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A Primer on Employment Tax Withholding

When the IRS is involved, monetary transactions are never as simple as they appear on the surface. The late, great comedian Mitch Hedberg once told a story about being given a receipt after buying a doughnut.

Employment Tax WithholdingI bought a doughnut, and they gave me a receipt for the doughnut. I don’t need a receipt for the doughnut. I’ll just give you the money, and you give me the doughnut, end of transaction. We don’t need to bring ink and paper into this.

I just can’t imagine a scenario where I would have to prove that I bought a doughnut. Some skeptical friend: “Don’t even act like I didn’t get that doughnut! I got the documentation right here…oh, wait it’s at home…in the file…under “D.”

When it comes to the payment of wages, ink and paper are always required. Think of the IRS as Mitch’s skeptical friend. The IRS will zealously require proof of the doughnut transaction, which is a complex (and wholly impertinent) metaphor for the payment or wages and the concomitant withholding and proper deposit of employment taxes with the government.

If a person responsible for withholding and paying over employment taxes to the government fails to do so, and such failure is “willful,” then that responsible person may find himself personally liable for the taxes due to the government under IRC § 6672 (Trust Fund Recovery Penalty). However, that’s a story for another post.

An Introduction to Employment Tax Withholding

Employment Tax WithholdingUnderstanding full well that I am being, perhaps, overly pedantic—it is necessary to state the obvious: in order for employment tax liability to arise, there must be an employer, an employee, and a payment of wages or other compensation.[1]  Employers do not withhold from the compensation paid to (true) independent contractors; though the independent contractors are subject to self-employment taxes, which carry their own tax issues, which we’ll discuss in a future post.

For a discussion of worker classification—that is, the difference between an employee and an independent contractor—look no further than Briefly Taxing’s article, “Worker Classification: The Thin Line Between Employees and Independent Contractors,” from June 2021.

When an employer pays wages, it must withhold from such wages certain Federal employment taxes including Federal Insurance Contributions Act (FICA) taxes (also known as Social Security and Medicare taxes),[2] as well as Federal Income Tax Withholding (FITW).[3]

The employer holds the FICA and FITW taxes “in trust” for the eventual deposit with the government. The employer must also pay over Federal Unemployment Tax Act (FUTA) taxes, but since FUTA taxes are borne only by the employer, they are not—technically—withheld from an employee’s wages.[4] Authority for the withholding, depositing, and penalties for failure to do so are found in Subtitle C of the Code (“Employment Taxes”), as well as in IRC § 6672.[5]

The Federal Insurance Contributions Act (FICA)

Employment Tax Betty White
Why? Because Betty White, that’s why.

The Federal Insurance Contributions Act (FICA) provides for a federal system of old-age, survivors, disability, and hospital insurance. The old-age, survivors, and disability insurance part is financed by the social security tax. The hospital insurance part is financed by the Medicare tax. Each of these taxes is reported separately.

An employer is generally required to withhold social security and Medicare taxes from its employees’ wages and to pay the employer share of the FICA taxes. In most cases, employee wages are subject to social security and Medicare taxes regardless of the employee’s age or whether he or she is receiving social security benefits.

For 2021, the social security tax rate is 6.2% (amount withheld) each for the employer and employee (12.4% total), and the tax rate for Medicare is 1.45% (amount withheld) each for the employee and employer (2.9% total). In addition to withholding Medicare tax at 1.45%, an employer must withhold a 0.9% Additional Medicare Tax from wages paid to an employee in excess of $200,000 in a calendar year.

Note, however, that the Additional Medicare Tax is imposed only on the employee; thus, there is no employer share of Additional Medicare Tax.

