Taxes are an inevitable part of running a business, and as a business owner, it’s common to struggle with understanding tax laws. However, failing to withhold taxes from employees’ paychecks properly can lead to serious consequences for your organization.
This is your guide to tax withholding, including why it matters, what happens if you fail to meet your obligations, and how Mosey can help with state compliance.
What Is Tax Withholding?
Tax withholding is the process of deducting a portion of an employee’s wages to pay federal income tax, Social Security, Medicare, and state taxes. This deduction occurs during each pay period and ensures employees contribute toward their annual tax liability throughout the year.
What Are the Key Components of Tax Withholding?
There are several types of taxes, each with different rates. Most taxes occur at the federal level, but some taxes are state-specific. This can be especially challenging for multi-state employers who must tailor their compliance strategy to each state where their employees reside.
Here are the key components of tax withholding:
- Federal Income Tax: Based on the employee’s Form W-4 and the IRS withholding tables, this deduction helps cover the employee’s federal income tax liability.
- FICA Taxes: Federal Insurance Contributions Act (FICA) taxes include Social Security and Medicare taxes. Both employers and employees contribute.
- State Income Tax: Many states also require income tax withholding, which varies based on the state’s tax laws.
Employers report withheld taxes using IRS Form W-2 at the end of the year. These taxes are crucial for funding essential programs like Social Security and Medicare, as well as for meeting individual taxpayer obligations.
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What Are an Employer’s Responsibilities for Tax Withholding?
Employers have several tax obligations:
Federal Income Tax
First, use Form W-4 and IRS withholding tables to calculate the correct amount of federal income tax for each employee. Employees can also customize their income tax withholding, which may require special care.
Social Security and Medicare
For Social Security and Medicare, the rates are fixed at 6.2% and 1.45%, respectively. These rates apply to employers and employees. Ensure your payroll system accurately deducts income tax, Social Security, and Medicare taxes from every paycheck.
Remit to a Tax Authority
Employers need to remit all of these taxes to the appropriate tax authority — such as the Internal Revenue Service (IRS) or state tax agencies — by the due date. Make sure you’re sending your tax remissions to the right place.
Report Tax Payments
Finally, employers must report employment tax payments quarterly using IRS Form 941, also known as the Employer’s Quarterly Federal Tax Return. For unemployment taxes, Form 940 is used annually.
At the end of the year, provide employees with Form W-2 summarizing their wages and the amount of tax withheld.
What Are the Consequences of Not Withholding Taxes?
Failure to withhold or properly remit taxes can lead to significant legal penalties for organizations. Tax violations are among the most serious non-compliance issues a business can encounter, so it’s important to be as timely and accurate as possible.
IRS Penalties and Interest
The IRS imposes penalties for late or insufficient tax payments. For example, you can be penalized for failing to file Form 941 or Form W-2 on time or if taxes are not remitted by the due date.
Organizations can also be liable for interest on unpaid tax amounts, compounding their financial burden.
Trust Fund Recovery Penalty (TFRP)
The IRS can assess a Trust Fund Recovery Penalty for willful failure to collect and remit employment taxes. This penalty applies to the responsible person or people within the non-compliant business, which could include owners, officers, or even payroll managers.
Employee Tax Issues
If taxes are not withheld, employees may face greater tax liabilities when filing their annual tax returns. This can put a severe strain on your relationship with your workforce, and they may be able to take legal action if their tax situation is impacted by something you were supposed to do.
State Tax Penalties
States have their own withholding laws and penalties for non-compliance. These penalties can vary significantly from location to location, so it’s a good idea to consult with a local tax professional about state-specific requirements that may impact your organization.
Loss of Tax Credits and Tax Refunds
Employers who fail to comply with withholding requirements may lose eligibility for certain tax credits or deductions, increasing their overall business taxes. Startups and small businesses, especially, can become so burdened by their loss of tax credits that they can no longer afford to operate.
