Accurate processing of payroll and all related payroll tax deductions and payroll tax reports is much more complex than many people believe. Based on AccuPay’s experiences dealing with 1,000s of employers over the past 24 years, here are 10 common mistakes which employers make regarding payroll and payroll tax matters:
- MULTI-STATE AND LOCAL PAYROLL TAX REPORTING IS VERY COMPLEX. If an employer has employees who either live or work in multiple states, research is needed to determine which state, local, school district, etc taxes are withheld from the employees, and which states to report and pay state unemployment tax to. If an employer has Indiana only employees, the employer still needs to determine which county tax is required from their employees since Indiana counties have differing county tax rates. Ohio employers must determine how much to withhold from employees for municipal/city taxes, along with school district taxes, which all have different rates and rules. Louisville, KY has various taxes for employees living in Louisville, working in Louisville, as well as Jefferson County and Jeffersontown, KY. Most states have online resources which will explain various state/local/unemployment tax rules which affects multi-state employers. AccuPay licenses software which helps us “pinpoint” relevant taxes on where an employee resides and also where they work. Our MasterTax software pays, files and reports payroll taxes in over 11,000 taxing jurisdictions. Many states have “tax treaties/reciprocity agreements” with one another, which are “exceptions” to the general tax jurisdiction rules.
The various taxing jurisdictions are armed with numerous penalty statutes to fine employers for improper withholding or incorrect reporting and, in many cases, the employer can be financially liable to pay the taxes which were inadvertently not withheld from the employees. WHAT ARE YOUR MULTI-STATE PAYROLL TAX PROCEDURES?
- WORKER CLASSIFICATION IS PERHAPS THE MOST SERIOUS OF ALL PAYROLL/TAX FUNCTIONS. When you hire a “worker” for services, are they an “employee” or instead an “independent contractor”? Most individual workers should be “on the payroll”, OR you need to KNOW why they can correctly be treated as “1099 workers”. IF the IRS is successful in reclassifying a worker from 1099 reporting to an employee who should have been on the payroll, the employer then owes considerable back taxes (which should have been withheld), possible fringe benefits which employees receive, and if the number of 1099 workers are significant, major financial repercussions could exist as to Affordable Care Act reporting and insurance requirements as a “large employer”. The IRS has some excellent online explanations of “who is an employee” as compared to “independent contractors”. We are aware of many organizations who incorrectly classify “1099 workers” to avoid payroll taxes, benefits, etc. HOW DO YOU DETERMINE IF A NEW WORKER IS AN EMPLOYEE OR A CONTRACTOR?
- RETIREMENT PLANS VARY AS TO REPORTING, FUNDING DEADLINES AND EVEN TAX ISSUES.We have observed many mistakes made regarding “qualified retirement plans”, as to taxes to withhold, when to fund the plan accounts, employer matches, and even W-2 coding. Employee 401K plan “elective deferrals” are generally exempt from tax withholding, UNLESS they are Roth contributions (which are “after-tax”). Simple IRA plans are often ideal for smaller employers since they have less complexity than 401K plans, but Simple IRA plans have totally different rules as to Roth provisions (cannot do with Simple’s), funding deadlines, and even W-2 coding for Simple’s is different than 401K W-2 coding. As a “general rule”, 403B annuity and 457 government retirement plans have similar tax and funding deadlines as do 401K plans. MAKE SURE YOU CAREFULLY SELECT THE RETIREMENT PLAN WHICH IS THE BEST FIT FOR YOUR ORGANIZATION, AND ALSO MAKE SURE THAT THE ADVISORY TEAM MEMBERS ARE ON THE SAME PAGE AS TO “WHO DOES WHAT.” Examples include who transfers the funds to the investment custodian, when is the employer match made, etc. ALSO make sure that you do not permit employees to electively defer more than the annual legal limit!!
- FRINGE BENEFIT PLANS MUST BE HANDLED CORRECTLY. Make sure you understand the income and payroll tax treatment of various types of employer-sponsored fringe benefit plans. Health Savings Accounts (HSA’s) employee contributions are “pre-tax” IF the employer has a written Section 125 “cafeteria plan” which includes HSA accounts as a benefit in the Section 125 plan — find your written plan and read it!! Health reimbursement arrangements (HRA’s) are paid by the employer and generally are exempt from any type of employee tax. HSA contributions, both the employee pre-tax and employer matching contributions, are reported on W-2 forms whereas HRA employer contributions do not appear on the W-2 form. Employee group-term life insurance is tax-exempt up to $50,000 of coverage per employee, but the excess over $50,000 is generally taxable to the employer based on IRS tables and also reported on the employee’s W-2 form in box 12, code C. MAKE SURE YOU UNDERSTAND THE TAX AND W-2 REPORTING RULES PERTAINING TO YOUR COMPANY-SPONSORED FRINGE BENEFIT PLANS.
