Payroll compliance requires all sizes of businesses—even those with a single employee—to adhere to all federal, state, and local guidelines that regulate how employees are paid. Everything from withholding requirements to unemployment insurance contributions must be filed on time, and employers that violate the regulations are subject to steep penalties and risk being shut down.
Here are 12 things to know to keep your business on the right side of payroll compliance in the coming year.
Hiring Your First Employee
- Obtain an Employer Identification Number (EIN): An EIN (also called a Federal Tax ID Number) is a nine-digit number used for tax filing, reporting, and other documentation purposes. The EIN is required for any business with employees and companies that operate as a partnership or corporation. You can apply for an EIN through the Internal Revenue Service (IRS) website portal or by faxing or mailing Form SS-4 to the IRS.
- Register with the state: Before hiring any employee, you must register your business with the state where your business is formed. Typically, this requires the company to obtain an employer tax account number from the state’s department of revenue or employment development department.
- Register for unemployment insurance: Unemployment insurance Tax (UI) is a federal program that provides temporary payments to unemployed workers (who are unemployed, not based on their own actions). Each state has its own unemployment rates and thresholds for qualifications. UI contribution is the responsibility of the employer.
- Check for additional requirements: State payroll tax regulations and requirements vary by state, so check with the state of formation for other tax obligations. For example, in addition to payroll and UI taxes, California imposes a State Disability Insurance Tax (SDI) and Employment Training Tax (ETT) on employers.
- Complete all required payroll forms: For federal purposes, employees must complete a W-4 withholding form and an I-9 form to prove the employee is legally permitted to work in the United States. In addition, check to see if your state requires a state withholding tax form to be completed and submitted.
- Understand your tax obligations: As an employer, you must know which taxes must be withheld from employees and which taxes you are obligated to pay.
- Federal income tax—withheld from employees’ paychecks.
- State income tax—withheld from employees’ paychecks.
- Local income tax—withheld from employees’ paychecks.
- FICA—Social Security and Medicare Taxes. (Half is withheld from the employee’s paycheck, and the employer pays the other half.)
- State and local payroll taxes—Some may be withheld from employees’ pay, while the employer might pay others.
- Unemployment taxes—FUTA (Federal unemployment tax is paid by the employer and not withheld from employee paychecks.); SUTA (State unemployment tax is typically paid by employers and not withheld from employee paychecks. This is also known as “SUI,” state unemployment insurance.)
- Workers’ compensation insurance—Paid by the employer, not deducted from employee paychecks.
- Employee wage garnishments—withheld from employees’ paychecks.
- Benefits and other voluntary deductions—withheld from employee pay.
Local Payroll Compliance
- Research local income taxes: In addition to federal and state payroll tax obligations, many municipalities require additional income taxes from employees and employers working and/or living in specific locations. For example, employees living in New York City must pay an additional surcharge on their wages; employers with employees working or living in Newark and Jersey City, New Jersey, must register with those cities and pay a 1% employer tax.
- Research bonus and commission taxes: Some states and cities require employers to withhold special taxes for supplemental wages, such as bonuses and commissions.
Hiring Out-of-State Employees
- Register for payroll taxes in other states: Businesses that hire employees must register to pay payroll taxes in the state(s) where the employees work. The state departments that govern labor and payroll taxes vary by state; however, typically, out-of-state employers should register with the state’s department of labor and the unemployment insurance office. You will be assigned an employer tax account number for that state.
- What to do in states without income tax: Eight states don’t have a state income tax: Wyoming, Washington, Texas, Tennessee, South Dakota, Nevada, Florida, and Alaska. However, employers in these states are still responsible for withholding federal income taxes.
- What if you have employees in multiple states? Employers must register the business with the tax agency of every state where employees carry out their primary work. In most cases, employers hire a third-party payroll service to ensure compliance with each state.
- States with a reciprocal agreement: Several states have “State Tax Reciprocity Agreements,” which allow employees who work in one state but live in another to only pay income taxes to their state of residency. If reciprocity exists, employees must complete and deliver a non-residency certificate to the employer to have the residency state tax withheld instead of the work state tax. However, while reciprocity is based on the employee’s home address, unemployment liability is typically determined by an employee’s/employer’s work address. The following states currently have reciprocity agreements:
- Arizona (California, Indiana, Oregon, and Virginia)
- Illinois (Kentucky, Michigan, and Wisconsin)
- Indiana (Kentucky, Michigan, Ohio, Pennsylvania, and Wisconsin)
- Iowa (Illinois)
- Kentucky (Illinois, Indiana, Michigan, Ohio, Virginia, West Virginia, and Wisconsin (Note: Virginia and Ohio’s agreements are conditional, so check with the states on conditions)
- Maryland (Pennsylvania, Virginia, West Virginia, and Washington, D.C.)
- Michigan (Illinois, Indiana, Kentucky, Minnesota, Ohio, and Wisconsin)
- Minnesota (Michigan and North Dakota)
- Montana (North Dakota)
- New Jersey (Pennsylvania)
- North Dakota (Minnesota and Montana)
- Ohio (Indiana, Kentucky, Michigan, Maryland, Pennsylvania, and West Virginia)
- Pennsylvania (Indiana, Maryland, New Jersey, Ohio, Virginia, and West Virginia)
- Virginia (Kentucky, Maryland, Pennsylvania, Washington, D)C), and West Virginia)
- Washington, D.C. (Maryland and Virginia)
- West Virginia (Kentucky, Maryland, Ohio, Pennsylvania, and Virginia)
- Wisconsin (Illinois, Indiana, Kentucky, and Michigan)
Payroll Tax Changes for 2023
Here’s a quick look at what’s changed for the 2023 tax year:
- The Social Security wage base has increased to $160,200.
- The health flexible spending arrangement (FSA) contribution limit has increased to $3,050.
- The 401(k) pre-tax contribution level has risen to $22,500.
- The FICA threshold for household employees has increased to $2,600.
A Final Word on Income Nexus
If you have full- or part-time employees working and/or residing in states other than the business’s state of formation, then you have income nexus in that state. Nexus occurs when an employee works in a different state, whether or not they reside there. As an employer, you must comply with the other state’s payroll tax regulations and register for foreign qualification.
Also, companies with foreign qualifications must name a registered agent with a local address in the state. A registered agent is a person or company with the authority to accept “service of process” (legal documents and government notices) on behalf of a business. Typically, there’s an initial fee to file for foreign qualification, and the company must renew the registration yearly.
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