Payroll Tax vs. Income Tax – What Is the Difference?

By Daniel Lewis
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Technically, both payroll and income tax are distinct. And you need to understand both in order to withhold employment taxes. Don’t make the mistake of treating them both the same or using the terms interchangeably. It could cost you at tax time.

Editor’s Note: Under President Trump’s Executive order as of early September 2020, employers have the option of withholding employee social security or not. If you want to be nice to your employee, you can pay them 6.25% extra so their take-home pay is increased, instead of withholding it. This lasts from September 1 to December 31. Employees will have to repay the amount in 2021. 

Payroll Taxes vs. Income Taxes: A Brief Introduction

There are many similarities between income and payroll taxes. Both of these taxes are withheld from an employee’s paycheck. First, you tot up the total hours worked per employee. This will give you the gross pay.

After all of the deductions and contributions have been shaved off the top, you are left with net pay, alternatively called the take-home pay. This is what you actually pay your employees. The two primary distinctions between payroll and income taxes are that:

  1. Payroll Tax – This refers to Medicare and Social security, which are collectively known as FICA (“Federal Insurance Contributions Tax) tax contributions. Employers and employees each pay half of the FICA tax. It will be a percentage of the employee’s pay.
  2. Income Tax – This tax goes to Local, State, and Federal funds. Every employee will pay Federal tax unless exempt. Most states will have an additional state income tax. A small percentage of localities will have a local income tax. To understand payroll tax obligations, you need to look at the Form W4 for each employee, which each new hire fills out at the outset of employment.

So both taxes go to different funds and thus have to be accounted for differently. You must withhold each tax separately. However, you can account for both on the same form (Form 941 or Form 944).

Income Taxes In-depth

Incomes taxes are progressive, meaning they increase the more you earn. So you will have to calculate the income tax per employee using the Form W4. This will contain information such as marital status, withholding requests, dependents, disabilities, and other variables that determine the total income tax obligations.

Take a look at the IRS publication that governs income taxes for employees. As you can see, it contains a lot of information. This is where having a streamlined system can help, as it does all of it automatically. According to the publication:

“To know how much federal income tax to withhold from employees’ wages, you should have a Form W-4 on file for each employee. Encourage your employees to file an updated Form W-4 for 2020, especially if they owed taxes or received a large refund when filing their 2019 tax return.” 

To make it easy on yourself, can use the IRS withholding tax estimator. You can merely fill in the details to estimate the withholding tax per employee. But it is still far easier to purchase automatic software that does it for you and also files the forms for you with the relevant authorities.

This is just the Federal tax. The State and Local counties may have additional taxes you need to consider. However, these are generally more straightforward than Federal taxes. You will need to furnish employees with state tax withholding forms if there is one in place. For local taxes, consult your local authorities.

Payroll Taxes In-depth

Payroll taxes are a flat percentage of employee earnings. Social Security is 12.4% and Medicare is 2.9. So total payroll taxes are 15.3%. But you will only be paying half of this figure, and the employee will pay the other half. So you will contribute 7.65% and withhold 7.65% (yes, the IRS tax code is needlessly complex and inefficient).

For the purposes of payroll, you will be withholding 7.65% from the employee gross pay, and this money goes to Social Security and Medicare. In the event that an employee earns above $200,000, the Medicare obligation increases by 0.9%. This is levied on the employee only, and the employer will have the original 1.45%. To recap:

Employee pays: 1.45% + 6.2% = 7.65%
Employer pays: 1.45% + 6.2% = 7.65%

If you have paid social security of 7.65% for an employee that earns above $127,200, you do not have to pay further social security. While social security is capped, Medicare is not. The thresholds for the additional 0.9% on an employee are included in the table below:

Filing Status Max Threshold
Married filing jointly (income combined) $250,000
Married filing separately $125,000
Single, Head of Household, Qualifying Widow or Widower $200,000

As mentioned above in the editor’s note, employers do have the option of releasing the 6.2% social security to employees, until December 31. The only requirement specified in the executive memo is that you earn no more than $4,000 every two weeks under the latest IRS guidelines.

People who earn more than that will not be able to participate in the payroll tax holiday. It’s unclear how Trump’s payroll tax deferment would affect self-employed workers and contractors who typically pay their Social Security taxes with their income taxes.

However, employees will have to repay the taxes in early 2021 when the economy stabilizes, so it is not free money, merely a tax deferral.

What Is The Federal Income Tax Right Now?

The following is a table listing the Federal income tax for a single individual. Federal income Taxes will change depending on whether you are married and filing jointly or not.

