Payroll taxes, whether under the IRS or the State of California, are treated differently by the different agencies because of a variety of different factors. If you have employees, payroll taxes are a fact of life. Some taxes are withheld from your employee’s wages, some you must pay yourself.
Before diving into the topic of California payroll tax audits though, we briefly wanted to discuss how things are handled differently at the federal and state level. After all, for the purposes of understanding how California payroll tax audits work, it is important for us to define exactly what being in compliance means. In a nutshell, remaining in compliance means understanding how and when payroll taxes are calculated, filed, and paid.
In this first chapter, we are going to address the federal model, which the Internal Revenue Service (IRS) administers payroll taxes as part of its responsibilities. Later, we will contrast the California payroll tax system before moving on to our main topic of California payroll tax audits.
Brief Overview of IRS Payroll Tax System
The IRS administers the Internal Revenue Code, which means it is in charge of income and payroll taxes for the entire nation. Included in the payroll tax are payments for the federal unemployment tax, also known as FUTA.
The IRS also performs audits of tax returns for fraudulent activity, underpayment and other issues. The agency has the capability to levy fines, interest on unpaid taxes and liens on a property. It can also charge civil and criminal charges depending on the severity of the offense and whether or not it was considered to be willful or negligent (unintended).
IRS Payroll Tax vs. California Tax Agencies
The primary difference between the IRS and the tax agencies of the State of California is that the IRS is a single agency that administers federal taxes including federal income tax, Social Security and Medicare. It also collects federal unemployment taxes.
Federal unemployment tax helps fund state workforce agencies including the Employment Development Department (EDD). It also pays those who have become unemployed as a supplement to state assistance.
Taxes for the State of California are administered by three separate agencies. The Franchise Tax Board (FTB) administers the state’s personal income tax and corporate taxes.
The California Department of Tax and Fee Administration administers sales and use tax, property tax, and special taxes.
The Employee Development Department (EDD) is in charge of payroll taxes at the state level.
The EDD collects state unemployment insurance tax and an employee training tax from the employer as well as collecting disability insurance and state personal income tax from the employee. The disability insurance tax pays for Paid Family Leave.
The state unemployment insurance tax provides temporary assistance to people who are unemployed through no fault of their own. The employee training tax was enacted to help the California labor market grow. It provides training to workers in specific targeted industries.
State disability insurance tax provides assistance to employees who are temporarily unable to work because of a non-work-related disability (work-related disabilities are covered by workers’ compensation). It also provides for paid family leave for employees who must remain at home to care for a seriously ill family member or a new child.
IRS Payroll Taxes
As mentioned before, federal payroll taxes are applied to Social Security, Medicare (FICA) and federal unemployment tax (FUTA). These are paid by the employer through wages withheld (FICA) and through a tax on the employer (FUTA).
The employer provides Form W-4 to the employee to use in determining withholding amounts and a Form W-2 by the end of each January showing withholding for the previous tax year.
Independent contractors can be provided a Form 1099 since there is no withholding from the pay given to independent contractors and independent businesses. An independent contractor, by definition, is responsible for their own federal payroll tax withholdings (or alternatively self-employment taxes).
Taxes are calculated as a percentage of the employee’s income, which tells the employer how much to withhold from wages and how much to pay into the system. Deposit and return filing deadlines depend on the type of tax.
Tax return filings and deposits are not necessarily done together.
IRS Payroll Tax Returns
FICA requires returns to be filed quarterly using Form 941. The deadline is the last day of the first month after the quarter ends. FUTA, on the other hand, is filed with Form 940 as an annual return with a deadline of January 31 for the prior calendar year.
If you have deposited the funds on time during the year, you are automatically granted a 10-day extension which may be lengthened through a written request.
IRS Payroll Tax Payments/Deposits
FICA deposit timing depends on the size of the employer. Only very small employers that have an estimated annual employment tax liability of $1,000 or less for an entire calendar year can pay annually using Form 944. Agricultural and household employers have different rules as well.
FICA can be paid quarterly as long as employment tax for the current or preceding quarter is less than $2,500. The tax can be deposited along with filing the employer’s Form 941 return. Monthly deposits are allowed if $50,000 or less in tax is owed. Anything more than that and the employer must pay semi-weekly.
