Small Business Withholding

What is Withholding?

Withholding is the portion of an employee’s wages deducted from their paycheck and directly paid to the government by the employer on the employee’s behalf. This process acts as a prepayment of the employee’s federal and state income tax, as well as Medicare and Social Security. By withholding the taxes, employers help employees avoid owing a large lump sum at the end of the year.

The amount that is withheld from an employee’s checks varies based on the employee’s earnings and certain details the employee provides on their Form W-4. An employer will generally withhold more taxes for higher earners based on tax brackets and use the information on Form W-4 to account for details such as marital status and number of dependents.

What Taxes are Withheld?

The taxes typically withheld from an employee’s paycheck consist of federal and state income tax, Social Security tax, and Medicare tax. These are collectively known as FICA (Federal Insurance Contributions Act) taxes.

• Federal income tax: The amount withheld depends on the employee’s income, filing status, dependent count, and the information on their W-4.
• Social Security tax: This tax funds the Social Security program, providing benefits for retired workers and their dependents and disabled individuals and their dependents.
• Medicare tax: This tax funds medical benefits for individuals 65 and older and those with certain disabilities.

In addition to these taxes, depending on the location of your business and where your employees live, you may also need to withhold certain state and local income taxes. The rates and requirements for these taxes vary from state to state. 

Because withholding varies for each employee, it’s usually best to use accounting or bookkeeping software that includes a payroll function to calculate employee withholding and other taxes for your business. 

How to Set Up Withholding

As a small business owner, setting up withholding involves gathering details from an employee, calculating how much of your employees’ pay will be deducted for taxes, and withholding those amounts when you issue employee paychecks.

Here are the steps to set up employee withholding:

1. Obtain an Employer Identification Number (EIN)

Before you can start withholding taxes, you need to have an EIN. This is a unique number the Internal Revenue Service (IRS) assigns to businesses for tax purposes. If you don’t have an EIN, you can apply for one directly from the IRS’s website. The EIN will be required when reporting amounts the business withheld from employee checks, as well as for other tax filings.

2. Ask your Employees to Complete Form W-4

Each employee you hire must complete a Form W-4, officially known as the Employee’s Withholding Certificate, at the start of employment. The form provides the information you need to determine how much federal income tax to withhold from your employee’s wages, such as their filing status and number of dependents.

3. Calculate the Amount of Federal Income Tax to Withhold

The IRS publishes tax withholding tables yearly in Publication 15, also known as the Employer’s Tax Guide. These tables and the information from Form W-4 will help you determine how much federal income tax to withhold from each employee’s paycheck.

4. Calculate and Withhold FICA Taxes

Federal Insurance Contributions Act (FICA) taxes include Social Security and Medicare taxes. The employer and the employee each contribute 6.2% of gross income for Social Security and 1.45% for Medicare. Total FICA taxes are 15.3% based on current rates.

5. Pay Federal and State Unemployment Taxes

Employers are responsible for paying Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Act (SUTA) taxes. FUTA tax rate is 6% of the first $7,000 of an employee’s income, but you can usually take a credit of up to 5.4% for SUTA taxes. SUTA rates vary by state, so consult with your state’s unemployment insurance agency for specifics.

Tips for Setting Up Withholding 

Here are some practical tips that can guide you in setting up withholding for your small business that ensure your business’s compliance with tax laws:

• Keep up-to-date with tax laws. Tax laws are subject to constant changes and updates. Stay informed about any changes in tax rates, laws, or forms, and adjust your withholding setup accordingly.
• Document everything. Keep a record of all your tax documents, including EIN, employee W-4s, and any tax payment receipts. This will help in case of any future disputes or audits.
• Use a payroll service. Consider using a payroll service, especially if you have numerous employees. These services handle the complexities of calculating and withholding the correct amounts. QuickBooks has a payroll feature that’s very easy to set up and will automatically classify payroll expenses in your records.
• Educate your employees. Ensure your employees understand the importance of accurately filling out their Form W-4. Explain how it affects their paycheck and taxes.
• Don’t skirt the law by making everyone a 1099 contractor. It’s tempting to make everyone you hire an independent contractor instead of an employee, as it makes the payroll process simpler. However, this is illegal and can lead to hefty fines if found out by the IRS.
• Consult with a tax professional. If you’re unsure about any step in the process, don’t hesitate to consult with a tax professional. They have the knowledge and experience to guide you through the withholding setup process.
• Regularly review your withholding setup. Regular reviews ensure that your withholding arrangements remain compliant with current tax laws and meet the needs of your business and employees.