Rate of Taxation Taxable Income Range Owed Tax
10% $0 –  $9,875 10% of taxable income
12% $9,876 – $40,125 $987.50 + 12% of the amount over $9,875
22% $40,126 – $85,525 $4,617.50 + 22% of the amount over $40,125
24% $85,526 – $163,300 $14,605.50 + 24% of the amount over $85,525
32% $163,301 – $207,350 $33,271.50 + 32% of the amount over $163,300
35% $207,351 – $518,400 $47,367.50 + 35% of the amount over $207,350
37% $518,401 and above $156,235 + 37% of the amount over $518,400

There is too much variance in local and states taxes to outline specifically. Check with the appropriate authorities to find out what you are expected to pay. Keep in mind that taxpayers in the most expensive states can pay three times more than the cheapest states. But also keep in mind that this is never the full story, and you can only compare your entire tax burden to another state. You have the look at the whole thing to see it clearly, and not just one or two figures.

The Importance Of Accurate Small Business Accounting

With so many complex nuances in the realm of compliance and accounting, it is essential that you have a streamlined payroll and accounting system in place. There are local, state, and Federal income taxes to be paid, as well as FICA taxes for fixed employees. And this is the only payroll for typical services. How do you account for professional services such as legal and finance on a consultancy basis? How do you account for short term freelancers?

Only by having a secure and automated payroll and accounting system (ideally, but not necessarily, provided by the same vendor) can you expect to handle all of these components successfully. All employee records will be automatically stored in the appropriate repositories for quick and easy retrieval. And files will be automatically filed before the relevant IRS deadlines.

How Did Covid-19 And The PPP Affect Payroll/Income Taxes?

COVID 19 has a major effect on the payment of payroll and income taxes. It led to the creation of the Paycheck Protection Program (“PPP”). This allowed qualifying businesses the capability to pay employees during the disaster. This loan was later forgiven, and the loan amount would take place over 12 weeks. The loan was to be spent on essential payroll costs to keep businesses afloat. It was one of the most sought after loan programs in the history of the United States. 

As mentioned previously, Trump has also issued an Executive Order in relation to the deferral of Social Security until next year. While the media has been hypercritical of this program, employees will certainly be very happy with the extra cash for the time being.

But by and large, payroll and income taxes have remained the same, as has the mechanisms of accounting. They have to, as they play a large role in the wider economy. What happened is that the PPP and numerous other programs came into use which gave businesses the liquidity needed to survive the collapse.

Businesses were thus able to stay afloat and pay their income and payroll taxes, though many employees still got permanently laid off, and many businesses did go under. The IRS tax code is not going to change much, despite the disaster. But liquidity programs can help business owners to meet the obligations imposed under them.

12 Key Payroll & Income Tax Forms

When it comes to payroll and taxes, you need to know your forms. As a business owner, it helps to become familiar with them even if you have a dedicated accountant to see how everything fits together. The following are the most essential forms to familiarize yourself with. You will need to collect information from employees using some of these forms.

#1 – Form W4

One of the most important of all the forms on the list. You cannot really run a business and do payroll without it. Form W4, Employee’s Withholding Certificate, determines the amount of federal income tax to withhold from an employee’s wages. When you hire a new employee, have them fill out Form W4. Form W4 asks for the employee’s information, such as their name, Social Security number, address, and marital status. And, the form asks for the employee’s withholding adjustments, such as claiming dependents.

#2 – Form I9

All business owners (with very few exceptions) are required to file an I9 for every single hire. It determines that the work is allowed to work in the USA and is concerned more with immigration than payroll. It must be completed before the first day of payment.

#3 – Form 1099

This is most often used as a form to record payments made to freelance professionals. Many payment processors now have the capability to cater for 1099 forms. However, some payment processors only offer this functionality at the higher tiers. It is also used to report rental income dividends, sales proceeds, and any other miscellaneous income.

#4 – Form W2

Form W2 (the Wage and Tax Statement) reports the taxes you withheld from employee wages to the IRS. You must file Form W2 for each employee that you had during the calendar year. Use information from your payroll to fill out Forms W2. Send a copy of Form W2 to each employee and to the Social Security Administration (SSA) each year. Keep a copy of Form W2 for your records.

#5 – Form W3

Form W3, Transmittal of Wage and Tax Statements, summarizes information from Form W2. Send Form W3 along with Forms W2 to the SSA. Do not send Form W3 to your employees. Form W3 contains information like total compensation, taxes, Medicare wages, Social Security wages, and federal income. The total tax withheld should match your Forms W2.

#6 – Form 940

Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, is an annual tax form for reporting your FUTA (Federal Unemployment Tax Act) liability to the IRS.

