Who knew that Uncle Sam came in so many forms?
I mean…there’s federal taxes, state taxes, sales taxes, Medicare taxes, social security, unemployment, and so on.
As a business owner, understanding how to navigate taxes can be extremely overwhelming. With our first business, LYFE Marketing, I remember stressing to figure out what was the best way to pay my taxes.
To start, I didn’t know what forms I needed to fill-out. I missed payroll tax filing deadlines that cost me thousands of dollars. Like, literally, I paid my payroll taxes one-day late by accident, the IRS sent me a penalty for over $1,000.
In addition, I didn’t know the requirements of income taxes, especially for self-employed individuals. I thought you just paid your income taxes once per year when you filed your tax return, but NO – I was penalized over $4000 because I didn’t make quarterly “estimated tax payments”.
Fortunately, after becoming a CPA and studying this much more, not only was I able to figure this out for our own business, but many other businesses who are struggling with the same thing.
In this post, I’m going to fully explain the difference between payroll taxes and income taxes. I’m also going to give you some tips to help you in your journey.
Lastly, the information in this post is solely for informational purposes only. It is not meant to take the place of legal and accounting advice specific to your business.
With that said, let’s talk about taxes.
Let’s start with the simplest to understand, but most expensive tax – income taxes.
What are Income Taxes?
Income taxes are taxes based on the amount of income you made in a tax period.
The tax you pay ultimately depends on your income.
There are tax brackets that fully explain the amount you will be taxed based on your income.
For example, let’s say your business made $300,000 in revenue, and $100,000.00 in profit. The business profits is what would be subject to taxes.
Now, on that profit, you are assessed taxes based on each tax bracket.
You’d pay 10% tax on the first $10,000. 12% on the next $30,000 income. And 22% on the next $45,000. And 24% on the last $15,000 of income that you have in that tax bracket.
As you can see, the tax is not a flat tax based on your income. Your income is split into the corresponding tax brackets, starting with the smallest, and allocates each applicable % to your income.
So that’s how income taxes work in general. Here are some important things to keep in mind.
#1 There are Federal Taxes and State Taxes
There are 2 main income taxes you pay – federal and state taxes.
- Federal taxes are paid to the IRS to fund the federal government’s budget.
- State taxes are paid to your State’s Department of Revenue to fund the State’s budget.
Like federal taxes, state taxes also have tax brackets. For example, for the 2019 tax year, this was Georgia’s tax bracket.
As you can see, the state taxes are not as high as Federal taxes.
Now let’s move on the 2nd important thing you need to know.
#2 Tax Return Filings are Different from Tax Payment Rules
Income tax RETURNs are required to be filed once per year. However, income tax PAYMENTS should be made throughout the year.
The tax RETURN shows all of your income, and computes your tax payment (or refund) based on the taxes you’ve already paid.
The tax PAYMENT should be made throughout the IRS. I’m sure you asked them, they’d like to receive tax payments as soon as you receive payment.
And in a way, they certainly do!
Which leads me to my next major point.
#3 How You Make Tax Payments Depends On If You’re an Employer or Employee
This primary way W-2 employees pay their taxes is through payroll tax deductions.
Federal and State Income Taxes are withheld from employee’s paychecks before they even receive their income.
So when tax time comes, they will typically receive a refund, or owe a little more depending on their income tax bracket.
On the other hand, you have self-employed individuals. These are people who are “independent contractors” or own businesses.
Because their pay does not go through a formal payroll system, the IRS can’t just tax every payment they receive. Not yet, anyway.
And if they could, I’m sure they would.
But no, self-employed individuals and businesses receive their payment from customers in cash, checks, bank transfers, credit cards, and so on. And because of this more informal method of payment, the IRS is unable to tax it immediately to get their fair share of taxes as soon as they’d like.
So here’s what they require instead – quarterly estimated tax payments.
You are required to make “estimated” tax payments every quarter.
Now, you’re probably wondering how you’re going to estimate your tax payments.
An easy way to estimate tax payments is by simply looking at your prior year’s tax return. Paying 100% of your prior year’s tax, in quarterly increments, is currently an acceptable method to estimating your taxes.