- OWNERS’ COMPENSATION CAN BE VERY TRICKY! Sole proprietors and partners of businesses should take “profit distributions/draws/guaranteed payments” from the business, NOT payroll, since no employer-employee relationship exists between the business and a proprietor or partner. On the other hand, corporations generally pay their “employee-owners” payroll with tax withholdings, similar to any other employee. Limited liability companies (LLC’s) are quite popular and you must determine who the “member/owners” of the LLC are, and whether the LLC is taxed as a proprietorship, partnership, or corporation. Furthermore, several “special rules” pertain to S corporation “employee-owners”, which include “setting” their compensation at a “reasonable level”, as interpreted by the IRS. CHECK WITH YOUR CPA/TAX ADVISER/ATTORNEY ON HOW THE OWNERS SHOULD BE PAID FROM THE EMPLOYER.
- S CORPORATIONS HAVE SPECIAL TAX RULES. S corporations (including LLC’s which have elected S corporation tax status) have “special tax laws/rules” which pertain to their owner-employees. In addition to asking your CPA how much an owner should take via payroll as a “reasonable salary” (WHICH IS YET MORE IMPORTANT IN LIGHT OF THE BRAND NEW 2018 20% DEDUCTION FOR BUSINESS NET INCOME), S corporations should generally pay 100% of the owner-employees’ health insurance so they can totally write-off health insurance premiums as a tax deduction on their Form 1040. The medical insurance premiums are reported on the employee-owner’s W-2 form, and then written off on the owner’s personal income tax return. The owner-employees of an S corporation should not participate in the employer’s group insurance plan or HSA program on a “pre-tax basis”, since participation by employed owners could remove all tax benefits of the Section 125 plan for all employees. Some S corporations may wish to “over withhold” income taxes from their owners’ payroll checks in order to help pay owner income taxes on the S corporation net income which is taxed to the owners. IF YOU OPERATE AS AN S CORPORATION, OR LLC WHICH HAS ELECTED S TAX STATUS, MAKE SURE YOU HAVE DISCUSSED THESE SPECIAL PAYROLL TAX RULES WITH YOUR TAX ADVISER.
- CHURCHES AND PASTORS HAVE UNIQUE TAX LAWS. Churches are exempt from paying unemployment taxes, but the most confusing payroll/tax laws pertaining to churches revolve around their pastors/ministers, technically referred to as “CLERGY” in the tax code. Churches must first identify which of their employees qualify for “minister/clergy” tax status (as a general rule, clergy are “ordained, licensed or commissioned”). Pastors/clergy never have FICA or Medicare tax withheld from their wages, since their participation in the social security system is voluntary on their part as pastors can “opt out” of social security within the first 2 years of their status as “clergy”. Pastors also typically have a “housing allowance”, which is a tax-exempt portion of their salary used for expenses to “maintain their household”. Finally, many churches will agree to withhold a targeted amount of federal income tax to fund a pastor’s “self-employment tax” IFthe pastor has not personally opted out of social security. OUR CONCLUSION IS THAT A CHURCH SHOULD HAVE A TECHNICAL ADVISER OR PAYROLL COMPANY WHICH THOROUGHLY UNDERSTANDS THE SIGNIFICANT SPECIAL TAX LAWS PERTAINING TO MINISTERS/CLERGY.
