As everyone learns with their first job, the gross amount you earn is not the amount you take home on your paycheck. However, merely setting and forgetting your withholding is a recipe for disaster come tax time, especially when major life changes occur. Employees and employers need to periodically check their withholdings to avoid unnecessary penalties and interest. Keep reading for small business tax advice to make managing withholding easier.
How Does Withholding Tax Work?
Withholding is the process of reducing your gross paycheck to pay your Federal and State income taxes to the government throughout the year. Your employer withholds the money and remits it to the government on your behalf, which grants you a credit for taxes paid on your tax return.
Tip: Withholding is treated as evenly contributed throughout the year, even if it isn’t. If your tax planning requires a large tax payment in Q4, look into whether increasing your Q4 withholding on a few paychecks could save you from penalties and interest as compared to a large Q4 quarterly estimated tax payment.
For Employees
Employees fill out two forms, a Federal W-4 and a State W-4. Minnesota residents can find a copy here, telling their employer how much to withhold from each paycheck.
The Federal W-4 changed drastically in recent years. It is no longer as simple as saying ‘I’m claiming Married 2’ or ‘I’d like to change to Married 0 and increase my withholdings’. Employees should take their time filling them out, and project their year-end numbers after receiving their first paystub to verify they filled out their W-4 as intended. If not, they should contact their employer and ask to submit new W-4’s as soon as possible.
For Employers
Employers have two sets of withholding to consider: their own and their employees. The responsibility falls on the employer to withhold taxes according to the employee W-4’s, and remit those taxes to the correct Federal and State agencies in a timely manner. The IRS treats payroll taxes seriously, and aggressively shuts down businesses that fail to remit payroll taxes.
As the employer, you also withhold FICA tax from all wages. FICA tax funds Social Security and Medicare for US Citizens in retirement. 7.65% must be withheld from the employee’s wages, and the employer must fund a matching 7.65%, taking the total FICA tax to 15.3%.
For Self-Employed
Self-employed people filing as sole proprietorships do not take a wage and thus are not subject to income tax withholding. However, they are still subject to the above 15.3% in the form of Self-Employed Tax (SE Tax) on Sch. C of their tax return, as well as Federal and State income tax earned by their business on Sch. C. To avoid penalties and interest, as well as a huge bill come tax time, they must pay quarterly estimated tax payments throughout the year. More information on estimated tax payments can be found here.
Details to Review
Worker Classifications
To determine your withholding requirements as a small business owner, begin with your employee vs. independent contractor worker classifications. Independent Contractors are self-employed and thus don’t require withholding. While many employers would love to save money by classifying all workers as independent contractors, most are not. If you control what they do and when they do it they’re probably an employee. You can read more about the IRS employee vs. independent contractor tests here.
Life Changes
Major life changes often have major tax impacts, and you should double check your withholdings when they occur. Marriage, divorce, and death can change your filing status and tax bracket. Children and dependents can affect the credits you qualify for. Job changes, such as working in another state, can have unexpected state tax consequences.
Safe Harbor
The IRS will not charge you underpayment penalties if you’ve paid in 90% of your current year tax or 100% of your prior year tax (110% if AGI > $150,000). For example, a taxpayer whose income went up this year calculated their year-to-date withholding and projected that they would meet the 100% prior year tax threshold by the end of the year. They knew they would still owe, but didn’t want to pay anything additional at that time, and felt happy knowing they wouldn’t owe any additional penalties.
Check your Withholding
For a quick, rough estimate, take your most recent paystub and project your gross wages and Federal and State withholding for the year based on the remaining weeks in the year. Compare that to your prior year tax return. Income up but taxes the same or lower? You’ll probably owe more than you did last year, or receive a smaller refund if you overpaid.
For a more detailed Federal estimate, try out the IRS tax withholding estimator, found here. This tool can be a great resource, but it can also be difficult to use. As the site says, you should have copies of your most recent paystubs, other income and your most recent tax return to assist you. You will complete a mini tax return, and the output will only be as good as the input.
Working with Haworth & Company, Ltd.
At Haworth & Company we love planning ahead and helping you make smart decisions. Small business owners can sleep better at night outsourcing their payroll to our trusted EZ Payroll team and never worry about whether they’re withholding the correct amount or when to remit payroll taxes. They receive proactive tax planning from their trusted Business Advisor, who will go over their projected business income, withholding, and estimated tax payments so they know months in advance where they may stand come tax time, as well as strategies to reduce their taxes. If you own a small business in the greater Minneapolis/St. Paul or Rochester areas and want to take a proactive approach to payroll and taxes please give us a call.
