California collects an incredible amount of taxes each year. Last year, the state collected a whopping $119 billion in tax revenue. A large portion of this money came from payroll taxes or employment taxes and includes personal income tax withholding.
Owning a business in California that has employees means being responsible for withholding, filing returns, and paying payroll taxes, both for the federal and California government. This responsibility can be onerous, especially for a small business.
The federal and California laws governing an employer’s payroll tax responsibilities can be very complex. To top it off, these laws can often change every year. If that wasn’t enough, a variety of taxing agencies collect taxes, and each of these agencies has its own set of laws and rules governing how and when payments are to be made. All it takes is one inadvertent mistake and a business can find itself penalized for noncompliance with one or more of these various laws and rules.
In this article, we’re going to look at a business’ payroll tax responsibilities at both the federal and California level. We’ll also look at some of the more common problems a business may face when it comes to payroll taxes, as well as how these problems can be resolved if a taxing authority has imposed penalties for noncompliance.
Payroll Taxes at the Federal Level
The federal government uses the payroll taxes it collects from you and me to pay for government expenses and services, as well as, social security, Medicare, and federal unemployment programs. In general, an employer pays federal payroll taxes for Medicare, social security and unemployment (FUTA). In addition, the employer withholds federal personal income taxes, Medicare and social security from its employees’ wages.
Personal income tax withholding, social security, and Medicare taxes are usually paid over to the IRS on a monthly basis (and these must be paid electronically on the workday prior to the 15th of each month). However, some employers are required to pay over these taxes on a semi-weekly basis. These employers reported $50,000 or more in taxes during the previous one year look-back period (7/1-6/30). Their payroll taxes must be paid electronically on the following Wednesday if the payday falls on a Wednesday, Thursday or Friday or on the following Friday if the payday falls on a Saturday, Sunday, Monday or Tuesday. Is that confusing enough for you? These taxes are then reported on a quarterly return that is due on the last day of the month following the close of each quarter. For instance, the quarters end on 3/31, 6/3, 9/30 and 12/31; so, the quarterly payroll or employment tax returns are due on 4/30, 7/31, 10/31 and 1/31. Money withheld for federal unemployment tax (FUTA) is usually paid and reported annually on 1/31, one month after the end of the calendar year; however, there are many exceptions to all of the above rules. See IRS Publication 15, (Circular E), Employer’s Tax Guide for more information.)
Payroll Taxes at the State Level
State payroll taxes in California are overseen by the Employment Development Department or EDD. The EDD not only collects payroll taxes, but it also performs tax audits, enforces collection of the tax and handles various appeals, e.g., payroll tax, unemployment, disability, penalty abatements, etc.
California’s payroll taxes, like federal payroll taxes, support our state government and its many government programs, e.g., state unemployment and disability insurance and employment training. An employer withholds California personal income taxes and state disability insurance (SDI) from its employees’ wages. However, the employer must pay the state’s unemployment insurance and employment training tax (ETT) directly out of its own pocket.
Common Payroll Tax Problems
By now you must admit that the laws governing federal and state payroll taxes are complex. Trying to deal with payroll taxes on your own is simply an invitation for trouble. This is especially true if your business employs a significant number of workers. In general, as your business grows, the more complex your payroll tax responsibilities become.
If you only have one or two employees, you may be able to deal with payroll taxes on your own or, at worst, you may have to hire an accountant to handle them for you. However, for all growing businesses, there will come a point where you or your accountant will need the advice of an experienced California tax attorney to help you understand the various tax codes involved. That advice can be crucial to helping you avoid a situation where either the IRS or the EDD, or both, are penalizing you for failing to meet your payroll tax obligations.
Another common problem that befalls many employers is misunderstanding exactly how the term “employee” is defined in the law. In general, an employee is under the direction and control of the employer. That is, an employer “has the right” to control what will be done and how. But, many employers erroneously classify their workers as independent contractors to avoid withholding and paying employment taxes; and, when that happens, the potential audit liability can grow very quickly. The IRS formerly used a 20-factor test to determine who was an employee and who was an independent contractor; but, that test has evolved into one key test and that is, “direction and control”.
Penalties for Payroll Tax Miscalculation and Errors
An employer is generally liable for social security, Medicare taxes and income tax that should have been withheld if it did not deduct and withhold taxes because it treated an employee as an independent contractor or non-employee. However, the IRS may relieve an employer from having to pay employment taxes if the employer “had a reasonable basis” for not treating a worker as an employee. See Pub. 1976, Do You Qualify for Relief Under Section 530.” The IRS also has a Voluntary Classification Settlement Program (VCSP) that can be advantageous if an employer wants to voluntarily reclassify their independent contractors, non-employees/workers as employees for future periods and certain requirements are met. See IRS Form 8952.
The IRS also has deposit penalties if an employer does not make the required deposits on time or if the employer makes deposits of less than the required amount. These penalties do not apply if any failure is due to reasonable cause and not willful neglect but proving that is no simple matter. In addition and more importantly, if federal income, social security, or Medicare taxes that must be withheld (that is, trust fund taxes) aren’t withheld or aren’t deposited or paid to the U.S. Treasury, the trust fund recovery penalty may apply. This penalty is the full amount of the unpaid trust fund tax and it may apply to any person who was responsible for collecting, accounting for, or paying these taxes, and acted willfully in not doing so.
The State of California has a similar law. Under the EDD rules, any officer of a corporation, major stockholder, or individual responsible for payroll taxes who intentionally does not comply with California’s payroll tax laws will be held personally responsible for the tax monies owed to the state.
Take note of the word “willfully.” Both the IRS and the EDD are cognizant of the difference between a simple calculation error and willful failure to follow tax laws. An innocent miscalculation will simply result in a penalty plus interest on the amount owed. However, willful failure to follow the tax laws is considered to be tax evasion. In such a case, not only will the penalties and interest be due, but criminal charges may also result.
Dealing With Payroll Tax Penalties
Resolving payroll tax penalties requires payment of the back taxes owed, plus any interest and penalties on the overdue amount. Keep in mind however, that you have the right to dispute taxes and penalties. Even if you exercise this right, you will be expected to continue to pay all payroll taxes on time.
This is where an experienced state and local tax professional or payroll tax expert can help. We can guide you through the audit and appeal process, using our knowledge of federal and state payroll/employment tax laws and rules to help you achieve the best possible results on your behalf. Contact us today for a free and confidential consultation.