- USE AN ACCOUNTABLE EXPENSE REIMBURSEMENT PROGRAM. Many employers will reimburse job-related expenses, or pay “allowances”, to employees for their personal payment of expenses which benefit their employer. The 2018 new tax law makes it nearly impossible for an employee to deduct job-related expenses on their personal income tax returns on a Form 2106 as an itemized deduction. Employers who pay “allowances” to cover anticipated employee business expenses generally must report the “allowances” as taxable income on W-2 forms, and also withhold taxes on the allowance-payments. It is not uncommon for an employer to provide fixed payment expense allowances for an employee’s business use of a vehicle, a supply reimbursement allowance, etc. Less taxes will be paid to the IRS and state/local tax jurisdictions IF the employer drafts an “accountable expense reimbursement program” in which the employee substantiates/submits business expenses they have paid personally and the employer reimburses the precise amount of the “proven” expenses, in effect, the employee has “accounted for and to” the employer for their out of pocket business expenses. Reimbursements made by an employer to employees pursuant to “accountable expense reimbursement plans” are TAX-FREE, whereas payment of “allowances” are generally totally taxable for all income/payroll taxes. EMPLOYERS SHOULD GENERALLY MAINTAIN ACCOUNTABLE EXPENSE REIMBURSEMENT PLANS.
- NON-PROFIT EMPLOYERS OFTEN HAVE SPECIAL TAX RULES. There are essentially 3 different types of “non-profit employers” — churches somewhat stand alone as a unique type of 501c3 employer, many charities are yet a different type of 501c3 organization (think American Cancer Society), and many non-profits are not churches nor are they charities, but they generally are not formed with a profit motive in mind (think your local chamber of commerce). You must determine what type of non-profit you are so that the correct federal and state unemployment taxes are paid by your organization. Churches are exempt from both federal and state unemployment taxes (an exception could exist for churches which have lost their status as a church since they are in a PEO arrangement). Non-profit organizations which are not charities and do not have 501c3 IRS charity status (chamber of commerce, business league) pay unemployment taxes just like any other “for profit” employer — no special status for non-profits who are not churches or charities. Non-profit organizations who have received charitable organization status from the IRS never pay federal unemployment tax, BUT often pay state unemployment tax. Each state has their own state unemployment tax statutes for 501c3 organizations, which means that a 501c3 employer with employees who work in different states need to research the SUTA tax application for each state. Many states also exempt very small 501c3 organizations from state unemployment tax status until they reach a certain number of employees. Finally, many states permit 501c3 organizations to choose to either pay the SUTA tax or to reimburse the state unemployment agency for unemployment benefit claims made by former employees. BE CAREFUL WITH YOUR DECISION TO EITHER PAY OR SELF-FUND 501C3 ORGANIZATION UNEMPLOYMENT BENEFITS! PAYING THE SUTA TAX VOLUNTARILY OFTEN IS MUCH LESS EXPENSIVE THAN REIMBURSING CLAIMS, WHICH COULD BE VERY COSTLY FOR EMPLOYEES WHO ARE ON UNEMPLOYMENT FOR SEVERAL MONTHS. DETERMINE THE TYPE OF NON-PROFIT ORGANIZATION YOU ARE SO YOU CAN CORRECTLY COMPLY WITH UNEMPLOYMENT TAX LAWS.
- W-2 REPORTING IS OFTEN RIFE WITH ERRORS. AccuPay has written a “guide” on “How to Read Your W-2”, which we send out annually to our clients so they can answer the inevitable employee questions about their W-2 forms. Wages reported in boxes 1, 3 and 5 are often totally different figures, since “wages” for income tax purposes (box 1) is frequently different from wages subject to Social Security taxes (box 3) and wages subject to Medicare taxes ( box 5). Box 12 has dozens of “information reporting codes” dealing with retirement plans, group-term life insurance, total cost of health insurance, etc. Employers who are multi-state may have multiple copies of the “state/local” tax withholding information, since total wages and withheld taxes must be separately stated for each location, which can not all fit on one W-2 copy. The W-2 also has a box for “pension plan” participation, which affects a person’s ability to contribute and deduct IRA contributions on their personal income tax returns. Box 14 is an “information only” box, which often has helpful information about S corporation health insurance premiums, a pastor’s housing allowance, the amount an employee contributed to an employer-sponsored 529 education plan, and other items which may help an employee with accurate tax information for their Form 1040 personal income tax return. MAKE SURE YOUR HR/PAYROLL DEPARTMENT AND YOUR PAYROLL COMPANY KNOWS HOW TO PREPARE ACCURATE W-2 FORMS. W-2’s ARE NO LONGER EASY!!
CONCLUSION
We have seen virtually every type of payroll/tax/reporting error made by employers over the past 20+ years. Our objective is to be a resource and adviser to employers to minimize mistakes which are time-consuming, costly and frequently frustrate both employees and the employer. Do not hesitate to contact your payroll specialist with questions specific to your unique fact pattern.