So all you’d have to do is take your total tax payments for the last year, and divide that by 4. Then pay that every quarter to the IRS.
Now for high-income earners, you may be required to pay up to 110% in estimated taxes per year, so be sure to consult your CPA or tax advisor to make sure you’re doing this correctly.
So that’s income taxes in a nutshell. Now, let’s talk about payroll taxes.
What are Payroll Taxes?
Payroll taxes are taxes imposed on employers and employees based on the employee’s salary.
There are 3 main types of payroll taxes – withholding taxes, FICA taxes, and FUTA taxes.
1. Withholding Taxes
These are income taxes withheld from employees and paid directly to the federal and state governments. These are the same income taxes that we discussed earlier.
So since you understand that already, let’s spend a couple of minutes on FICA and FUTA taxes.
FICA, which stands for Federal Insurance Contributions Act, imposes taxes to fund social security and Medicare taxes.
The tax is split evenly amongst the employee and employer.
For example, there is a 12.4% social security tax and a 2.9% medicare tax, equating to a total tax of 15.3% of employee wages. The employee and employer split this tax percentage, which would mean 7.65% would be paid by the employee, and another 7.65% would be paid by the employer.
But wait, what if you’re self-employed? What if you’re the business owner?
Self-employed individuals do not pay Medicare and social security taxes in this manner. However, instead, they must pay a 15.3% self-employment tax to contribute to social security and Medicare tax.
This means that if you’re self-employed, you must pay the “employee” and “employer” side of FICA taxes.
Certainly not the funnest tax to pay, but there are ways to minimize it. To learn more about that, read this post on “LLC vs S-Corp”.
Now, let’s talk about FUTA taxes.
FUTA, which standards for Federal Unemployment Tax Act, imposes taxes to fund unemployment programs.
FUTA taxes are only imposed on employers, not employees of firms.
So basically, businesses must fund unemployment benefits for each employee that they hire.
Like income taxes, there are federal unemployment taxes and state unemployment taxes. The tax imposed is based on a % of reported wages for the employee.
Ok, so this is the fundamental difference between payroll taxes and income taxes. But I don’t want to leave you here.
Let me give you some filing, reporting, and payment tips so you can avoid hefty penalties and fines that I’ve seen many people make.
Tips in Filing, Reporting and Paying Taxes
#1 Make your estimated tax payments
Pay your estimated tax payments on time to avoid income tax penalties. By doing this, paying your taxes becomes less of a giant to tackle.
I’ve seen self-employed individuals cry and moan about making their tax payments, but, these are the same taxes that would have automatically been deducted from your taxes if you worked at a company.
I recommend aggressively paying your estimated taxes so your tax debt doesn’t become so big that you don’t:
A) save the money to pay it or;
B) decide not to pay it at all and risk bigger consequences
#2 Automate your payroll tax filings
Even though you fully understand payroll taxes, it doesn’t make it any easier to keep up with all of the government agencies, their filing requirements, and payment requirements.
I recommend that you use a system to automate your payroll payments and taxes. QuickBooks, for example, has a full-service payroll feature that automatically files your payroll tax returns and makes automatic payroll payments to the respective government agencies.
I suggest that you use an automated payroll system to make this process easier for you. I haven’t missed receiving another tax penalty ever since I automated my tax filings. The extra cost is well worth it, if you’re avoiding big tax penalties that come with missed deadlines.
#3 Tax Plan
As a business owner, there are ways to minimize your overall tax liability. You start by reading other tax posts here on our blog, or contacting us directly to receive a custom tax plan for your business.
With this said, let’s quickly recap this post.
Today we discussed the difference between payroll taxes and income taxes.
Income taxes are taxes based on your income. Payroll taxes are taxes based on your pay. Specifically, it imposes pay-based taxes to advance income tax payments, medicare and social security taxes, and unemployment taxes.
Businesses must pay all taxes, and employees pay all taxes except unemployment taxes.
My biggest suggestions to you are:
- to start making your estimated tax payments
- use automated payroll software to simplify tax filings and payments
- have a tax plan to minimize your tax liability
I hope you found this post useful and interesting.
And if you need any help with your taxes- whether you’re a business owner or an individual, we’ve got you covered. Reach out to us today to get started!