Monthly deposits on wages paid out for a calendar month must be paid by the 15th of the next month.
Semi-weekly deposits for wages paid on Wednesday, Thursday and Friday must be made by the following Wednesday. Deposits for wages paid on Saturday, Sunday, Monday, and Tuesday are due the following Friday.
FUTA deposits are made quarterly unless the tax liability is $500 or less. Then it can be rolled into the next quarter. For anything over $500, FUTA must be paid by the last day of the month following the end of each quarter.
For example, for the quarter ending March 31, the FUTA deposit is due no later than April 30.
All payments are required to be made electronically unless the employer has a small business exception. Payment may be made through the Treasury Department’s Electronic Federal Tax Payment System.
You can also pay through a financial institution using an ACH credit payment or through a trusted third party such as an accountant or a payroll service.
IRS Payroll Tax Penalties
Late payments are subject to penalties and interest on the unpaid amount. Incorrect payments can be punishable if they are due to evasion and fraud, such as falsified returns or misclassification of employees. Willful tax evasion can get you sent to prison and you may have liens placed on your property.
If the cause is simply due to miscalculation or error, it is not considered to be done willfully, and a penalty plus interest will be levied.
The penalties for late or non-payment of federal taxes often differs from the state. For example, the IRS uses the Trust Fund Recovery Penalty (formerly known as the 100 Percent Rule). This penalty holds responsible parties personally responsible for employment taxes. However, it is limited to the money withheld from the employee’s wages. It cannot hold the employer personally liable for the employer matching funds or for corporate level tax issues.
For example, let’s say a business owed $50,000 in federal payroll taxes. Liability to corporate officers or other responsible parties would only extend to half the liability, or $25,000. This was the amount that was held for the employee’s portion of their payroll tax liability. The reason the term “trust fund recovery” is used is because these are the amounts that are held “in trust” on behalf of the employee.
California, on the other hand, has a more severe version of the 100 Percent Rule that allows the state to hold any officer, major stockholder, or other person with the responsibility for EDD payroll tax compliance liable for 100 percent of the entire tax burden owed by the corporation or limited liability company, if the failure to comply can be considered willful.
Federal Payroll Tax Administration
In conclusion, federal payroll taxes are used to fund Social Security, Medicare and federal unemployment. These taxes are paid by the employer through withholding from the employee’s wages and by the employer itself. The tax is calculated as a percentage of the employee’s income.
Social Security and Medicare (FICA) is paid quarterly. FUTA, the federal unemployment tax act, requires an annual return. Employers are required to provide an IRS Form W-2 detailing the wage withholdings. Periodically, employers must file returns and pay the tax throughout the year depending on the size of the employer.
Very small employers, defined as those with an estimated tax liability of $1,000 or less for a calendar year can file annually. For employers with taxes of $2,500 or less per quarter must file quarterly. Employers with taxes over $2,500 per quarter must file monthly or semi-weekly, which is most employers.
California Payroll Tax Administration
The true cost of employees goes far beyond wages. Every new hire comes with tax obligations and having a strong grasp on payroll taxes is something fundamental to your peace of mind as a business owner and employer.
Whether you are a household employer or taking care of a huge team, you need to understand how to compute taxable income, what to withhold, what to contribute and how to file.
Payroll taxes occur on both a federal and a state level, but we will be taking a look at the specific issues around California payroll taxes.
The Employee Development Department (EDD) administers the state payroll tax for California. It is one of the largest departments within the state government. The EDD has a number of responsibilities including:
- Filing quarterly taxes
- Tax audit program
- Collection division
- Audits and investigations
- Information exchange
California payroll taxes include withholding for personal income tax and support unemployment insurance, an employment training tax, and state disability insurance.
California state disability and personal income tax are withheld from wages while the employer is required to pay into the system for unemployment insurance and the employment training tax.
How California Payroll Taxes Are Calculated
California payroll taxes are calculated as a percentage of an employee’s income. Some taxes are deducted from the employee’s paycheck and some are paid by you, the employer, based on the employee’s wages. An employer usually becomes subject to payroll taxes after they have paid more than $100 to one or more employees in a calendar quarter.
This holds true whether you run a business, a nonprofit organization, or have just hired a housekeeper or nanny for your home.
