Chapter 05

Federal (IRS) Payroll Tax

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 article, 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.

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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.

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