What are payroll taxes?

Employers and employees who receive any form of compensation as part of their employment are generally subject to payroll taxes. Payroll taxes were authorized under the Federal Insurance Contribution Act (FICA) and are made up of Social Security and Medicare taxes. Employers must withhold these taxes from the compensation paid to employees. The employer then contributes a similar amount to that withheld from the employees compensation. The employer then deposits these funds with the Internal Revenue Service (IRS). These payments go to fund the Medicare program and the Social Security benefits that the employee will receive when she is eligible.

• Example: I go to work for ABC, Corp. ABC pays me a salary. Each pay period, ABC will withhold an amount of income, Medicare, and Social Security taxes. The Medicare and Social Security taxes are known as payroll taxes. ABC will contribute an amount approximately equal to the amount of payroll taxes withheld from my compensation and then deposit those funds with the IRS.

Next Article: Sole Proprietorships Explained Back to: BUSINESS ENTITIES

Who has to pay Self-Employment Taxes?

Self-employment taxes apply to individuals who are self-employed or are owners of an entity taxed as a partnership. You can think of it as the employer and the employee are one in the same. As such, the self-employed individual is responsible for paying the employer and employee portion of the payroll tax.

• Example: Mary and I form a partnership. We both work in the partnership. As owners of a partnership, we do not receive a salary; rather, we receive compensation by splitting the profits of the business. We are considered self-employed, as we are owners of an entity taxed as a partnership. Mary and I will have to pay self-employment taxes equal to the portion of payroll taxes traditionally paid by an employee and the employer combined.
• Note: An employee must fill out form W-4 to provide necessary withholding information, which is then used to determine the amount of income to withhold. The withheld wages serve to satisfy the employees federal and state income tax obligations. In addition to payroll taxes, the employer will also withhold Federal Unemployment Tax (FUTA) and State Unemployment tax (SUTA) from the employees wages. She deposits all of the taxes withheld at regular intervals with the IRS or state taxing authority.

Discussion: It is a common scenario where employers wrongfully treat employees as independent contractors. What is the benefit to employers in doing this? What are the detriments to the employee?

Practice Question: Howard and Janet are the sole owner of Searchlight, LLC. Howard and Janet work in the business and Searchlight has one employee, Taylor. Searchlight is taxed as a partnership. What are Howard and Janet's self-employment tax obligations? What are Searchlights payroll tax obligations?

• Howard and Janet are members (owners) of the LLC. As such, they cannot receive a salary. They are compensated by receiving a company draw. The LLC is not required to withhold payroll taxes on Howard and Janet's draw. H and J will, however, have to pay self-employment taxes on the compensation. The LLC is required to withhold and deposit payroll taxes on Taylor's compensation, as Taylor is an employee and not an owner of the company.