Payroll Tax Compliance: Overview and Common Problems

Paying taxes is just a part of doing business. When it comes to payroll tax compliance, businesses need the right practices in place to withhold the correct amount from employee paychecks, calculate compensation accurately, and send the withheld taxes to the government.

Failing to comply with payroll tax regulations can mean penalties, audits, and legal issues. You don’t want to risk an even higher tax bill or dealing with months-long problems.

Find out all the basics on payroll tax compliance, common tax issues for businesses, and how to get help. Stephen B. Kass and his legal team are here to assist you with implementing better tax processes and staying in compliance throughout the year.

Key Takeaways:

• Payroll tax requirements – accurately calculate wages, withhold the correct amount of taxes (FICA and income), make timely federal and state tax deposits, and file required returns.
• Failing to comply with payroll tax laws – can result in penalties, audits, and even personal liability for business owners or responsible parties under the Trust Fund Recovery Penalty (TFRP).
• Common errors – misclassifying employees as independent contractors, late deposits due to poor cash flow management, and inaccurate tax reporting or missed deadlines.
• Deposit due dates – The IRS requires FTDs based on employer size and lookback periods. Understanding the correct schedule — monthly or semiweekly — is critical to avoid late deposit penalties.
• Professional help – Stephen B. Kass assists businesses with audits, TFRP defense, and developing better payroll practices to prevent future issues.

How to Comply with Payroll Tax Laws

There are several components of payroll tax compliance to know for New York businesses. Keep in mind that you must comply with federal requirements via the IRS and state and local laws. Here’s an overview of what to do:

Calculate Employee Wages

You won’t be able to accurately report and pay taxes without properly calculating employee wages. This includes calculating totals for each pay period, but also factoring in extras like overtime pay. The employee’s pay as well as the pay period and the information on their W4, determines how much tax you should withhold.

Withhold Taxes

As an employer, you’re responsible for withholding certain taxes from employees’ paychecks. These are:

• • FICA taxes: Social Security and Medicare taxes.
  • Federal income taxes: Based on the federal income tax rate and the employees’ filing status, dependents, and other details.

• State income taxes: Unless you operate in a state without income tax, you must withhold state income tax from your employees’ checks as well. 

The amounts withheld from each paycheck will depend on how much an employee earns and the details they provide on their Form W-4 when they’re hired.

Calculate Matching Employer Payments

Employers must match the FICA taxes withheld from their employees’ checks and remit these payments with their payroll deposits. For instance, if you withhold a total of $1000 in FICA taxes from your employees’ checks, you will make a matching deposit of $1000.

Make FUTA Payments

Employers also need to pay FUTA, which is the federal unemployment tax, along with the state unemployment tax. You must pay this tax if you pay employees who aren’t household or agricultural workers, you paid at least $1,500 to employees in a quarter, or you had at least one employee working in at least 20 different weeks during the year.

FUTA is 6% and is applied to each employee’s first $7,000 paid. You may also have to pay state unemployment tax in your state, but this could make you eligible to take a credit of up to 5.4% of the federal rate, lowering it to 0.6%.

Make Payroll Tax Deposits on Time and File Tax Returns

You then must deposit the tax withholdings to federal, state, and local tax agencies. This must be done by the deadline for each period so you don’t have to pay payroll tax penalties like the late-deposit penalty or the Trust Fund Recovery Penalty (TFRP).

Along with these deposits, you’ll have to submit payroll tax returns each quarter, but some small employers file annually.

Consequences of Payroll Tax Non-Compliance

If you don’t comply with tax laws, whether state or federal, you will have to contend with the consequences right away. Here are the repercussions of noncompliance:

• Tax penalties and interest: The IRS and state agencies charge penalties if you’re late on making a deposit or you don’t deposit enough. These can be very high, not to mention the added interest to your account that accrues until you pay off the balance.
• IRS audits and investigations: When you don’t comply, the IRS will first look into who was at fault for a missed payment or underpayment. This could take a while, requiring investigations into the business and interviews with employees. The IRS may also audit your business if it detects something suspicious.
• Additional professional fees: If you need professional tax help or legal assistance to deal with a complicated issue, that’s an extra cost for your business.
• Getting behind on payments: Missing a payment means that amount is added moving forward, so you’ll have to deal with back pay and any extra costs on top of it.
• Personal liability risk: If you’re found responsible for a payroll tax compliance mistake, your personal property is then at risk for IRS collections. For example, if you get the TFRP as the responsible party for a payroll error, and you don’t pay the penalty or the balance owed, the IRS could come after your assets to cover the bill.

It’s never worth failing to comply with payroll tax law. You don’t want to put your business or personal assets at risk, and you want to avoid building costs with added penalties and interest. Always talk through your situation with a legal expert when you need help.

Common Payroll Tax Compliance Issues

So, what could lead to payroll tax compliance issues? With all the moving parts of running a business, taxes and payroll can unfortunately be overlooked. Here are common problems businesses deal with:

Cash Flow Problems

It’s very common for a business to fail because of cash flow management issues. Cash flow measures the influx and outflow of money, and when something is miscalculated, the whole system can suffer. Make sure you have a plan in place to cover your costs in case a payment comes in late. This will help you ensure you’re not getting behind on tax deposits because you can’t afford to pay them.

