Employment Taxes: The True Cost of Hiring an Employee

Before launching into the hiring process, small business owners need to take into account the full cost of hiring employees, including budgeting for salaries and wages of each employee, in addition to out-of-pocket expense of payroll taxes and processing fees.

It might be tempting to calculate and track payroll yourself, but be warned that it’s relatively time consuming and there’s a learning curve, which can be very expensive if you don’t know what you’re doing. It’s relatively inexpensive to hire a payroll processing company, and many banks also offer the service, which usually includes direct deposit of payroll tax liabilities and direct deposit of employee paychecks as well as preparation of the quarterly and year end reports due to the government and W2s for the employees.

To legally hire employees, you must have a federal EIN which can be applied for by completing Form SS-4. You may also need to apply for a state identification number as well.

For each hire, you must withhold the following taxes from each paycheck: federal income tax (based on tax tables), FICA (4.2%), Medicare (1.45%), state income tax (unless you are in a state that does not levy income taxes), and state disability insurance (again, depending on state requirements). What the employee receives is the net pay after these items are deducted--this is the cost for the employee. The withheld taxes are sitting in your checkbook – these are called trust funds – and must be deposited to the government.

The employer must match the FICA and Medicare amounts withheld from each employee’s pay, . Currently the FICA rate is 6.2% of the wage up to $110,100. Medicare is calculated at 1.45% of the employee’s pay with no upward limit.  These taxes along with the employee’s share of FICA and Medicare as well as federal income tax withholding must be deposited with the US Treasury Department via electronic funds transfer. Frequency is regulated by the amount of the liability. It could be you must deposit these funds the day after pay day or once a month or twice monthly. All new employers are set up on a monthly deposit schedule unless the payroll liability is greater than $100,000. Each quarter wages and taxes are reported to the IRS on Form 941.

There is no penalty if you pay your liability with Form 941 if the amount is less than $2,500 and you were not subject to the $100,000 next-day deposit rule at any time during the quarter.

The employer must also pay into the federal and state unemployment funds (FUTA). The rate is 0.8% of the first $7,000 of an employee’s pay each year. Once you have accumulated more than $500 of FUTA tax, you must make a deposit. Annually, if you pay wages in excess of $1,500 you must report the wages and liability on Form 940.

Each state has different requirements and rates regarding unemployment taxes, so check with the appropriate department in the state in which you do business.

If you are a sole proprietor or in a partnership with your spouse and you hire your own child who is under the age of 18, you do not have to withhold and match FICA and Medicare taxes.

Some fringe benefits are subject to payroll taxes, so be sure to check out the rules in Publication 15-B.

The IRS does not take kindly to failure to deposit trust fund taxes – these are the withholdings from your employee’s pay and is your employee’s money. If for some reason you are unable to deposit the entire payroll tax liability by the due date there is a penalty. If you can make a partial deposit, do so and mark it “Form 941 trust fund taxes.” If you cannot pay the full amount, always pay the trust fund taxes first.

The penalty for failure to deposit trust fund taxes can be levied against the owners, the accountant or employee who controls the payroll tax deposits, and can be as much as 100% of the liability. It is considered a civil penalty. It is next to impossible to reduce the liability via an offer in compromise and it cannot be discharged in bankruptcy. In fact, there is no statute of limitations on the collection of these trust funds.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook