Federal Payroll Requirements

Federal Requirements for Setting Up Payroll in a New Business

Starting a new business takes a lot of work. A new business owner must decide what legal structure to use, prepare a market plan, acquire financing, obtain business licenses and permits, etc. The possible alternatives seem endless, but if your business will be paying employees, then there are specific requirements that are either necessary or highly recommended.

Although some of the following steps are not required by law, we recommend that all new businesses with employees carry out the following steps:

Obtain a Federal Employer Identification Number (EIN). This step is normally required for all businesses except sole proprietorships, but even a sole proprietor must obtain an EIN if he hires any employees. Details on how to obtain an EIN can be found in IRS Publication 1635, Understanding Your EIN.
Enroll in the Electronics Federal Tax Payment System (EFTPS). Since January 1, 2011, employers could no longer use tax coupons and make deposits at their bank.
Enroll in the Social Security Administration's Business Services Online (BSO). Since all wages paid are reported to the SSA and the key to accurate reporting is using the employee's correct Social Security Number (SSN), this can be used to verify employee SSNs. In addition, small businesses can electronically file their Forms W-2 and W-3 on this website.
Obtain the necessary IRS publications and forms from the IRS website.
Obtain software for calculating payroll and taxes, or use a payroll services provider, such as Justworks, as your payroll administrator.

Why are these steps necessary? Page 4 of IRS Publication 15, (Circular E), Employer's Tax Guide lists all of the employer's responsibilities, and the above steps enable the employer to fulfill those responsibilities. So let's consider these responsibilities in detail.

Obtain Required Documentation from Each New Employee

Before an employer can employ an individual, it must establish two important facts: (1) the individual's identity, and (2) the individual's right to work in the United States. This is accomplished by having the employee complete Form I-9, Employment Eligibility Verification.

In order to calculate federal income taxes that must be withheld from an employee's payroll, the employee must complete Form W-4 (Employee's Withholding Allowance Certificate). An employee has to record his Social Security Number on both the Form I-9 and the Form W-4, but each employer is required to “record each new employee's name and number from his or her social security card. Any employee without a social security card should apply for one.” (IRS Publication 15, p. 4.)

In addition to seeing a new employee's social security card, employers can use the SSN Verification Service on the SSA BSO website to verify that the information obtained from the employee is accurate and valid.

Withhold and Deposit Federal Taxes

Every employer must withhold the following federal taxes from each employee's pay:

Federal income tax
Social Security tax
Medicare tax
Additional Medicare tax if required

The federal income tax is a graduated tax, and IRS Publication 15 contains complete instructions and tax tables for calculating the tax.

The Social Security tax and the Medicare tax are straight percentages. The Social Security tax is currently 6.2%, but it is withheld from only a portion of the employee's earnings. (In 2018 the maximum earnings subject to the Social Security tax is $128,400.) The Medicare tax is 1.45% of all of an employee's earnings. If an employee's earnings exceed $200,000 during the year, an additional 0.9% must be withheld from the excess earnings.

In addition to the taxes withheld from an employee's payroll, the employer must also pay the following taxes based on employees' earnings:

Matching Social Security tax
Matching Medicare tax
Federal Unemployment tax (FUTA)

The tax rate for the matching employment taxes is the same as the employee's. Employers do not have to match the Additional Medicare tax paid by employees.

The federal taxes that are withheld from an employee's payroll, as well as the matching taxes paid by the employer, must be deposited with the IRS at least once each quarter using EFTPS. The actual frequency of deposits is determined based on the average total accumulated taxes for each payroll.

The minimum FUTA tax that must be paid by each employer is 0.6% of the first $7,000 earned by an employee each year. The tax must be deposited with the IRS using EFTPS at least once during the calendar year, and it must be deposited if the accumulated liability totals $500 or more during any single calendar quarter. For more information on how the rate may change for an employer, see the article How the Federal Unemployment Is Calculated.

File Information Returns

Each employer is required to file the following tax information returns each year:

Form 941, Employer’s Quarterly Federal Tax Return, is filed with the IRS each quarter, and it is due by the last day of the calendar month following the end of each calendar quarter. (Some small businesses may qualify to file Form 944 once a year instead.) The form is used to calculate the employer’s total liability for withheld and matching taxes. Any federal depositories are also reported on the form in order to determine whether or not the employer owes additional taxes or is due a refund.
Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, is used to report the employer’s FUTA tax. The return must be completed and filed by January 31 of the following year. Any unpaid liability may be either paid with the return or electronically deposited.
Form W-2 is used to report each employee’s wages and withheld taxes for the calendar year. This information is reported to the Social Security Administration (SSA), and each employee is given copies that the employee uses when he files his income tax returns. Form W-3 is a form that is used to reconcile and total all of the amounts reported on individual Forms W-2. This form is also sent to the SSA, and the totals reported on it must reconcile to the totals reported on Forms 941 and 940 for the calendar year.

The above discussion outlines only the federal requirements for payroll, but a business is also responsible for state and local payroll tax requirements as well. These may include state income taxes, unemployment taxes, and new hire reporting requirements.