The first thing to know is that every California employer is required by law to report information about new employees to the California New Employee Registry within 20 days of their first day of work.
You may do this in one of four ways:
- Submitting a Report of New Employee(s) (DE 34) electronically with the California Employment Development Department (EDD)’s e-Services for Business page
- Submitting a paper DE 34. You can download a fill-in DE 34 here
- Submit a copy of the employee’s W-4 form, but you also need to add the employee’s start-of-work date, your California employer account number and Federal employer identification number (FEIN) to the W-4
- You may also create your own form with the above information and mail it to the EDD
The Four Types of California State Payroll Taxes
Most wages are automatically subject to all four taxes, but there are certain fields of employment where payroll tax liability is limited or not applicable.
For a full list of types of employment and whether or not they are subject to payroll taxes/and or withholding, you can consult this list from the California Employment Development Department (EDD).
Payroll taxes are a complex subject, in part because there are four separate taxes which must be calculated. The first two, Unemployment Insurance (UI) Tax and Employment Training Tax (ETT) are paid by the employer.
The other two, State Disability Insurance (SDI) Tax and California Personal Income Tax (PIT) are paid by the employee, but you are responsible for withholding these taxes on behalf of the state. Each of these taxes is calculated at a different rate:
Unemployment Insurance (UI) Tax
Unemployment insurance is in place to provide temporary support to people who are unemployed through no fault of their own.
- As the employer, you are responsible for paying this tax based on a percentage of the first $7000 in wages that you pay each employee over the course of a calendar year.
- Exactly how much you pay will depend on how long you have been an employer. For the first two to three years, you will pay 3.4 percent (.034) but this rate is subject to change, and will increase over time.
- The highest UI tax rate is currently 6.3 percent (0.62), which works out as a maximum tax of $434 per employee annually.
Employment Training Tax (ETT)
The Employment Training Tax was put into place to help the California labor market grow. The funds raised by the ETT are used to provide training to workers in certain targeted industries.
- In your first year as an employer, you will automatically be subject to ETT.
- After that first year, most employers will continue to pay the ETT, if they have a positive UI reserve account balance
- The ETT rate is one-tenth of 0.1 percent (.001) on the first $7,000 of taxable wages you pay each employee. This means that the maximum tax is $7 per employee each year.
State Disability Insurance (SDI) Tax
The state disability tax program offers support payments to employees who are temporarily unable to work because of a non-work-related disability. The SDI tax also funds Paid Family Leave (PFL) benefits.
The PFL program extends benefits to employees who cannot work because they are needed at home to take care of a family member who is seriously ill, or to bond with a new child.
- SDI is deducted from your employees’ wages.
- You are responsible for withholding a percentage of the first $106,742 in wages that you pay each employee over the course of a calendar year.
- In 2016, the SDI tax rate is 0.9 percent (.009) of SDI taxable wages per employee, per year, which means that the maximum tax is $960.68 per employee.
- SDI rates may change annually: they are set by the California State Legislature each year.
California Personal Income Tax (PIT)
Personal income tax is levied on the income of California residents as well as non-residents who are earning income in California. The funds raised by income tax paid for local amenities such as schools, public roads and parks, as well as health and human services. These taxes are administered by the EDD, which is also responsible for reporting, collections, and enforcement.
- PIT is deducted from your employees’ wages.
- The rate is based on the Employee’s Withholding Allowance Certificate (Form W-4 or DE 4) your employee filled out at the beginning of the year.
- There is no maximum amount of tax in this category.
Doing the California Payroll Tax Calculations
With four different taxes to track, calculating your payroll tax liability and withholding rates can seem overwhelming, especially to new employers. If you break the task down into distinct steps, you may have an easier time navigating the system:
Determine Taxable Wages
This is the first and most important step, because you will base all other calculations from this number. The EDD has a very helpful table with examples of how you would calculate the taxable wage for each employee
Calculate UI and ETT
Since these are the taxes that you will be paying as the employer, determine your liability according to your rates. Current UI rates can be found on the EDD website: you will need to log in to see your specific rate.
Withhold the current SDI rate, as determined by the California State Legislature: 0.9 percent in 2016.
