Tax Rules for Sole-Proprietors with Employees

November 19, 2014 : Mike Slack

Ed note: FICA, FUTA, FIT. No, that isn’t the start of some wacky Dr. Seuss book. It’s just a few of the alphabet soup of taxes that you will need to know once you bring on employees. Lucky for you, our Tax Institute small business expert Mike Slack is here to help you learn more about sole proprietorship taxes.

Hiring employees is a telltale sign that a business is growing and becoming a stable success. The only difficult part is complying with the various reporting requirements.

Generally, employers are required to withhold and deposit federal income tax (FIT), state income tax, social security and Medicare taxes, and federal unemployment tax. Depending on where the employee is working, they may also be required to withhold and deposit local income taxes.

Even when a sole-proprietor hires an employee, the owner’s earnings from the business remain subject to self-employment tax, and they cannot be treated as an employee as well. The exception to this rule is in the case of corporations, where the business owners are considered to be employees of the corporation as well.

Federal and State Income Tax

When hiring a new employee, one of the first documents that should be received is a Form W-4. This form helps determine the amount of federal and state income taxes that should be withheld from the employee’s wages. Failure to receive a Form W-4 from the employee means that the income taxes from their wages must generally be withheld at the maximum rate provided for their amount of wages.

  • How It Is Reported: Most employers are required to file IRS Form 941 quarterly to report income tax withheld from the employee’s wages, while agricultural employers file IRS Form 943 annually. Reporting for state income tax withholdings is varied.
  • Year-Reporting: In addition to Form 941 or 943, an employer is required to file IRS Form W-3, with the employees’ Form W-2s attached, annually with the Social Security Administration.

Social Security and Medicare Taxes

Employers generally must withhold part of social security and Medicare taxes (referred to as “FICA” taxes since they were created based on the Federal Insurance Contributions Act) from their employees’ wages and pay a matching amount themselves.

Currently, the withholding rate is generally 6.2% for social security and 1.45% for Medicare. The employer is responsible for paying an equal amount for each employee. However, once the employee’s wages for that year exceed a certain amount ($117,000 in 2014) their wages are no longer subject to the social security portion of the tax.

Since 2013, employers are also responsible for withholding the 0.9% Additional Medicare Tax on wages and compensation that exceeds a threshold amount based on the employee’s filing status. However, employers are not required to pay matching amounts for the Additional Medicare Tax.

  • How It Is Reported: Most employers are required to file IRS Form 941 quarterly to report FICA withheld from the employee’s wages, while agricultural employers file IRS Form 943 by February 28 annually.

Unemployment Taxes

Federal unemployment tax (FUTA), together with state unemployment systems, provides for unemployment compensation payments to workers who have lost their jobs. Most employers pay a federal and state unemployment tax. Currently, FUTA is only paid on the first $7,000 in wages, while for states this wage base will vary. Only the employer pays FUTA tax, meaning nothing is withheld from the employee’s income to pay the tax.

It is important to note that FUTA rules differ in the case of business employers, farm employers, and household employers.

  • How It Is Reported: The employer should file IRS Form 940 annually to report the amount of FUTA tax on wages paid to employees. Different forms will apply for each state.

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Mike Slack

Mike Slack

The Tax Institute, H&R Block

Mike Slack, JD, EA, is a senior tax research analyst at The Tax Institute. Mike leads research teams focused on business and investment tax issues.