IRC § 3102(a) and IRC § 3402(a) respectively require deduction of the employee’s share of FICA taxes and the withholding tax on wages applicable to individual income taxes from wages paid to employees. The withheld sums are commonly referred to as “trust fund taxes,” reflecting the Code’s provision that such withholdings or collections are deemed to be a “special fund in trust for the United States.”[6] If an employer fails to withhold, the employee must pay over the tax.[7]

The Federal Unemployment Tax Act (FUTA)

Employment Tax UnemployedThe Federal Unemployment Tax Act (FUTA) provides for Federal payments of unemployment compensation to workers who have lost their jobs and works in conjunction with state unemployment systems. Most employers pay both a federal and a state unemployment tax. As noted above, only the employer pays FUTA tax; thus, FUTA taxes are not withheld from the employee’s wages.

Generally, an employer is subject to FUTA tax in 2021 on the wages it pays employees,[8] as long as (a) the employer paid wages of $1500 or more in any calendar quarter in 2020 or 2021; or (b) the employer had at least one employee for at least some part of the day in any 20 or more different weeks in 2020 or 2021. For 2021, the FUTA tax rate is 6.0%. The tax applies to the first $7,000 an employer pays to each employee as wages during the year, which is known as the federal unemployment tax “wage base.”

Note, however, that the employer’s state wage base may be different.[9]

Generally, an employer can take a credit against its FUTA tax for amounts the employer paid into state unemployment funds. The credit may be as much as 5.4% of FUTA taxable wages. If an employer is entitled to the maximum 5.4% credit, the FUTA tax rate after credit is 0.6%. An employer is entitled to the maximum credit if it paid its state unemployment taxes in full, on time, and with respect to the wages subject to the FUTA tax.

Employer’s Reporting Requirements

The employer must also report wages, tips, and other compensation paid to an employee, as well as the taxes that the employer deposited with the IRS, by filing certain returns on or before specific deadlines. By January 31, an employer must file

  • Employment Tax ReportForm 940 (Employer’s Annual Federal Unemployment Tax (FUTA) Return);[10]
  • Copy A of all paper Forms W-2 (Wage and Tax Statement) with Form W-3 (Transmittal of Wage and Tax Statements);[11] and
  • if the employer is reporting non-employee compensation payments in box 7 of Form 1099 (Miscellaneous Income), Copy A of all paper Forms 1099 with Form 1096 (Annual Summary and Transmittal of U.S. Information Returns).[12]

Additionally, an employer must file Form 941 (Employer’s Quarterly Federal Tax Return) by April 30, July 31, October 31, and January 31 (for the fourth quarter of the previous calendar year).[13]

Employer’s Depositing Requirements

Employment Tax DepositGenerally, an employer must deposit federal income tax withheld (FITW) and both the employer and employee social security and Medicare (FICA) taxes. There are two deposit schedules—monthly and semiweekly—for determining when an employer must deposit social security, Medicare, and withheld federal income taxes. These schedules tell the employer when a deposit is due after a tax liability arises, which liability is based on the dates that payments were made or that wages were paid.

Before the beginning of each calendar year, an employer must determine which of the two deposit schedules it is required to use. The deposit schedule an employer must use is based on the total tax liability it reported on Form 941 for a 4 quarter (12 month) lookback period, beginning July 1 and ending June 30. It is important to understand that an employer’s deposit schedule is not determined by how often it pays its employees or make deposits.

Thankfully, it does not require a post-graduate degree in theoretical or applied mathematics to determine whether an employer is a monthly or semi-weekly depositor.

If an employer reported $50,000 or less of taxes for the lookback period, it is a monthly schedule depositor; if it reported more than $50,000, it is a semiweekly schedule depositor.[14]

Note, however, that if an employer makes an adjustment to a Form 941 (by filing a Form 941-X), such adjustments will not affect the amount of tax liability for previous periods for purposes of the lookback rule.[15]

Employment Tax MonkeyMoneyIf an employer accumulates $100,000 or more in taxes on any day during a monthly or semiweekly deposit period—kudos to them; it was a banner freaking day—the employer must deposit the tax by the next business day, whether the employer was, heretofore, a monthly or semiweekly schedule depositor. The employer’s largesse has further consequences, insofar as a previously-monthly-depositor-employer becomes a semiweekly depositor on the next day and remains so for at least the remainder of the present calendar year and throughout the following calendar year.

