Payroll tax compliance issues abound. These issues stem, mainly, from constraints imposed by various laws, regulations, and standards. Businesses need to be on alert and cognizant of the imposed constraints and their changes and take measures to handle payroll tax-related issues.
What are Payroll Taxes?
Payroll taxes are taxes imposed on wages and salaries that employers and sometimes employees must pay to federal, state, and local governments. Payroll taxes are different from income tax, which are applied to all manner of earnings including wages, salaries, investment income, etc. Payroll taxes are of various types and are administered by Federal, State, and local authorities. Federal Payroll taxes, through the Federal Insurance Contributions Act (FICA), fund Social Security and Medicare, and the Federal Unemployment Tax Act (FUTA) fund federal-operated unemployment programs. State unemployment tax, through State Unemployment Tax Acts (SUTA,) funds state-specific unemployment benefits. State and local Withholding Taxes are used to fund a variety of public services and government operations at the state and municipal levels.
It works by employers withholding a portion of an employee’s paycheck. Employers pay a matching portion or specific employer-only taxes, e.g. FUTA or SUTA. The payments are reported and submitted regularly to tax authorities.
Payroll Tax Compliance Issues
Payroll tax compliance can be troublesome for businesses—especially small ones—because a web of federal, state, and local regulations is involved. Misclassification of workers is a typical concern as employees can be confused with independent contractors. Such misclassification can trigger IRS audits, back taxes, penalties, and lawsuits. Incorrect tax withholding, i.e., failing to withhold the correct amount of Social Security or Medicare, can result in financial penalties and employee dissatisfaction. Late or inaccurate filing, i.e., missing deadlines, quarterly or annual, or submitting incorrect payroll tax forms can lead to interest charges and fines. Poor record keeping, i.e., inadequate documentation of wages, hours, and tax filings, can hinder audits and legal defences. Employers are required to maintain payroll records for a specified period. Miscalculation of overtime pay can violate Fair Labour Standards leading to back pay claims. Ignoring state and local laws as each jurisdiction may typically have unique payroll tax rules, including disability insurance, local income taxes, and paid leave requirements. Not least, faulty payroll software or poor integration with HR systems can cause delays, miscalculations, and data breaches.
Laws, Regulations, And Standards Applying To Payroll Taxes
As suggested before several laws, regulations, standards, and guidelines, govern the application of payroll taxes. They originate from acts of Congress, federal agencies, state legislatures and authorities, and municipalities. The Internal Revenue Code (IRC) – Title 26 governs federal income tax withholding, Social Security, Medicare, and unemployment taxes. FICA enables the IRS to collect Social Security and Medicare. The Federal Unemployment Tax Act (FUTA) mandates employer-only contributions to federal unemployment insurance. The Fair Labor Standards Act (FLSA) sets rules for minimum wage, overtime pay, and payroll recordkeeping. The Affordable Care Act (ACA) impacts payroll through employer mandates for health insurance and reporting requirements. Equal Pay Act (EPA) requires equal pay for equal work, which affects wage calculations and payroll systems. Finally, the Davis-Bacon Act requires prevailing wages for workers on federally funded public works.
State Income Tax varies by state and some states, e.g., Florida and Texas, don’t have income tax, however, State Unemployment Tax Act (SUTA) requires employers to contribute to state unemployment funds according to varying rates and wages bases. State Disability Insurance (SDI) are required in some states like California, New York, and New Jersey. Paid Family Leave and Sick Leave Laws are mandated in many states and they affect payroll deductions and benefits. State may set higher minimum wage laws than the federal standard that can impact payroll taxes by influencing the total taxable wages on which payroll taxes are calculated.
Some municipalities require paid sick leave or other benefits whilst some, like New York City and Philadelphia, impose local income taxes.
The IRS, Department of Labor (DOL,) and the Social Security Administration (SSA) publish standards and guidelines regarding payroll taxes. IRS publications include Publication 15 (Circular E) – Employer’s Tax Guide; Publication 15-A – Employer’s Supplemental Tax Guide; Publication 15-B – Employer’s Guide to Fringe Benefits; and Publication 505 – Tax Withholding and Estimated Tax.
The U.S. Department of Labor (DOL), primarily through its Wage and Hour Division (WHD), enforces wage and hour laws that directly affect payroll tax compliance. It acts through the FLSA, requirements of payroll recordkeeping, the establishment of classification standards for employees and independent contractors, interaction with Payroll Tax laws, and by establishing DOL compliance resources like a summary of Major DOL Laws, and the Payroll Compliance Guide by ADP.
The Social Security Administration provides wage reporting standards for Social Security contributions.
Measures to Handle Payroll Taxes Compliance Issues
To alleviate payroll tax compliance issues, businesses can adopt a mix of proactive strategies, technological tools, and procedures. To start, they must ensure accurate worker classification by using the IRS Common Law rules and DOL tests to distinguish employees from independent contractors. They must review contracts for language that supports independent contractor status
Filings must be timely and correct. So, businesses should set automated reminders for filing deadlines or create calendars with IRS, state, and local filing deadlines. They should utilise electronic filing systems, where available, to reduce errors and ensure timely submissions. They should reconcile filings with the general ledger monthly. They should consider outsourcing filings to professionals if internal resources are limited.
Invest in reliable payroll software to automate tax calculations, deductions, and reporting. Tax tables and rates should be updated in real-time to remain compliant with changing laws. The system should auto-update tax rates and should be integrated with the HR system to ensure consistency across employee data. Ensure that the software accommodates multi-state or international workers it warranted.
Businesses should withhold and remit FICA taxes and pay FUTA taxes accurately. File Form 941 quarterly and Form W-2/W-3 annually for employees. Issue Form 1099-NEC to independent contractors paid $600 or more. Register with the appropriate state payroll agencies. Calculate and remit SUTA. Withhold state income taxes where applicable. Manage and state disability insurance and paid leave requirements (e.g., California, New York). File required state payroll reports according to the specified frequency. Locally, check for local income taxes or municipal obligations. Comply with local paid sick or family leave ordinances and adjust software to reflect local rates.
Maintain proper and detailed records of wages, hours, benefits, and tax filings. These records should be stored securely and accessibly for the legally required duration of three to seven years.
Make sure that HR teams and payroll teams are trained. They should have access to ongoing education on federal, state, and local payroll regulations. Cross-functional awareness between HR, finance, and compliance teams should be encouraged. Set up review protocols to double-check calculations and filings and engage external advisors for multi-jurisdictional compliance or audits.
Conduct regular payroll audits to ensure correct wage calculations, tax withholdings, and benefits reporting. In addition, the audits should verify employee classifications and ensure all filings are accurate and timely.
Monitor legislative changes by subscribing to IRS, DOL, and state tax authorities for updates. Subscribe to their bulletins. Periodically review the eCFR 25 CFR Part 31 for federal withholding rules. Use compliance monitoring tools to track changes across jurisdictions.
Hire tax advisors or payroll compliance experts for complex scenarios, especially for multi-state or international operations.
Withhold and remit FICA taxes and pay FUTA taxes accurately. File Form 941 quarterly and Form W-2/W-3 annually for employees. Issue Form 1099-NEC to independent contractors paid $600 or more.
Conclusions
Payroll tax compliance poses challenges for businesses, especially small ones, due to a complex network of laws, regulations, and standards at federal, state, and local levels. These taxes, separate from income tax, apply to wages and salaries and help fund social programs and worker protections. Errors in payroll processing can lead to serious legal and financial issues. Employers must stay vigilant and adapt to changing requirements to ensure proper handling of payroll obligations.
By Richard Thomas