Most employers pay FUTA. However, some tax-exempt organizations do not need to file Form 940 or pay FUTA tax. Do not withhold FUTA taxes from employee wages. File Form 940 if either of the following is true:

  • You paid wages of at least $1,500 to any employee during the standard calendar year
  • You had an employee (temporary, part-time, or full-time) work anytime during 20 or more weeks

File Form 940 once per year to report FUTA payments. File Form 940 online or mail it to the IRS. Use Form 940 Schedule A to help determine your FUTA taxes on Form 940.

The due date for Form 940 is January 31 each year.

#7 – Form 941

This is a very important form for business owners. Form 941, the Employer’s Quarterly Federal Tax Return, reports the number of employees you have, their wages and taxable tips, and the federal income taxes you withheld. Social Security, Medicare taxes, and sick pay are also documented here, along with any adjustments made to them. In most instances, you must file a Form 941 unless you filed a final return, are a seasonal employer, or employ a household, etc. Information filed on Form 941 includes:

  • Wages paid to employees
  • Reported tips
  • Federal income taxes withheld
  • Social Security and Medicare taxes (employee and employer portions)
  • Additional taxes withheld
  • Adjustments to Social Security and Medicare taxes, sick pay, tips, and group-term life insurance

#8 – Form 944

Form 944, Employer’s Annual Federal Tax Return, is for smaller businesses that report federal income taxes and FICA taxes annually, rather than quarterly.

Even though most businesses need to file a quarterly Form 941, some businesses may need to file Form 944 instead. The IRS will notify you if you qualify.

#9 – Form 1095B

Use Form 1095B to report employee health coverage. If you offer your employees a self-insured health plan, file Form 1095B. Self-insured health plans are health insurance plans your business operates versus purchasing coverage from an insurer. Many larger employers have self-insured health coverage. File a Form 1095B for each full-time employee covered by medical. Send a copy to both your employee and the IRS. Keep a copy of your records for at least three years.

#10 – Form 1094B

Form 1094B, Transmittal of Health Coverage Information Returns, is a form that summarizes Form 1095B. Similar to the purpose of Form W3, Form 1094B outlines the information from Forms 1095-B, including the health insurance you offer employees. There is no need to send Form 1094B to employees.

#11 – Form 1095C

Form 1095C, Employer-Provided Health Insurance Offer, and Coverage Insurance provide your employees with health care coverage information. And, it lets employees know whether or not they were covered. Applicable large employers (ALEs) must file Form 1095C. Applicable large employers are businesses that employ at least 50 full-time equivalent employees. ALEs must complete a 1095C form for all full-time employees, regardless of whether or not they had coverage.

#12 – Form 1094C

You must send Form 1094C, Transmittal of Employer-Provided Health Insurance Offer and Coverage Information Returns, along with Form 1095C to the IRS. Form 1094C is a transmittal form summarizing information from Form 1095C. Do not send Form 1094C to your employees.

Summary

We hope that this article clarified the differences between payroll and income taxes. In reality, it is a lot more simple than all the jargon makes it out. Payroll Taxes simply consists of Social Security and Medicare, for a total of 15.3% split equally between the employer and employee. 

Income taxes are calculated depending on how much you earn as an individual. They increase depending on your filing status (especially marital status), but you only pay a certain percentage on a certain tax bracket. In addition, you might also have to pay local and state taxes.

To make it all a whole lot easier, consider using a high-quality payroll service such as Gusto, OnPay, and Patriot Software. They are built to make the entire system of financial compliance a whole lot easier.

FAQ

Is Payroll The Same As Social Security Tax?

Payroll taxes consist of both Social Security and Medicare. So it is mostly Social Security (6.2% for each party) but also contains Medicare (1.45% for each party). In a more general sense, payroll is the payment of various types of workers, such as freelancers, fixed employees, managers, professional third-party services, etc. In order to run a smooth payroll and take care of social security obligations, you will need to make use of payroll software that automatically does it for you.

How Does Trump’s Payroll Tax Work?

Trump’s payroll tax deferral is quite simple to understand. Usually, business owners deduct (“withhold”) 6.2 % of the employee’s salary to pay for the Federal social security fund. This obligation has been deferred so that business owners can give these funds directly to employees. The employees will still have to repay these funds in 2021, as the program only lasts until September 1 to December 31. But most employees would be happy with the extra cash right now.

What Is The Benefit Of Tax Deferral?

Tax deferral is simply an instance where you will pay taxes later as opposed to paying for them today. Depending on both your expertise and your perspective, deferring tax obligations can have advantages or disadvantages. It is never nice having a large tax bill at the end of the year. However, in different industries tax deferral can have different consequences. For instance, tax-deferred retirement investing means your investments can grow tax-free, and you only pay money when you withdraw.

Daniel Lewis
Daniel Lewis
Daniel Lewis is an MBA accredited investment professional who wants to assist small business owners to gain access to finance. After going through many channels for funding, Lewis has found that getting the first loan right is vitally important for future success.