Legal Consequences
Willful failure to withhold taxes can escalate into criminal charges. The IRS and state tax agencies take these violations seriously, and business owners can face fines, imprisonment, or both.
That said, this scenario is rare and generally only applies to organizations that knowingly engage in illegal or fraudulent activity.
What Are the Most Common Tax Mistakes Employers Make?
Understanding where employers go wrong can help prevent issues down the road.
Here are the most common tax withholding mistakes:
Misclassifying Workers
Treating an employee as an independent contractor to avoid withholding taxes is a common and costly mistake. Independent contractors are responsible for their own self-employment taxes, while employers must withhold taxes for employees.
Incorrect Calculations
Failing to update payroll systems with the latest IRS withholding tables or not accounting for employee changes in Form W-4 can lead to errors in the amount of tax withheld.
Late Payments
Missing the due date for remitting taxes can result in penalties and interest charges.
Overlooking Changes in Tax Laws
Tax rates and regulations change frequently. These adjustments are often small, and updates can be easy to miss. Make sure to check your tax percentages at the beginning of each fiscal year.
Regular compliance audits can also prevent simple mistakes from slipping through the cracks.
Avoid costly fines and penalties.
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How To Ensure Tax Compliance
A reliable compliance plan is required, and everyone who handles payroll taxes at your business should be included.
Most organizations use a similar template to ensure tax compliance:
Use a Reliable Payroll System
Consider using a payroll service that automatically calculates and withholds the correct amount of tax for each pay period. Many payroll systems also handle tax payments and filings, and automation can significantly reduce the risk of human error.
Regularly Review Tax Forms
Ensure employee W-4s are up to date and reflect any changes in withholding allowances. The IRS updates and re-releases many forms each year, so use the new form provided on their website to stay compliant.
Stay Informed on Tax Laws
Tax laws, rates, and regulations change periodically. To stay current, subscribe to IRS updates or consult with a tax professional. State tax laws tend to change more frequently than federal tax laws, so pay attention at the local level.
Perform Payroll Audits
Review payroll records regularly to ensure all taxes are withheld and remitted accurately. Cross-check these records against IRS and state requirements.
Hold on to your records for several years. The IRS can go back far if they notice errors or discrepancies, and having older records can expedite the review process.
Consult an Employment Tax Specialist
If you’re unsure about any aspect of tax withholding, seek guidance from a qualified tax attorney or CPA. This is particularly important for small businesses without a dedicated HR or payroll department.
What To Do if You’re Noncompliant
If your business has fallen behind on its tax withholding obligations, act as soon as possible. It’s better to come forward with an honest effort to rectify the situation than wait for the IRS to demand a response.
- File Missing Tax Forms: Submit any overdue IRS forms, such as Form 941 or Form 940, to report unpaid taxes.
- Make Payments: Pay any outstanding tax amounts as soon as possible to minimize penalties and interest. If your business cannot pay in full, setting up a payment plan with the IRS can help.
- Communicate With the IRS: If you cannot remit the full tax due, contact the IRS to discuss your options.
- Seek Professional Advice: Consult a tax professional to address compliance issues and develop a plan to prevent future problems.
That said, the best compliance strategy is proactive, not reactive.
Compliance Is Easy With Mosey
Failing to withhold taxes can create significant financial and legal risks. By understanding your obligations, implementing strong payroll systems, and staying informed about tax laws, you can ensure compliance and avoid trouble with the IRS.
Federal tax withholding requirements are the same across the board, but state tax requirements often differ. Mosey’s payroll tax compliance solution helps organizations track and manage state and local-specific compliance requirements. All the information you need is conveniently streamlined and just a few clicks away. Automate payroll tax account registration, manage filing and reporting deadlines, and integrate your payroll date to get notified when new requirements apply to your business based on employee locations.
Book a demo with Mosey to learn how we can simplify compliance for you.
