Mistakes in withholding and paying payroll taxes to the IRS can spell real trouble for small business owners.
Every employer faces countless rules and regulations involving the payments it makes to its employees. There are rules that dictate when (and which) workers must be paid overtime, the amount of taxes that must be withheld and when they must be paid to the IRS. Unfortunately, the potential for problems recently increased for many businesses when the U.S. Department of Labor (DOL) proposed new payroll-related rules.
Overtime burden increased
There currently are no limits on the number of hours of overtime that may be scheduled by an employer. The rules do, however, require employers to pay covered employees not less than one and one half times their regular rate of pay for all time worked in excess of 40 hours in a work week.
Effective in 2016, the DOL raised the threshold at which workers making up to about $50,000 annually (even those currently exempt because they are classified as managers) could qualify for overtime pay under the Fair Labor Standards Act (FLSA).
Not all employees or all businesses are covered by all DOL rules. Exceptions include employees of retail stores and service establishments with annual gross receipts of less than $500,000, outside salespeople, executives, administrators and professional personnel.
Remember, however, businesses not covered by federal law are, in all likelihood, subject to similar state overtime laws. Where employees are subject to both state and federal overtime laws, the employee is entitled to overtime according to the standard providing the higher rate of pay.
Are they really employees?
Workers can be either employees or independent contractors, although the DOL and the IRS are often skeptical of both labels. In general, employees are treated as taxable workers subject to payroll taxes, while independent contractors are responsible for paying their own taxes.
Until the IRS is able to connect missing payments for withheld taxes to the employer, the clock continues to tick on those unpaid payroll taxes, as well as any interest and penalties.
Generally, workers are considered employees if the business has the right to direct and control the way they do their work, rather than merely the results of the work. However, just because a worker
agrees to be paid as an independent contractor doesn’t mean it’s the legal way of paying that person.
Married couples who jointly own and operate a business and share in the profits and losses are considered partners, regardless of whether there is a formal partnership agreement. The wages of an individual who works for his or her spouse in a business other than a partnership are subject to income tax withholding and Social Security and Medicare taxes, but not the Federal Unemployment Tax Act (FUTA) tax.
Payments to a child under age 18 who works for his or her parent are not subject to Social Security and Medicare taxes if the business is a sole proprietorship or a partnership in which each partner is a parent of the child.
Payments to a child under age 21 who works for his or her parent in a trade or business are not subject to the FUTA tax. The wages of a child are subject to income tax withholding as well as Social Security,
Medicare and FUTA taxes if he or she works for:
- a corporation, even if it is controlled by the child’s parent.
- a partnership, even if the child’s parent is a partner, unless each partner is a parent of the child.
- an estate, even if it is the estate of a deceased parent.
The Affordable Care Act (ACA) redefined full-time employment, at least when it comes to its benefits and penalties. First, every business owner and manager should understand that the ACA’s taxes and tax credits are based on the number of full-time equivalent employees (FTE) and their average annual wages—not on the number of full-time employees. In simple terms, FTE equals the total number of full-time employees plus the combined number of part-time employee hours divided by 30. Seasonal employees, contractors and business owners don’t count toward the total for most specialty fabric operations.
And don’t forget the Medicare tax hike. The Medicare Part A tax is paid by both employees and employers. Often overlooked, however, is the fact that an individual or business with profits of more than $250,000 faces a .9 percent increase (from 2.9 percent to 3.8 percent) on the current Medicare Part A tax.
Since this tax is split between the employer and employee, they will both see a .45 percent increase. Small businesses making under $250,000 are exempt from the tax. Employees making less than $200,000 as an individual or $250,000 as a family are also exempt.
Reducing payroll tax penalties
Uncle Sam is reportedly focusing on small businesses that fail to collect or remit payroll taxes. Because small businesses with delinquent tax problems are the largest contributors to the annual tax gap, the IRS appears to be cracking down on them.
One of the troublesome and most feared taxes currently imposed is the “Trust Fund Penalty Tax,” a whopping 100 percent penalty on payroll taxes withheld from a business’s employees but not forwarded to the federal government. The fear stems from the IRS’s authority to assess the penalty on all “responsible parties,” a label that can include the owners, shareholders, partners, members, managers and officers in a business.
Some payroll taxes are not payable by the business, but must be collected as withholding and turned over to the IRS. Failure to collect and pay those taxes can mean a 100 percent penalty tax, accruing additional penalties and interest the longer the money goes unpaid.
Approximately 40 percent of small businesses use a third-party payer for tasks ranging from paying employees to federal employment taxes. While third-party payer arrangements usually work as intended, there have been instances in which third-party payers receive funds from employers for payment of payroll taxes but fail to remit those taxes to the IRS. This causes significant problems for employers because the funds have been expended but the taxes are still due.
In a recent audit, the Treasury Inspector General for Tax Administration (TIGTA) evaluated whether IRS controls are adequate to protect the taxpayer’s and the government’s interests when third-party payroll providers are not compliant with payment and filing requirements. Until the IRS is able to connect missing payments for withheld taxes to the employer, the clock continues to tick on those unpaid payroll taxes, as well as any interest and penalties.
Avoiding the pain
Avoiding payroll tax penalties, especially those that result from audits, isn’t usually difficult. Reducing payroll tax penalties levied as the result of an IRS audit, or even resulting from errors detected by the operation itself, begins with simply asking the IRS to abate or eliminate the payroll tax penalty. The IRS does have the discretion to waive penalties, especially if the penalty is the exception, not the rule.
It’s important to understand the basic rules for withholding payroll taxes—and the requirement to pay over-withheld amounts—on the wages of all employees. Guidance and advice from a competent, qualified advisor is a necessity for most businesses to keep in the IRS’s good graces.
Mark E. Battersby, based in Ardmore, Pa., writes extensively on business, financial and tax-related topics.