California offers two methods for withholding schedules:
- Method A – Wage Bracket Table Method (PDF) – with Instructions
- Method B – Exact Calculation Method (PDF) – with Instructions
How to Get More Information About These California State Payroll Tax Calculation
If you are still worried about getting it right, do not worry. There is more support available. California offers in-person payroll tax seminars to walk you through the process, and you can find a current schedule here.
If you want more specialized assistance, or if you are dealing with an especially complex payroll tax issue, it may be worth your time to consult with a tax professional or an attorney trained in tax law. Their familiarity with all the rules and regulations means that they know the ins and outs of payroll taxes for businesses of all sizes.
A one-on-one consultation gives them the chance to offer you personal guidance and total peace of mind that you are meeting all the payroll tax requirements for the state of California.
Other Issues Concerning California State Payroll Taxes
California has some other tricky rules for state payroll taxes:
- If you have family members working for you, they are subject to state personal income tax withholding, but they are not subject to unemployment insurance, employment training taxes or state disability insurance payments.
- Family members include children under the age of 18 employed by a parent, or partnership consisting only of parents and include adopted children but not stepchildren or foster children.
- Family members also include persons employed by a spouse or a registered domestic partner or a parent employed by a son or daughter, again including adoptive parents but not stepparents or foster parents.
- Most nonprofit organizations are subject to unemployment insurance, employment training tax, state disability insurance and personal income tax withholding.
- Special exclusions from unemployment insurance and state disability insurance payments include elected officials, members of legislative bodies or the judiciary, and members of the state National Guard or Air National Guard except those who provide services as regular state employees.
California Payroll Tax Pitfalls and Penalties
The greatest pitfall in dealing with federal and state income taxes can be attempting to handle them yourself as a business owner. The larger your business, the more complicated payroll taxes become.
If you only have a couple of employees or are experienced with the California payroll tax provisions, you may be able to take care of it yourself or pay an accountant, but at a certain point, you may require the services of a tax attorney to advise you about the details of tax law or to help you resolve penalties.
Sometimes employers are not aware of those defined as statutory employees. These are individuals who may not be employees as defined by common law but who should be classified as employees for employment tax purposes.
- Any officer of a corporation
- Agent-drivers or commission-drivers
- Traveling or city salespersons
- Unlicensed construction workers engaged to perform services for which a license is required
- Workers who have a work-for-hire provision in their contract
As mentioned in previous chapters, the IRS has something known as the Trust Fund Recovery Penalty or TFRP (previously called the 100 Percent Rule). This extends liability for payroll taxes to corporate officers and owners of the company. However, this is limited to what was withheld from an employee’s wages, and it cannot hold an individual responsible for employer matching funds.
The California Employment Development Department has similar rules and powers but the penalties tend to be more severe in proportion. The EDD rules state that any officer, major stockholder, or other person with the responsibility for EDD payroll tax compliance who willfully fails to comply with EDD withholding laws is personally responsible for 100 percent of every red cent owed by the corporation or LLC.
If that person is you, you will be required to pay interest on the late payment as well as penalties.
The EDD and IRS equally do recognize a difference between miscalculation and tax evasion. If you simply miscalculated, it is considered to be non-willful, and you will still be responsible for penalties and interest plus you will need to file corrected tax returns.
Evasion, on the other hand, is punishable by criminal charges. Evasion can take the form of willfully misclassifying employees as independent contractors, falsifying returns, and paying workers in cash.
California Payroll Tax Penalty Resolution
Penalty resolution involves paying the full amount of payroll taxes owed plus the penalties levied by the taxing organizations. If you have been charged with evasion, of course, you will also be facing potential jail time.
You are within your rights to dispute taxes and penalties, which is where an experienced tax attorney comes in handy. However, you must understand that, while you can appeal, you will be expected to pay taxes on time until the appeal is resolved.
Both the IRS and the EDD are amenable to setting up installment payments to keep the total amount due at one time to a manageable level. You can also request an Offer in Compromise or a Hardship letter.
Payroll taxes, both federal and state, can be difficult to understand, but unwillful errors can still be costly. If you misclassify an employee or do not handle withholding properly for family members who work for you, or if you run a non-profit organization and do not handle taxes properly, you will be responsible for not only back taxes but interest and penalties, too.
An experienced tax attorney can help you avoid the pitfalls of tax law and provide valuable assistance for disputes, appeals, and other methods of resolving tax problems.