There are many complexities when it comes to Employment Taxes. Continue reading to learn more about Income Taxes on the Federal, State, and Local levels.

💡 For the most up-to-date information on Federal, State, and Local tax information, websites such as the IRS or USA.gov are great resources.

One of the first facts to discuss is taxable wages. The IRS defines taxable wages as “all remuneration for services (including noncash benefits).” Publication 15, (Circular E), Employer’s Tax Guide, states “Wages subject to federal employment taxes generally include all pay you give to an employee for services performed. The pay may be in cash or in other forms. It includes salaries, vacation allowances, bonuses, commissions, and taxable fringe benefits. It doesn’t matter how you measure or make the payments. Amounts an employer pays as a bonus for signing or ratifying a contract in connection with the establishment of an employer-employee relationship and amount paid to an employee for cancellation of an employment contract and relinquishment of contract rights are wages subject to social security, Medicare, and FUTA taxes and income tax withholding. Also, compensation paid to a former employee for services performed while still employed is subject to employment taxes.”

🎓 You can also find information about supplemental wages in Publication 15-A and taxable and nontaxable benefits in Publication 15-B.

An initial concept that is important to taxability is the idea of constructive receipt. Wages are considered to be paid when the employee actually or constructively receives their paycheck - free of restrictions. Even if the employee does not have the check in hand, if it has been set aside for an employee, it is considered constructively received.

Taxing tips can be somewhat confusing as some tips are left in cash and others are left on a credit card or debit card. The constructive receipt and thus the taxability is when they are reported and then recorded with the payroll. If the reported tips are at least $20 in a calendar month, they are taxable for all federal employment taxes (and most state taxes). If the wages paid to the employee are not enough to collect all of the taxes, the taxes are collected in the following order:

In the case that there is not enough money to deduct the Social Security and Medicare taxes, the shortage or uncollected amounts get reported on the employee’s Form W-2 in box 12 with codes A and B. The employee will pay these taxes (and any uncollected federal income tax) when they file their Form 1040. The employer is still responsible for their portion of Social Security and Medicare.

It is vital to withhold the correct amount of federal income tax from each employee's check. If not, you could be held liable for the amount that should be withheld. There are a number of factors that go into the calculation including (in no particular order):

Regardless of which method is used to calculate the taxes, the basis for the calculation is the pay frequency or pay period. It is not unusual for larger companies to have more than one pay frequency (e.g., biweekly for hourly employees and semi-monthly for salaried employees). Publication 15-T, Federal Income Tax Withholding Methods, is based on the number of pay periods in the year.

There are four basic methods for calculating FITW:

Starting in 2020, with the introduction of the new Form W-4, the IRS published Publication 15-T with the various methods of calculating FITW. Because there wasn't a requirement for all employees to complete the new Form W-4, the IRS had to develop methods of calculating FITW utilizing the old (legacy) and new Form W-4. The worksheets were designed to calculate the FITW either manually or electronically using these worksheets and corresponding tables.

For the percentage method, there are 3 worksheets (tables) that can be used.

The only difference between the two worksheets (4 & 5) is the year of the most recent, valid Form W-4.

For the wage bracket method, there are 2 worksheets (tables) that can be used. These are generally only going to be used to calculate a manual check. The only difference between these two worksheets is the year of the most recent, valid Form W-4.

The flat rate method is used for supplemental wages. The definition of supplemental wages can be found in Publication 15, (Circular E) Employer’s Tax Guide. In it, the IRS defines supplemental wages as “wage payments to an employee that aren’t regular wages. They include, but are not limited to, bonuses, commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, reported tips, retroactive pay increases, and payments of nondeductible moving expenses. However, employers have the option to treat overtime pay and tips as regular wages instead of supplemental wages.”

If the year-to-date (YTD) supplemental wages are equal to or less than $1M, the optional flat rate can be utilized. The current optional flat rate is 22% (2022). If the YTD supplemental wages exceed $1M, the mandatory flat rate MUST be used. The current mandatory flat rate is 37% (2022). If an employee claims exempt on Form W-4, the optional flat rate will not result in a FITW deduction. However, if the mandatory rate must be used and the employee is claiming exempt, the mandatory rate must be used.

These rates come from the Publication 15-T percentage tables.

The last method is the aggregate method, which is actually a combination of taxing regular and supplemental wages together. This calculation utilizes either the percentage method or the wage bracket method (any appropriate worksheet). This calculation is a 3-step process.

Example: Theodore is paid biweekly and has regular wages of $1,500. He also earned a bonus of $500 this pay period. Theodore claims Single with no other entries on a 2022 Form W-4. Using the wage bracket method the taxes would be calculated as follows:

Social security tax pays for benefits to retirees, disabled workers, and survivors of deceased workers. It is critical that employers properly tax and report these wages to the Social Security Administration (SSA) so the benefits can accurately be calculated. This is accomplished on each employees’ Form W-2. Medicare tax began in 1966 and was originally established at a rate of 0.35% for each employee and employer.

Like FITW, the taxable wages are defined very similarly. Once the taxable wages have been calculated, then the taxes can be calculated properly.

