) Wednesday - Friday
(2) Saturday - Tuesday

(1) Payroll tax obligations resulting from wages paid between Wednesday and Friday need to be deposited by the following Wednesday. Although this calculates to be 5 days, it's actually 3 banking days when Saturday and Sunday are excluded.

(2) Payroll tax obligations resulting from wages paid between Saturday and Tuesday need to be deposited by the following Friday (3 banking days).

Note: Regardless of the method you use for determining when to make deposits, you must make a deposit by the next banking day if your tax and withholding liability reaches $100,000 at any time. If you are currently a Monthly Depositor, you are also required to begin using the Semi-Weekly Deposit Rules.

You use Form 8109 (coupons) to make deposits at authorized financial institutions or the Electronic Funds Transfer Payment System (EFTPS) . Which should your business use ? The IRS is gradually moving in the direction of requiring all businesses to use the EFTPS. Currently, only businesses that have many employees might be required to use the electronic payment system. Basically, if your total payroll deposits were more than $200,000 in the period 2 years prior to your current year or you were required to use the EFTPS system in the prior year, you are required to use the EFTPS system.

Penalties for not abiding by the deposit rules can range from 2% to 15% of your unpaid tax liability. Interest is also charged on the unpaid balance. In addition, the IRS has what is called a Trust Fund Recovery Penalty which may be imposed on any or all persons who are determined by the IRS to be responsible for collecting, accounting for, and paying over these taxes and who acted willfully in not doing so. The amount of this penalty is the amount withheld for income tax, social security, and medicare that has not been paid. The employer's share of social security and medicare is not included.

Forms Used To Report IRS Taxes and Withholdings

As I stated earlier, not only does a business have to pay or deposit these deductions as they go but periodically they must also file forms that summarize and report the information about these deductions. Form 941 is filed each quarter to report and summarize the deductions made from your employee's wages and the deposits made to the IRS for these taxes and withholdings. In 2005, the IRS released the newly designed Form 941. The redesigned form features an improved layout, plain language instructions, simplified deposit reporting and paid preparer identification.

Unemployment Taxes

Most states have payroll taxes that are normally only paid by the employer and are used to accumulate funds for paying employees when they are unemployed. The federal government also collects these taxes and uses the money to administer the unemployment programs. If your business has any employees, you will normally have to pay both state and federal unemployment taxes.

Federal Unemployment

If you have at least one employee for 20 calendar weeks during the current or preceding calendar year, or you pay at least $1,500 in wages during any calendar quarter in the current or preceding year you are required to pay federal unemployment taxes.

Form 940 or 940-EZ are used to report and account for Federal Unemployment Taxes. The report is filed annually and is due by January 31. If all Federal Unemployment taxes have been paid (deposited) when due, you may take some additional time and file on or before March 10.

Which form 940 or 940-EZ should you use ? If you qualify, the 940-EZ is easier to prepare. In order to qualify to file the 940-EZ your business must meet all of the following conditions:

  • Pay state unemployment taxes to only one state.
  • Pay all state taxes that are due by the due date for filing the Federal Unemployment report (940 or 940-EZ).
  • All wages subject to Federal Unemployment Tax are also taxable for State Unemployment Tax.

The taxes are calculated and paid (deposited) quarterly. They should be deposited by the last day of the first month following the end of a quarter. If the calculated amount for any quarter is less than $500, the calculated amount may be carried over to the next quarter. In other words, the tax needs to be paid when the balance is $500 or more.

The federal unemployment tax rate is 6.2 % but this rate is reduced by a maximum of credit of 5.4% for payments made to your state unemployment tax fund. If your business qualifies for the maximum state credit, the rate used to compute your federal unemployment tax is .8 %.

How do I calculate the federal unemployment tax ? Simply determine the wages paid during the quarter that are subject to the tax and multiply by the federal unemployment tax rate of .8 % (in most cases). The federal unemployment tax only applies to the first $7,000 of wages that you pay to each of your employees so in order to determine the wages paid during a quarter that are subject to the tax you need to calculate what is called their exempt wages. Exempt wages are wages paid to any of your employees during a quarter that exceed $7,000.

Not only does a business have to pay or deposit these taxes as they go, but periodically they must also file forms that summarize and report the information about these taxes. Form 940 or 940-EZ is filed annually to report and summarize these taxes and the deposits made to the IRS for these taxes.

Form 940-EZ

Form 940

The following links are provided to allow you to obtain the 941 forms and instructions.

941 Form - PDF

Schedule B - PDF

941 Instructions - PDF

Schedule B Deposit Schedule- Instructions - PDF

State Unemployment Taxes

Normally, state unemployment taxes are imposed directly on employers and the business (employer) does not withhold these taxes from employees' wages. In most of the states, if you're required to pay federal unemployment tax you're also required to pay state unemployment tax. Actually all employers should check with their state to determine what if any special rules apply. The tax is usually reported and calculated quarterly and the state supplies the forms used for reporting and calculating the tax.

Normally, like the Federal Government each state has a maximum wage amount on which the tax is imposed on each employee's wages. Once an employee's wages for the calendar year exceed the maximum amount, you as an employer are not required to pay any more employment tax with respect to that employee. In other words, if the limit per employee for your state is $7,000 , once an employee's earnings exceed this limit you will not have any additional unemployment liability resulting from any additional wages paid to this or any other employee whose earnings are $7,000 or greater.

In order to calculate the tax, the state assigns a rate (experience rating) for the business to use normally based on their experience. In other words, if your business has a lot of layoffs your assigned rate will be higher than if your business has relatively few layoffs. If your starting a new business, an initial rate will be assigned and won't be adjusted until you've contributed to the state's unemployment compensation program for a specified period of time and have established a history where a new rate based on your experience can be assigned. Rates for established businesses are normally adjusted each year.

The state supplied forms are relatively easy once you have the information assembled for making the calculation. For the quarter, you will need the total amount of wages paid to your employees and the amount of what is normally called exempt wages. These are wages paid to each employee during a quarter that exceed the state's maximum limit.

Calculating what you owe is just a matter of multiplying the total wages paid less the exempt wages for a quarter by the businesses' assigned rate.

Most small business owner's don't want to fool with preparing these forms and have their bookkeeper or accountant prepare them for them. You should, however, at least be familiar with your deposit and reporting requirements and make sure that they are performed in a timely manner.

Additional Help & References:

Downloadable PDF Versions
If you followed my recommendation in the Introduction, you have already downloaded some of these references.

IRS Employer's Tax Guide
Publication 15 Circular E - PDF
This publication discusses the Employer's Payroll Requirements.

IRS Publication 505 Tax Withholding and Estimated Tax
Publication 505 - PDF

IRS Publication 583 Starting a Business and Keeping Records
Publication 583 -PDF

Online Versions
Or at the very least review the online versions of the Publications.

IRS Employer's Tax Guide
Publication 15 - Circular E

IRS Publication 505 Withholding and Estimated Tax
Publication 505

In this lesson, I hope you learned at least a little about how to report and deposit the amounts deducted from employee's wages for social security, medicare, and income tax. You did recall that you (company), as an employer, are also required to match the amounts deducted from your employee's wages for social security and medicare didn't you ? In addition, we discussed other payroll related taxes such as federal and state unemployment.

Time flies when your having fun - I know learning about payroll isn't really my idea of fun either ! Believe it or not, we're half way through ! Let's move on and discuss Payroll Records.

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