Payroll and Payroll Taxes
Ask most small business owners what they struggle with most or least like to do, in any case and they will say it is dealing with the complexity of managing payroll and payroll taxes. State, federal, and local requirements change frequently and are difficult for the average manager to stay on top of, and mistakes can be incredibly frustrating for employees and could create legal issues for the company itself.
First the basics: For tax purposes, what constitutes an employee? Workers are classified as either employees or independent contractors (employees are subject to payroll taxes, while independent contractors bear responsibility for their own taxes). To determine the difference, the IRS uses the following criteria:
- Behavioral Test. A worker is an employee when the employer has the right to, in large part, direct and control the worker.
- Financial Test. The financial test evaluates the degree of control the worker maintains over financial aspects of a job, including whether or not expenses are reimbursable and how the worker is paid. Plus, typically independent contractors are not formally tied to one particular business and can advertise services and seek other work opportunities.
- Relationship Test. The relationship test primarily focuses on the length of time a work engagement will last. If a worker has been contracted to work until a certain date or until the end of a particular project, he or she is usually considered an independent contractor. If the work engagement does not have time or project boundaries, the worker is generally considered an employee.
Independent contractors are paid a fee and are responsible for taking care of tax withholding, reporting, and deposits. The management of employee payroll taxes is handled by the employer.
In either case, records must be stored for at least three years (some states have different requirements): time and attendance records; records of earnings, deductions, taxes paid, etc; salary and wage schedules; and additional items like orders, shipping, and billing records. Companies are also required to comply with regulations regarding Workers Compensation Plans, the Family Medical Leave Act (FMLA), short- and long-term disability, etc.
Then, reporting and depositing payroll taxes to the appropriate agencies is required. Deposits made late or not made at all can incur stiff legal penalties and costly interest charges.
Here's a quick breakdown of the taxes and deductions a business is responsible for collecting and depositing:
- Federal Taxes. Federal income tax must be withheld each pay period from employee pay, and the employer is responsible for paying a matching amount. One of two basic tax tables is used: Wage bracket tables or percentage tables. The employer is responsible for determining which table to use.
- State Taxes. Most states also use tax tables; a few, like Alaska, Florida, Texas, New Hampshire, Wyoming, Washington and Tennessee, do not require state income tax. Other states like Arizona tax as a percentage of the federal tax, while a few others, like Pennsylvania, tax based on a fix percentage of total wages.
- FICA. FICA includes Social Security and Medicare taxes; the employer and employee split the tax responsibility. People who are self-employed pay the entire amount; that tax is often called the self-employment tax.
- FUTA. Unemployment taxes are paid by the employer only, if:
- The company pays wages in excess of $1,500 per quarter
- The company has one employee on any given day for twenty weeks in a total calendar year
Sound involved? It can be. Regardless of the complexity and time involved, companies with employees are required to handle payroll and deposit withholdings in some fashion. Here are the basic options:
- Maintain payroll in-house. Some companies choose to manage payroll internally, either using a manual bookkeeping system or through payroll and accounting software. The advantage is that total control is maintained and the cost of managing payroll assuming a skilled administrator is in charge of the process is usually relatively low. The disadvantage is that finding a knowledgeable employment and payroll specialist can be difficult, and mistakes can be extremely costly. Tight internal controls are also necessary to ensure the chance of embezzlement is minimized.
- Use a Certified Public Accountant. If the company uses a CPA firm for other bookkeeping and accounting duties, adding payroll responsibility could make sense. Having a CPA take over payroll could pay dividends since they are already familiar with your business and could find ways to cut costs or take advantage of different tax and general business opportunities. The downside is the cost could be higher than maintaining payroll in-house.
- Use a payroll processing service. Payroll processing services can handle the entire payroll process: Maintaining forms, writing checks, reporting, and depositing payroll taxes. The advantage of a payroll service is one stop shopping: the service takes care of all payroll functions, from adding a new employee to ending their employment (in payroll terms, at least). The disadvantage is that costs can be high for multiple employees. Transactions are usually billed on an a la carte basis; add a new employee, pay a fee for the service. Also, because the service operates at a site removed from the business location, complex or unusual situations may require time and effort to overcome and can create frustration.
The best option to use depends on individual circumstances. Start-ups are most likely to use a CPA or payroll processing service, since employees are unlikely to have payroll skills (and it doesn't make sense to spend the money on training). Established companies should perform a simple cost-benefit analysis:
- Determine current payroll management costs: The cost of a CPA or outside service or the internal cost of managing payroll (whichever applies)
- Determine potential payroll management costs: The cost of outsourcing to a CPA or outside service or the cost of bringing the function in-house
Keep in mind when calculating internal costs to include the time spent gathering payroll-related information, calculating wages, determining federal and state taxes due, depositing taxes with the appropriate authority, staying on top of tax regulation changes, and the cost of any software or training required.
Then simply determine which method is cheaper and balance the cost with the benefit. Some employers are more comfortable paying an outside service so they can focus on running the business; others prefer to keep confidential payroll information and the management of the entire process in-house.