The social security rate is 6.2% for the employee deduction and the employer match. The wage base is $147,000 for 2022 ($142,800 for 2021). The maximum deduction (and employer match) for 2022 = $9,114.00. There is no age limit so even if the employee is collecting social security benefits and still working or has reached the age of eligibility, the employer still has an obligation to withhold and pay their portion of social security up to the wage base.

The Medicare rate is 1.45% for the employee deduction and the employer match. Although there is no wage base for Medicare, there is an additional Medicare tax that must be withheld once an employee reaches $200,000 of taxable wages. That rate is 0.9% (no match) of each dollar above $200,000. When establishing this deduction, it is advisable to have a separate accumulator for the additional Medicare tax for a couple of reasons. It is reported differently on the Form 941 and it is taxed differently as there is no match for this deduction.

It is the employer’s responsibility to withhold and pay the social security and Medicare taxes accurately and timely. If either or both of these responsibilities are not properly carried out, the employer could be responsible for paying Trust Fund Penalties which will be assessed by the IRS.

Calculating state income tax is dependent on the state the employee works in. If the employer operates in only one state, there are generally no issues with state income tax or state unemployment insurance (SUI). However, when a company operates in more than one state, there are more issues with state taxation.

One of the first concepts which needs to be evaluated is NEXUS. Nexus literally means a business connection. Nexus is established simply by having a business presence in a state. This could be an office, store, warehouse, or simply when any employee goes into a state to make a sales call or perform any service. With more workers working remotely, it may be necessary to reach out to the state agencies to determine how each handles remote workers.

For income tax purposes, if a company or employer has a NEXUS relationship with a state, they are obligated to comply with that state's withholding requirements. Although each state has its own rules, generally speaking, one looks at the basic rule of thumb or the three rules of withholding.

The basic rule of thumb or default rule for withholding state income tax is the starting point. That default rule is to look at the state the services are performed in. If the residence state and the state services are performed are one and the same, again, you have few if any issues. However, when the resident state differs from the state where services are performed, then you need to look at the three rules for withholding.

Again, each state is slightly different in its definition but generally, it is the state where the employee has a residence or where they return to from vacation. This is primarily because the taxing state will have different rules for the taxation of residents and non-residents. There are rules for taxing residents working outside of the state and for nonresidents working inside the state. So the concept of residency is primary to taxing the employee properly.

Most states have a two-pronged definition of residency:

If an employee works in a state which is not their state of residency, then it is important to determine if the two states have a reciprocal agreement or reciprocity. If they do, then you will only be responsible for taxing the employee in their resident state. Generally, there will be a nonresidency form that will need to be completed by the employee. If the company has a NEXUS relationship with the resident state, then it must withhold for that state. If they do not have NEXUS with the resident state, they can still do a curiosity withholding.

🚨 Caution: Establishing a withholding account in a state MAY create NEXUS so it is advisable to coordinate the establishment of the withholding account with the corporate tax or legal teams.

The advantage of a reciprocal agreement is to (hopefully) reduce the administrative burden on the payroll department. If no reciprocity exists, the company (payroll department) can be burdened with a) determining the state of residency, and b) the correct taxation. In some cases, the employer will be responsible for taxing and reporting the wages to both states. This brings us to the third rule.

Much like the residency definitions, each state had its own rules on the taxation of residents working outside the state as well as nonresidents working inside the state. Generally, the taxation begins with the worked-in state’s rules. However, you must also consider the rules of the resident state for taxation of residents working outside the state. If the company or employer is required to tax and/or report in both states, generally there is a credit for the taxes paid in one or the other state.

Example: Oregon and Idaho do not have a reciprocal agreement. If an Oregon resident comes to Idaho to work, we look at Idaho's rules first. Idaho's rules for nonresidents state that “withholding required on services performed in state if the employee earns $1,000 or more in the year in ID and is subject to federal income tax withholding (report all ID wages on Form W-2 even if no ID tax is withheld.)”. Then, looking at Oregon's rules for residents working outside the state, the rules state to “withhold (report wages) unless withholding is taken for the state where services are performed.”.

It is important to note here, when an employee moves (especially if to a new state), it is important for the employee to update their master file data as soon as possible. This can change the taxation of their wages depending on their new state of residency and their worked-in state.

There are any number of jurisdictions within the United State which have a local tax that must be withheld from wages and paid to the jurisdiction in question in a timely manner and on different cadences. It would be virtually impossible to cover them all in this training document.

The states with local taxes (as of March 2022) are:

Not all of these jurisdictions have a withholding component, so they are an employer's liability, which is only based on the payroll data maintained in the system of record and is reported and paid on a quarterly or annual basis.

Additionally, they have different rules of taxation based on 1) worked location, 2) resident location, or 3) both. Example: In Williamstown, Kentucky, there is a life-size replica of Noah’s Ark called the Ark Encounter. It is a museum with tours and educational sessions. The employees of the museum pay a local income tax which is collected from their pay. It is not collected from ticket sales or donations; only from the employees working there.

💡 For the most up-to-date information on Federal, State, and Local tax information, websites such as the IRS or USA.gov are great resources.