Under the monthly deposit schedule, an employer must deposit employment taxes on payments made during a month by the 15th day of the following month. Under the semiweekly deposit schedule, an employer must deposit employment taxes for payments made on Wednesday, Thursday, and/or Friday by the following Wednesday.

Likewise, the employer must deposit taxes for payments made on Saturday, Sunday, Monday, and/or Tuesday by the following Friday.[16]  If a deposit is required to be made on a day that is not a business day, the deposit is considered timely if it is made by the close of the next business day. Federal tax deposits must be made by electronic funds transfer (EFT).

Critically, for deposits made by the Electronic Federal Tax Payment System (EFTPS) to be on time, an employer must submit the deposit by 8 p.m. Eastern time the day before the date the deposit is due.[17]

Depositing FUTA Taxes

Employment Tax ForwardIf an employer’s FUTA tax liability for any calendar quarter is $500 or less, it is not required to deposit the FUTA tax for that quarter. Instead, it may carry it forward and add it to the liability figured in the next quarter. If an employer’s FUTA tax liability for any calendar quarter is over $500 (including any FUTA tax carried forward from an earlier quarter), the employer must deposit the FUTA tax by EFT. The employer must deposit the FUTA tax by the last day of the first month that follows the end of the quarter.[18]

Accuracy of Deposits

Employment Tax AccurateAn employer is required to deposit 100% of its tax liability on or before the deposit due date, as discussed just above. However, penalties will not be applied for depositing less than 100% if both of the following conditions are met:

  1. Any deposit shortfall doesn’t exceed the greater of $100 or 2% of the amount of taxes otherwise required to be deposited; and
  2. The deposit shortfall is paid or deposited by the shortfall makeup date.

For a monthly schedule depositor, an employer must deposit the shortfall or pay it with its return by the due date of the return for period in which the shortfall occurred. For a semiweekly schedule depositor, and employer must deposit the shortfall or pay it with its return by the earlier of (a) the first Wednesday or Friday (whichever comes first) that falls on or after the 15th day of the month following the month in which the shortfall occurred; or (b) the due date of the employers’ return (for the return period of the tax liability).[19]

Deposit Penalties

Penalties may apply if and employer does not make required deposits on time or if it makes deposits for less than the required amount. The penalties will not apply if any failure to make a proper and timely deposit was due to reasonable cause and not to willful neglect. For amounts not properly or timely deposited, the penalty rates are as follows:

  • 2% for deposits made 1 to 5 days late
  • 5% for deposits made 6 to 15 days late
  • 10% for deposits made 16 or more days late, but before 10 days from the date of the first notice the IRS sent asking for the tax due
  • 10% for amounts that should have been deposited, but instead were paid directly to the IRS, or paid with the employer’s tax return[20]
  • 15% for amounts still unpaid more than 10 days after the date of the first notice the IRS sent asking for the tax due or the day on which the employer received notice and demand for immediate payment, whichever is earlier

Deposits are generally applied to the most recent tax liability within the quarter. If an employer receives a failure to deposit (FTD) penalty notice, it may designate how its deposits are to be applied in order to minimize the amount of the penalty, but only if the employer so designates within 90 days of the date of the notice.[21]

Filing Form 941

If an employer paid wages subject to federal income tax withholding (including withholding on sick pay and supplemental unemployment benefits) or social security and Medicare taxes, the employer must file Form 941 quarterly—even if it has no taxes to report, unless the employer filed a final return, or specific exceptions apply.[22] Form 941 must be filed by the last day of the month that follows the end of the quarter. Failure to file and failure to pay penalties apply to the nonfiling of Form 941.

Bottom Line

Employment Tax DogDonut
Don’t be complacent with your employment tax obligations.

