Tax Withholding for Small Businesses

When you own a business that hires employees, it is your responsibility to withhold certain payroll taxes determined by tax rates published by the IRS. You also have to pay your portion of Social Security and Medicare taxes for each employee and send a W-2 to both the employee and the IRS at the end of each year. Keep in mind that you only need to withhold taxes from an employee's paycheck if they are true employees and not independent contractors (ICs).

Difference between Employees and ICs

The main difference between an employee and an independent contractor is that with an employee you are able to direct how a job is performed. You can control or oversee each step and manage the employee as they do the work. With an independent contractor, you are only able to dictate what the end result will be, not how the work will get done. If your "employee" has the legal right to control what he or she does in order to complete your project, then that person is an independent contractor. If you have the legal right to dictate level of job performance, then the person is an employee. This distinction is important because you have to pay employment taxes for each employee, whereas independent contractors will pay their own.

Filling Out and Updating W-4s

You should have each new employee fill out a W-4 and then have the person update it each year. This is important because if the employee had a child leave the home, had a new baby, got married, had a large refund, or paid a large tax bill in the previous year, their tax status may change. The W-4 will let you know how many exemptions the employee is claiming, which is information you will need to know when using a chart of tax rates provided by the IRS to determine how much to withhold from the employee's paycheck.

Using a Chart of Tax Rates

There are two methods that you can use to calculate withholding amounts: the wage method and the percentage method. The wage method is pretty simple since you use a chart of tax rates provided by the IRS to find an employee's income and number of claimed exemptions to determine the withholding amount. The percentage method takes some small mathematical calculations and is little more complicated. It requires you to multiply a daily, weekly, bi-weekly, semi-monthly, monthly, quarterly, semi-annual, or annual withholding allowance by the number of exemptions claimed; subtract that number from the employee's earnings for that pay period; and compare that number with a chart of tax rates provided by the IRS to determine the withholding amount.

Using a chart of tax rates to calculate and withhold payroll taxes can be complicated and you may even need to hire an accountant to make sure it is done correctly, but it is your responsibility as an employer. Knowing exactly what you need to do the job yourself and how to get it done is a key part of keeping yourself out of trouble with the IRS.

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