How do you Manage Payroll Taxes? Pay it. That’s true, but there are some basic concepts of paying payroll tax you should know, and sound tax strategy/planning that improve your bottom line and keep compliance in the same time. As the old saying goes, the three most important success factors of investing in real estate are location, location, and location. When operating a business, the three most important rules for managing tax issues are pay your payroll taxes; pay your payroll taxes; and pay your payroll taxes. Although relatively simple to manage and understand in relation to the complexities associated with income taxes, the risks of not properly managing payroll taxes (to the business and its principal owners) can be far greater. Adopting the wrong payroll tax strategy could impose you into a payroll tax abuse.
This post provides basic understanding on how to manage payroll tax [and some tips, sure]. Through this I also demonstrate how payroll tax can be abused so that you won’t do it. Follow on…
Payroll Tax Basic
Payroll taxes represent withholdings of employee earnings that must be remitted to various federal, state, and local governmental agencies on a periodic basis. In almost all cases, wages paid to employees are subject to payroll taxes based on established guidelines, tables, and formulas as determined by various governmental agencies. Unlike income taxes, which are only due and payable if the business has generated taxable profits, payroll taxes are due when wages (including salaries, hourly compensation, bonuses, commissions, spiffs [special performance incentives], and other forms of compensation reported as W-2 earnings per the IRS) are paid to an employee. And once again, the various taxing authorities at the federal, state, and local levels all seem to have their hand in the pot.
The federal government imposes four primary payroll taxes: (1) Social Security; (2) Medicare; (3) individual income; and (4) unemployment (a form of insurance). To make it easier to understand [and remember], let me break them down into a two groups:
- The first three of these taxes are paid by the individual and are withheld from each employee’s wages. Social Security and Medicare taxes tend to be the most burdensome; not only are these taxes withheld from the employee’s wages, but the employer must match, dollar for dollar, the amount withheld and periodically remit the payroll taxes to the IRS.
- The fourth, federal unemployment tax isn’t a burden on the individual, but rather the employer. Thus, no tax is withheld from the employee’s wages for this particular tax.
At the state level, two types of payroll taxes are generally present: personal income and unemployment. Personal income taxes are withheld from the employee’s wages. Similar to the federal unemployment insurance, the state unemployment tax represents just the obligation of the employer. Other forms of mandatory withholdings are also present at the state level, including local taxes, disability insurance, and others. However, these taxes vary significantly on a state-by-state basis.
5 Key Issues Related to Each Payroll Tax Types
When reviewing payroll taxes calculations, you should notice the following key issues related to each payroll tax type:
. Social Security taxes (used to fund the United States national retirement and social security program) are applied at a certain rate on certain level of wages earned. The IRS raises this figure annually to account for inflation and other factors. A business is responsible for not just withholding the Social Security taxes amount from the employee’s wages, but it also must match the amount and remit the total to the IRS. This matching requirement represents an expense to the company.
. Medicare taxes (used to fund the United States national healthcare system for qualified parties) are applied at a certain rate of all employee earnings. Similar to Social Security, the business must match the amount withheld and remit it to the IRS on a periodic basis. However, unlike the Social Security component, the Medicare tax component has no limit or cap as it’s applied to all wages earned, including commissions, bonuses, salaries, hourly wages, and the like. This matching requirement also represents an expense to the company.
. Federal personal income taxes are withheld just from the employee’s wages as the company isn’t required to match it. The federal government collects these taxes based on what it estimates the individual will owe in federal personal income taxes at the end of the year. The federal government provides tables to assist employers for calculating how much federal personal income tax should be withheld, depending on the employee’s individual tax reporting status, which considers marital status, number of children/exemptions, and other personal factors. The IRS provides the W-4 form (completed by all employees at the time of initial employment) to assist with determining what the proper personal income tax withholdings should be.
. Federal unemployment taxes (used to support the unemployment insurance payment programs administered by the states to provide supplemental income to unemployed workers) represent an expense of the company as no withholdings are present from the employee’s wages. Unemployment taxes tend to be paid during the first two quarters of each year as once the employee exceeds the base wage level, no further tax is due. However, it is extremely important to note that the wage base level applies on a company identification basis and not to the employee. Hence, if you hire an employee in midyear at which time they’ve already earned in excess of $7,000 (with their previous employer), the unemployment tax will be due again as the new company hasn’t paid any wages to the employee.
