Payroll

Payroll is the set of activities by which an employer pays its employees and discharges the duties that come with employing them: computing gross pay, withholding income and employment taxes and other deductions, paying the employer's own share of employment taxes, depositing all of it with the government on time, filing the required returns, and issuing wage statements. The paycheck is the visible part and the smallest part.

What distinguishes payroll from other business bookkeeping is that most of the money passing through it is not the employer's to schedule. Amounts withheld from employees belong to the government from the moment they are withheld, and Treasury regulations set the dates by which they must be deposited. Missing one of those dates is a penalty event even where the tax is eventually paid in full.

The first question is which deposit schedule the business is on. Under 26 CFR 31.6302-1(b) the determination is annual and rests on a lookback period. For an employer filing quarterly Forms 941, "the lookback period for each calendar year is the twelve month period ended the preceding June 30." For an employer filing the annual Form 944, the lookback period is the second calendar year preceding the current one. Then:

• Monthly depositor. "An employer is a monthly depositor for the entire calendar year if the aggregate amount of employment taxes reported for the lookback period is $50,000 or less" (31.6302-1(b)(2)(i)). Deposits are due "by the 15th day of the following month" for taxes accumulated during a calendar month.
• Semi-weekly depositor. An employer whose lookback-period total "exceeds $50,000" is semi-weekly for the whole year (31.6302-1(b)(3)). Taxes on payments made Wednesday, Thursday or Friday are due the following Wednesday; taxes on payments made Saturday through Tuesday are due the following Friday. A semi-weekly depositor always gets at least three business days after the close of the period, and an additional day for each legal holiday falling in them.

A new employer is treated as having reported zero employment taxes for any part of the lookback period before it existed, so it starts as a monthly depositor.

One rule overrides both schedules. 26 CFR 31.6302-1(c)(3), the One-Day rule: "if on any day within a deposit period (monthly or semi-weekly) an employer has accumulated $100,000 or more of employment taxes, those taxes must be deposited ... in time to satisfy the tax obligation by the close of the next day." Tripping it also has a lasting consequence for a monthly depositor, which "ceases to be a monthly depositor on the first day after the employer is subject to the One-Day ($100,000) rule" and immediately becomes a semi-weekly depositor for the rest of that year and the following one.

The smallest employers can skip deposits entirely. Under the de minimis rule in 31.6302-1(f)(4), where the total accumulated employment taxes for a return period are "less than $2,500 for the return period" and the amount is fully paid with a timely filed return, it is deemed timely deposited. A parallel rule looks to the immediately preceding quarter. So a very small employer may be able to remit with the quarterly return rather than running a deposit calendar, which is worth checking before buying a service that assumes otherwise.

The penalty is graduated, and it is a percentage of the deposit. Internal Revenue Code section 6656(a) imposes a penalty "equal to the applicable percentage of the amount of the underpayment" unless the failure is due to reasonable cause. Section 6656(b)(1)(A) sets the applicable percentage at "2 percent if the failure is for not more than 5 days," "5 percent if the failure is for more than 5 days but not more than 15 days," and "10 percent if the failure is for more than 15 days." Under 6656(b)(1)(B) it becomes 15 percent once the tax is still undeposited ten days after a first delinquency notice, or after a demand for immediate payment. There is a first-time forgiveness: section 6656(c) allows the Secretary to waive the penalty for an inadvertent failure occurring in the first quarter the person was required to deposit employment tax, or on the first deposit after a required change in deposit frequency, subject to conditions.

A small mistake is also forgiven by rule rather than by discretion: 31.6302-1(f)(1) treats the obligation as satisfied where the shortfall "does not exceed the greater of $100 or 2 percent of the amount of employment taxes required to be deposited" and the shortfall is deposited by the make-up date.

The filing rhythm sits on top of the deposit calendar. Most employers file Form 941, which the regulation names as the "Employer's QUARTERLY Federal Tax Return," four times a year. Certain small employers are instead directed to file Form 944, the "Employer's ANNUAL Federal Tax Return." Federal unemployment tax is reported annually on Form 940, and each employee receives a Form W-2 after year end. Which taxes those returns actually report is treated on our payroll taxes page.

Outsourcing does not transfer the obligation. A payroll service provider or reporting agent can compute, file and deposit on an employer's behalf, and most small employers use one. The employer nonetheless remains the taxpayer responsible for the deposits, which is why the two protective habits worth building are enrolling in the Electronic Federal Tax Payment System in the employer's own name so deposits can be verified independently, and keeping the IRS address on file as the employer's own rather than the provider's so notices arrive.

The annual cycle for a small employer runs like this.

1. Register. Obtain an employer identification number, register with the state for withholding and unemployment insurance, and collect a Form W-4 from each employee.
2. Determine deposit status for the year. Add up the employment taxes reported for the twelve months ended the preceding June 30. At $50,000 or less the employer is a monthly depositor; above that, semi-weekly.
3. Run each pay period. Compute gross pay, withhold income tax and the employee share of Social Security and Medicare tax, apply other deductions, and pay net pay.
4. Deposit on schedule, by electronic funds transfer, watching for the $100,000 one-day override.
5. File and report. Form 941 quarterly or Form 944 annually, Form 940 for federal unemployment tax, and Forms W-2 after year end.

A hypothetical shows the penalty tiers. A monthly depositor accumulates $18,000 of employment taxes during March, making the deposit due April 15 under 26 CFR 31.6302-1(c)(1). It is short of cash and deposits late:

• Deposited April 19, four days late. Section 6656(b)(1)(A)(i) applies 2 percent: $18,000 × 2% = $360.
• Deposited April 27, twelve days late. Clause (ii) applies 5 percent: $18,000 × 5% = $900.
• Deposited May 10, twenty-five days late. Clause (iii) applies 10 percent: $18,000 × 10% = $1,800.
• Still undeposited ten days after a first delinquency notice. Section 6656(b)(1)(B) applies 15 percent: $18,000 × 15% = $2,700.

The penalty is charged on top of the tax and any interest, and it is imposed on the deposit rather than on the shortfall in cash flow that caused the delay. These are hypothetical figures illustrating the statutory tiers, not a prediction of any actual assessment.

What running payroll properly buys

• Deposit and filing compliance is the cheapest form of protection available to a small employer, because the penalties are percentage-based and the correct behavior costs nothing extra.
• Section 6656(c) gives a genuine first-time waiver for an inadvertent failure in the first quarter an employer is required to deposit, and 26 CFR 31.6302-1(f)(1) forgives a shortfall of the greater of $100 or 2 percent that is made up on time.
• An employer whose employment taxes run under $2,500 a quarter may be able to remit with the return under the de minimis rule instead of maintaining a deposit calendar.

What makes it hard

• The deposit calendar is fixed by regulation and takes no account of a business's own cash cycle, so a slow month is a compliance risk rather than just a cash problem.
• The penalty rises with delay, so a business that defers a deposit hoping to catch up is choosing the most expensive option available to it.
• The $100,000 one-day rule can convert a monthly depositor into a semi-weekly one mid-year, and for the following year as well, on the strength of a single large payroll.
• Outsourcing to a payroll provider removes the work but not the liability, and a provider that fails to deposit leaves the employer owing the money.
• State withholding and unemployment insurance run on their own separate schedules, so federal compliance is only part of the calendar.