Employ
Recruit
Key Takeaways
- Payroll tax is paid for by both employers and employees and is based on the gross earnings of employees.
- Income tax is based on the revenues generated by employees and businesses, with filing requirements varying by entity.
- Employees in the U.S. pay into Social Security and Medicare, but not into unemployment insurance.
- Employers must carefully determine the classifications of their workforce to determine accurate tax deductions.
- With a larger portion of the workforce choosing to be independent contractors, employers must be careful to document everything to file taxes correctly.
Any U.S. employer traversing the world of tax liabilities can find it challenging. This is certainly the case when determining the differences between payroll tax and income tax. Both types of tax provide critical government revenue, yet they are designed with distinct rules and objectives.
Here’s a quick and dirty definition of both payroll tax and income tax, to give you an overview.
Payroll tax is a tax that the government levies on both employers and employees to pay for programs such as Medicare, Social Security, and more. Income tax is based on the earnings of businesses and individuals with certain variables determining the amount that they alone must pay.
What is Payroll Tax?
Now that you have that basic information, in this section we will take a deep dive into what payroll tax is.
Payroll tax is a shared responsibility of employers and employees. This tax is paid based on wages, tips, and salaries reported to the Internal Revenue Service (IRS) as paid to employees. Employees have a certain amount of taxes withheld from their paychecks,and generally includes federal, state, and local taxes as well as their portion of Social Security and Medicare taxes, otherwise known as FICA.
Employers also pay a portion of FICA and they must also pay all of the required federal and state unemployment taxes. Generally, FICA (Social Security and Medicare) is an even split between employees and employers, and it’s based on a percentage of the employee’s gross earnings. For 2024, the total percentage of payroll tax allocated to Social Security and Medicare is 15.3%. Therefore, the employer-employee split is 7.65%.
What is Income Tax?
Income taxes are calculated based on the revenues generated by businesses and individuals. The income tax liability is determined by filing regular tax returns. Businesses are required to file and pay income taxes on a quarterly basis, while individuals must file a tax return once a year. These funds go to the U.S. Treasury department, to be allocated to federal, state, and local government projects and improvements. Examples of these expenses can be paying for road upgrades, giving schools more money for special programs, and funding community projects.
Income tax is deducted from gross reported earnings, with the percentage and amount varying by federal, state, and local governments. Generally, the higher the earnings; the higher the percentage and amount will be for taxes. As of 2024, federal income tax percentages range from 10% to 37%.
It’s important to note that not all states assess income tax, in which case they may charge sales tax, which is a percentage of tax paid on the total cost of goods. These funds go to many community and government programs to support the local and state infrastructure.
What is the difference between Payroll Tax and Income Tax?
As you’ve probably gathered from your reading, there are some key differences between payroll tax and income tax. Income tax and payroll tax are carefully calculated using financial software designed for this task. Some differences between payroll tax and income tax include:
- Payroll tax is a shared responsibility of the employer and employees; while income tax is the sole responsibility of employees.
- Income taxes depend on the tax bracket of the employee; but payroll taxes are calculated on a flat percentage rate.
- All revenue generating entities (businesses and individuals) must pay income tax based on the revenues they earn; however they are taxed at their individual tax brackets.
- A portion of payroll taxes is paid by both the employee and employer, but the employee only pays towards Medicare and Social Security.
- Income taxes pay for public improvements, while payroll tax goes towards entitlements.
- Payroll taxes are allocated from every payroll cycle; whereas income taxes are determined by total annual gross income.
- Income tax is levied from various income sources, which may include wages, salaries, commissions, tips, and business profits. Payroll tax only applies to wages and salaries.
What are best practices for processing payroll tax and income tax?
In order to process payroll tax and income taxes correctly, there are some general guidelines to follow. By implementing these best practices your business and the people who work for you can avoid any negative surprises.
Use the appropriate categories for your workforce
The U.S. government mandates that all employers classify their workers based on the requirements of each job and the agreement they have, which impacts what deductions employers must make for payroll and income taxes.
These classifications include part-time, full-time, contractual, freelance, temporary, salaried, hourly, and other factors such as legal status, entitlements, terms of employment, compensation, benefits, and more. Stay in compliance with your payroll and income tax classifications, and avoid penalties and lawsuits, by classifying employees correctly.
Complete all required documents and tax forms
During the new hire phase, as an employer you are required to have employees complete certain tax forms and provide documents (like contracts). These forms range from the I-9 and W-4 to formal employment agreements.
Employers must also be sure to complete certain required payroll and tax forms too. These can include Form 940 (Annual federal unemployment taxes), Form 941 (Income taxes and FICA taxes reported every quarter), Form W-3 (Each employee’s wages and tax withholdings reported to the Social Security Administration once a year), and Form 1096 (Payment to independent contractors reported once a year).
Use a payroll software that calculates the correct taxes
As every business grows, the complexities of processing payroll also increase. This is particularly the case with globe organizations and those that employ a wide variety of talent from in-house to remote employees, and contractors.
Once the workforce is categorized correctly, it is very important to have a payroll system that can manage all the different types of payroll taxes and income taxes. Sometimes, this involves a third-party payroll provider or a combination of payroll software.
Remember there may be additional deductions
Employees may also have many deductions, some mandatory and some voluntary. It is a good practice to set these up correctly so they are assessed correctly.
In the case of shared deductions like payroll taxes going to Social Security and Medicare, or benefits like health insurance and retirement savings, getting these correct can support your business and employees alike.
Consider voluntary deductions like union dues and employer loans, and involuntary deductions (debts, child support, court ordered) which are not setup under standard payroll tax.
Maintain accurate records and reports
It can be easy to get caught up in the processing of income taxes and payroll taxes, but then having records and reports that are not up-to-date or accurate. Take the time to update your records with every new hire. Maintain accurate reports by running an audit at least once a month.
Hire the services of a qualified payroll provider or accountant to audit your records at least quarterly when you send your business taxes. This will catch any mistakes that could potentially create havoc on your end-of-year filings.
Ensure Global Tax Compliance
Income and payroll tax obligations are perhaps the most important regulatory requirements imposed on businesses. Making a mistake can be extremely costly. To work out what your tax obligations are in your countries of operation, get in touch with our international expansion advisors.
Frequently Asked Questions
Payroll taxes that are taken out before taxes can reduce the taxable income, while those deducted after tax cannot.
Income is defined by the actual amount of compensation that an entity accepts for providing goods or services. This can include cash, property, stocks, and other items of value.
Author: Tess Taylor
Tess is an experienced HR and Recruitment professional with more than 2 decades in the industry. Tess holds a Masters in Education, and Bachelors in HR Management, as well as professional certifications in HR, professional coaching and instructional design.