. At the state level, generally only personal income tax and unemployment taxes are present. Similar to federal personal income taxes, a state collects these taxes based on what it estimates the individual will owe in personal income taxes at the end of the year. Tables are established by the state and provided to employers so that the appropriate amount of taxes can be withheld from the employee’s wages and remitted to the state periodically. State unemployment taxes operate in much the same fashion as federal unemployment taxes as a rate is established and applied to a base amount of wages earned by each individual. The company absorbs the expense because no withholdings are made from the employee’s wages. The main difference between federal and state unemployment taxes is based in the rates used and the wages subject to the rate.
How Payroll Tax Can Be Deflated [Abused]
Pass-through tax entities often use a rather unique and aggressive tax strategy in relation to the compensation paid to the owners of the corporation. For example: say that the architectural firm of Lie, Dharma, and Putra is formed as an LLC and has four equal owners/members who each own 25 percent of the company. Each owner is provided a base salary of $75,000 per year, which is treated as regular W-2 type earnings. At the end of the year, the company shows a profit of $1,000,000 before compensating the owners.
Below figure shows the total net tax effect of each owner given this criteria compared to if each owner was paid $200,000 per year (which would consume most of the profits):
Note: This calculation example still uses 2007’s rate [just to show how payroll tax can be deflated], you can update them yoursef to reflect current tax rate.
The reason total tax savings are present is based in the treatment of earnings of the company. In the low wage scenario, the emphasis is placed on maximizing company earnings and minimizing wages earned. This strategy allows for the company to reduce the total amount of payroll taxes realized as a result of Social Security and Medicare. Lower W-2 earnings results in lower “Social Security” and “Medicare” taxes [at both the employee and employer level]. And because income tax rates applied to either W-2 wages or the distribution of company profits are the same (as both types of earnings will flow through to the individual’s personal tax return), the total income tax due is approximately the same.
Caution!: Before you attempt to go out and implement this strategy, you need to know that the IRS has begun to focus on this area as a tax strategy that is being abused. Companies that artificially deflate W-2 wages to avoid paying Social Security and Medicare taxes can open themselves up to IRS audits, which may bring penalties and interest charges.
The key to using this strategy is that the W-2 wages paid to the owners of the company must be reasonable given the industry the company operates within, its geographical location, historical operating performance levels, and so on. If an attorney is paying himself $45,000, living in San Francisco, when his company is making $1 million a year, and attorneys performing similar services make $250,000 annually, a problem is present.
Again, proper planning represents the basis of managing owner compensation levels. If you remember just one thing about payroll taxes, remember this point:
Payroll taxes are held in trust for the employee by the withholding party (in other words, the business). As such, if the payroll taxes aren’t paid, taxing authorities will not only pursue the business in their attempt to secure funds for payment, but they’ll also pierce whatever legal business form is present to collect the taxes (including a corporation). Hence, the officers, board members, check signers, senior managers, and/or any other party aware of the deficiency or who was responsible for remittance of the payroll taxes can be pursued individually to collect the outstanding obligation.
Tax collection tactics include attaching to personal assets, such as homes, retirement accounts, college funds, savings, and/or just about any other type of personal asset. Needless to say, businesses don’t want to find themselves in trouble for unpaid payroll taxes.
Beyond Paying Payroll Tax Concept
Beyond the all-important concept of paying your payroll taxes, keep in mind the following:
- A number of external payroll services are available to assist in managing payroll tax issues. These organizations are cheap and reliable, provide quality services, and are one of the best outsourcing values a business can invest in. The list of services provided by these organizations goes well beyond just managing payroll taxes because they may also process the payroll checks or direct deposits, prepare management reports, support various human resource functions, and so on. For smaller businesses, these organizations offer a highly reliable and inexpensive solution with supporting the payroll processing function.
- Payroll taxes are remitted to the various taxing authorities on a periodic basis depending upon the dollar amount of the payroll tax obligation. The larger the periodic amount, the more frequent the business will be required to remit payroll taxes (including being required to transfer funds electronically).
- Payroll tax compliance reporting is essential and is usually completed on both a quarterly and annual basis (at both the federal and state levels). These reports reconcile the amount of payroll taxes withheld and owed against the amount paid to ensure employers are remitting their obligations in a timely manner.
- For every dollar of payroll and payroll taxes paid, from 25 to more than 40 percent, is remitted to various governmental agencies. This point is extremely important to understand as the nation continues to evolve into more of an employee-based service orientated economy from a production/manufacturing basis.
Effective management of payroll taxation issues can improve bottom-line performance.