In a previous post, we talked about the difference between independent contractors and employees. One of the biggest differences, and one that often drives intentional worker misclassification, is that employers must withhold and pay payroll taxes for employees whereas they do not for independent contractors.
Such employers see this as a cost-saving for their businesses because they not only do not have to pay taxes, they do not have to pay for someone to administer employee taxes. Since trying not to pay taxes is the national past-time for most of us, this is one way that can get you into trouble.
Federal Payroll Tax Administration
There is both the federal payroll tax and the state payroll tax.
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, otherwise known as 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.
State Payroll Tax Administration
The Employee Development Department 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
State payroll taxes include withholding for personal income tax and support unemployment insurance, an employment training tax, and state disability insurance.
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.
California has some 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 included 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.
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 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 that have a work-for-hire provision in their contract
The IRS has something known as the Trust Fund Recovery Penalty or TFRP (previously called the 100% rule). It limits IRS penalties to what was withheld from an employee's wages, and it cannot hold an individual responsible for employer matching funds. The IRS also may not hold the responsible person personally liable for corporate level delinquencies, penalties, and interest.
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% 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 do recognize a difference between miscalculation and tax evasion. If you simply miscalculated, it is considered to be unwillful, 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.
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. If you have willfully disregarded tax law, you can be charged as a criminal.
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.