Employment tax withholding is not like buying a doughnut.  The rules, though not incredibly complex once you wrap your head around them, are incredibly important to understand and follow.  As we’ll discuss in a future post, failure to withhold and/or deposit will give the IRS a one-way, all expenses paid ticket to assessment of the Trust Fund Recovery Penalty against the “responsible persons” in a company, which generally includes all officers and directors.

Personal liability for employment taxes is a very hard pill to swallow. Thus, it is absolutely critical for all employer-taxpayers and practitioners-advisors to understand the basic rules and timing issues related to employment tax withholding and depositing.


 

Footnotes:

[1] IRM pt. 4.23.8.1.1(1).

[2] IRC § 3101 – IRC § 3128.

[3] IRC § 3401 – IRC § 3406.

[4] IRC § 3301 – IRC § 3311.

[5]Federal Insurance Contributions Act (FICA) in Chapter 21; Federal Unemployment Tax Act (FUTA) in Chapter 23; and Collection of Income Tax at Source (FITW) in Chapter 24. Separate withholding taxes apply to compensation for working on the railroad (all the live-long day).

[6] Slodov v. United States, 436 U.S. 238, 243 (1978); IRC § 7501(a).

[7] See, e.g., IRC § 3102(f)(2) (employee’s responsibility regarding unwithheld FICA taxes);

[8] Excluding farmworkers and household workers.

[9] For example, Florida’s state unemployment tax wage base for 2021 is also $7,000, whereas the District of Columbia’s wage base is $9,500, and Connecticut’s wage base is $15,000.

[10] If the employer deposited all of the FUTA tax when due, the employer has 10 additional calendar days to file.

[11] Alternatively, the employer may file electronic Forms W-2, with the Social Security Administration (SSA) to report wages, tips and other compensation paid to an employee.

[12] Alternatively, the employer may file electronic Forms 1099 with the IRS. Copy A of paper Forms 1099 (other than those with entries in box 7) must be filed with Form 1096 by February 28th. Electronic Forms 1099 (other than those with entries in box 7) must be filed by March 31st.

[13] If an employer timely deposited all taxes when due, it has 10 additional calendar days to file the Form 941.

[14] An employer’s total tax liability for the lookback period is determined based on the amount of taxes it reported on Form 941, line 12. An employer’s total liability for 2020 isn’t reduced by the deferred amount of the employer or employee share of social security tax, the refundable portion of the credit for qualified sick and family leave wages, or the refundable portion of the employee retention credit.

[15] See IRS Publication 15, 28.

[16] If an employer has more than one pay date during a semiweekly period and the pay dates fall in different calendar quarters, the employer must make separate deposits for the separate liabilities. IRS Publication 15, 29.

[17] If an employer fails to submit a deposit transaction on EFTPS by 8 p.m. Eastern time the day before the date a deposit is due, it can still make its deposit on time by using the Federal Tax Collection Service (FTCS) to make a same-day wire payment.

[18] If an employer’s liability for the fourth quarter (plus any undeposited amount from any earlier quarter) is over $500, the employer must deposit the entire amount by the due date of Form 940 (January 31). If it is $500 or less, the employer can make a deposit, pay the tax with a credit or debit card, or pay the tax with its Form 940 by January 31.

[19] By way of example, if a semiweekly schedule depositor has a deposit shortfall during May 2021, the shortfall makeup date is June 16, 2021 (Wednesday). However, if the shortfall occurred on the required April 2, 2021 (Friday), deposit due date for the March 30, 2021 (Tuesday), pay date, the return due date for the March 30 pay date (April 30, 2021) would come before the May 19, 2021 (Wednesday), shortfall makeup date. In this case, the shortfall must be deposited by April 30, 2021. See IRS Publication 15, 30-31.

[20] The IRS may waive the failure to deposit penalty the first time an employer is required to make a deposit if it inadvertently sends the payment to the IRS rather than deposits it by EFT.

[21] For more information on designating deposits, see Rev. Proc. 2001-58.

[22] Such as if the IRS notifies the employer that it is eligible to file a Form 944 (Annual Employment Tax Return), certain seasonal and household employers, and agricultural employers.

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