Payroll Taxes for Startups: What You Need to Know

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Payroll taxes can be a significant challenge for up-and-coming businesses. Many startups opt to tackle this tricky issue themselves, but managing a growing workforce can quickly become overwhelming, even with the latest and greatest software.

This article provides an overview of payroll taxes for startups. We’ll also highlight common pitfalls, share our top tips, and more, so stay tuned.

What are Payroll Taxes?

Employers and employees must pay special taxes when they pay or receive waves. These taxes go towards government-funded programs like Social Security, Medicare, and Unemployment Insurance. Payroll taxes is an umbrella term that includes all the various types of these wage-related taxes.

Businesses are responsible for withholding the employee’s portion of payroll taxes from their paychecks. Anyone who receives a W-2 typically has Social Security and Medicare taxes withheld from their paycheck. Note that independent contractors (who have earnings reported on 1099s) do not have any payroll taxes withheld from their earnings. Independent contractors pay self-employment taxes on their individual tax returns.

Businesses are also responsible for paying their portion of the payroll taxes and remitting both portions to the government according to specified deadlines. If a business fails to properly handle payroll taxes, it could face penalties and interest.

key components of payroll taxes infographic from tax hack accounting

Key Components of Payroll Taxes

There are two key components to payroll taxes:

  • Social Security: Employees pay a rate of 6.2% of their gross income up to a certain wage base limit, and employers match this amount, making the total contribution 12.4%.
  • Medicare: Employees pay a rate of 1.45% of their gross income, with no wage base limit. Employers again match this, making the total contribution 2.9%. For individuals who earn more than a certain threshold, there’s an additional 0.9% Medicare tax, but this is only paid by the employee.

In addition, most wages also incur a federal unemployment tax, as well as a state-level unemployment tax. Federal rates vary according to the state’s unemployment rate, and sate-level tax rates depend on the state where you reside and earn your income.

Employers are also responsible for withholding federal income tax and state income tax (where applicable) from employee paychecks. Employees will out W-4 forms to determine how much tax is withheld from each paycheck. Some states have their own withholding forms which also need to be completed.

Some localities, like New York and Portland, also require employers to withhold local taxes from employee paychecks. As you can see, state and local taxes vary greatly, so you should ensure you have a thorough understanding of all local taxes that affect your employees.

W-2 Employees vs 1099 Contractors

The IRS has specific rules for who can be classified as a W-2 employee or an independent contractor. Employees generally have permanent work arrangements with their employers, while independent contractors may work for many businesses or have their own business.

There are benefits to hiring W-2 employees. Employers have greater control over the hours of employees and expect long-term training to pay off. The downside is the additional expenses in terms of the employer’s payroll taxes and benefit costs.

There are also benefits to hiring independent contractors. Companies will benefit from the payroll tax savings and lack of benefits for these workers. The downside is that company’s have little control over the contractor’s schedule and run the risk of the IRS later determining that the contractors should have been classified as employees.

Setting Up Your Startup’s Payroll

An efficient payroll system ensures timely and accurate payment to employees, fostering trust and satisfaction among your workforce. Moreover, it aids in compliance with tax obligations and other regulatory requirements, minimizing the risk of financial penalties and legal troubles. A structured payroll system also provides clear financial records, which are essential for audits, financial planning, and securing investments.

As your startup grows, manual calculations and record-keeping become cumbersome and prone to errors. It’s best to decide early on whether to invest in payroll software or hire a payroll service provider. Many modern payroll software solutions automate tax calculations, benefit deductions, and even regulatory reporting. Hiring a dedicated service provider can be an excellent option for startups without the expertise or resources to manage payroll in-house.

Before you can officially run your startup’s payroll, you’ll need to register your business with the Internal Revenue Service (IRS). An essential step in this process is obtaining an Employer Identification Number (EIN). The EIN serves as a tax ID for your business and is required for reporting taxes and other documents to the IRS. It’s also needed when setting up bank accounts or applying for business permits. You can apply for an EIN online using this link.

Reporting and Depositing Payroll Taxes

There are several tax filings that need to be completed once your company starts processing payroll.

  • Form 941: Used by most employers to report federal income tax, Social Security tax, and Medicare tax withheld from employees’ paychecks. It also reports the employer’s portion of Social Security and Medicare tax.
  • Form 944: Designed for employers who owe $1,000 or less in annual employment taxes (including federal income tax withheld, and both the employer’s and employee’s shares of Social Security and Medicare taxes). It allows eligible employers to report and pay these taxes once a year instead of quarterly.

Depending on your total tax liability for the prior year, you may be required to submit payroll tax payments annually, quarterly, monthly, semi-weekly, or next day. The frequency increases as your payroll tax liability increases. If you don’t submit payroll taxes according to your schedule, you will be subject to significant penalties and interest on the late payments.

What to Watch Out For

There are several common errors you should watch out for.

Misclassification of Employees:

A common mistake is classifying workers as independent contractors (1099) when they function more like traditional employees (W-2). This can result in underpayment of payroll taxes and lead to penalties.

Late Deposits and Filings:

Failing to deposit withheld taxes or file required forms by the deadline can result in hefty fines. Startups often overlook these deadlines in the hustle of operations.

Incomplete or Inaccurate Forms:

Submitting forms with missing information, mathematical errors, or discrepancies can draw attention from the IRS and lead to audits or penalties.

Ignoring State and Local Taxes:

While federal payroll taxes often take precedence, it’s crucial not to overlook state and local tax obligations.

To avoid these errors, you should stay educated on tax rules for your area. Note that payroll tax rates can change each year, so you need to be on the lookout for changes. If you do not have time to stay up on all regulations affecting your business, you should consider outsourcing your payroll processing to a third party.

Closing Thoughts on Payroll Taxes

Navigating the intricacies of payroll taxes is a challenging endeavor, especially for startups that are already grappling with numerous other challenges involved in growing a business.

Mistakes on payroll tax returns and payments can have significant financial and legal repercussions. With so many nuances and ever-evolving regulations, seeking guidance from experts becomes invaluable.


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