Inaccurate Tax Reporting

The amount you withhold from employees and then deposit to tax agencies must be exact and accurate. If you make calculation errors, the IRS or state agency could charge you for underpayment. Make sure you are calculating taxes correctly and have a checks and balances system in place to detect errors.

Missed Payroll Tax Deposits

Another common problem is missing a tax deadline. While you can still pay if you simply forgot the deadline, you will likely have to pay a penalty for making a late payment. Doing this on a regular basis can lead to a building tax balance with additional penalties and interest charges.

Misclassifying Employees and Independent Contractors

Some businesses misclassify employees, which quickly leads to issues. Regular employees who receive Form W-2 have taxes withheld from their paychecks, while independent contractors — those who receive Form 1099 — do not.

There are very specific labor laws that dictate whether someone is an employee or a contractor. If you misclassify these types of employees, you could face penalties and an unpaid balance for missed wages.

How Do Federal Tax Deposits (FTDs) Work?

Federal tax deposits (FTDs) are the payments you make to the IRS that include all the tax withholdings from employees’ paychecks. Form 941 FTDs are the withholding taxes, and Form 940 FTDs are FUTA taxes.

For Form 940 taxes, you need to deposit the correct amount by the last day of the first month following the end of the quarter. For Form 941 taxes, make payments on the same date you pay your employees or before the due date, which will be one of these:

• New employers filing Form 941 for the first time: Monthly schedule depositor for the first year. For every payday within a month, the deadline for monthly schedule FTDs is the 15th of the following month.
• Very small new employers: If you withhold less than $1000 per year, you can make your deposits monthly, but you must indicate that you want to do so when you apply for your EIN.
• Employers with at least $2,500 in taxes per quarter and that have prior payrolls: Either make monthly deposits or semiweekly deposits as follows.
  • Monthly: If your total taxes for the 2024 lookback period (July 1, 2022, to June 30, 2023) are $50,000 or less.
  • Semiweekly: If your total taxes for the 2024 lookback period are over $50,000.

Semiweekly deadlines are as follows:

• For wages paid Saturday through Tuesday, FTDs are due by the following Friday.
• For wages paid Wednesday through Friday, FTDs are due by the following Wednesday.

These requirements and deadlines can be very confusing, especially for newer businesses. Talk to a tax professional about your situation and what you need to do to comply with payroll tax laws.

How to Make Your FTDs

The IRS requires electronic deposits for FTDs. You can use the online business tax account, Direct Pay for businesses, or the Electronic Federal Tax Payment System (EFTPS). Use these tools for quick and simple payments.

What Are Trust Fund Taxes and the TFRP?

Another question you may have is why the payroll tax penalty is called the Trust Fund Recovery Penalty. Trust fund taxes just refer to FICA and income taxes withheld from employees’ paychecks. They’re called “trust fund taxes” because they’re held in trust when you withhold them before you deposit them with the Treasury via FTDs.

If these taxes aren’t deposited as they should be, the IRS initiates the TFRP investigation process. It looks into the mistakes that were made and who made them — in other words, who is the person responsible for payroll and taxes within the business. This person is then charged with the TFRP as the responsible party.

The TFRP is a big penalty — it’s equal to the total unpaid balance of withheld taxes.

Understanding the Failure to Deposit Penalty

Another penalty that goes directly to employers is the failure to deposit penalty, or the FTD penalty. This penalty is applied if you don’t deposit by the deadline, you don’t deposit the right amount, or you don’t deposit using the right method.

This penalty is based on the full amount of the deposit due, not just on the amount withheld from employees’ checks. The amount of your penalty will depend on how late your deposit is. Here’s how it’s broken down:

• 1 to 5 days: Penalty equals 2% of the unpaid deposit.
• 6 to 15 days: 5% of the unpaid deposit.
• Over 15 days: 10% of the unpaid deposit.
• Over 10 days after your first IRS notice or an immediate payment notice: 15% of the unpaid deposit.

The FTD penalty also accrues interest, so plan for that additional charge as well.

In some cases, you could get the penalty reduced or waived if you “acted in good faith” and can show reasonable cause for the noncompliance — such as a natural disaster, death, or serious illness.

The IRS FTD Alert Program

The IRS relies on the FTD Alert Program to automatically identify payroll tax deposit issues. The tool detects discrepancies in deposit behavior and missed deposits. The goal of the program is to catch mistakes early, before the taxpayer is unable to afford the building tax bill.

If the FTD Alert system flags your business and sends notices if a revenue officer wants to talk with you. You may receive Letter 5857 about an upcoming phone call with the IRS to discuss how you’ve fallen behind on your payroll tax deposits. You could also receive Letter 5664 if an IRS agent made a field visit to your business and you weren’t there.

Anytime you’re notified about a payroll tax deposit issue, act immediately. Talk to a tax expert who can help you get through the issue and avoid further expenses and penalties.

Contact Stephen B. Kass About Payroll Tax Problems

Collecting and depositing payroll taxes is a key part of running a business successfully. When you’re falling behind on compliance or are dealing with a business issue getting in the way, we can help at the Law Offices of Stephen B. Kass.

We’ll help you understand your requirements and what went wrong, defend you against the TFRP, represent you before the IRS or New York State tax agency, and negotiate on your behalf. We then work with your business to put better practices in place to avoid noncompliance in the future.

Contact Stephen Kass for a consultation to get started with a tax expert.