Taxes for Inventors with Employees

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Whenever you hire an employee, you become an unpaid tax collector for the government. You are required to withhold and pay both federal and state taxes for the worker. These taxes are called payroll taxes or employment taxes.

You must also satisfy these requirements if you incorporate your inventing business and continue to actively work in it. In this event, you will be an employee of your corporation.

Federal Taxes

The IRS regulates federal payroll taxes, which include:

  • Social Security and Medicare taxes -- also known as FICA
  • unemployment taxes -- also known as FUTA, and
  • income taxes -- also known as FITW. It’s important to withhold and pay these
  • taxes on time and in the proper amount because IRS penalties for failure to do so are substantial.

FICA

FICA is an acronym for Federal Income Contributions Act, the law requiring employers and employees to pay Social Security and Medicare taxes. The IRS imposes FICA taxes on both employers and employees. If you hire an employee, you must collect and remit his or her part of the taxes by withholding it from paycheck amounts and also pay a matching amount yourself.

Employers and employees are each required to pay a tax equal to 7.65% of the employee’s annual wages up to the Social Security tax ceiling, which is adjusted annually for inflation. You can find the Social Security tax ceiling for the current year in IRS Circular E.

There is no Social Security tax on the portion of an employee’s annual wages that exceed the ceiling. However, the Medicare tax marches on: Both you and the employee must pay the 1.45% Medicare tax on any wages over the ceiling.

FUTA

FUTA is an acronym for the Federal Unemployment Tax Act; the law establishes federal unemployment taxes. Most employers must pay both state and federal unemployment taxes. But even if you’re exempt from the state tax, you may still have to pay the federal tax. Employers alone are responsible for FUTA. You may not collect or deduct it from employees’ wages.

You must pay FUTA taxes if:

  • you pay $1,500 or more to employees
  • during any calendar quarter -- that is, any three-month period beginning with January, April, July or October, or
  • you had one or more employees for at least some part of a day in any 20 or more different weeks during the year. The weeks don’t have to be consecutive, nor does it have to be the same employee each week.

Technically, the FUTA tax rate is 6%, but in practice, you rarely pay this much. You are given a credit of 5.4% if you pay the applicable state unemployment tax in full and on time. This means that the actual FUTA tax rate is usually 0.6%. In 2011, the FUTA tax was assessed on the first $7,000 of an employee’s annual wages. The FUTA tax, then, usually is $56 per year per employee.

FITW

FITW is an acronym for federal income tax withholding. When you hire an employee, you’re not only a tax collector for the government, but you are a manager of sorts of your employee’s income. The IRS fears that employees will not save enough from their wages for their tax bill on April 15 and wants, of course, to speed up tax collections. So the IRS tells you, the employer, not to pay the employees their entire wages but to send part of the money to the IRS.

You must calculate and withhold federal income taxes from all your employees’ paychecks. You normally deposit the funds in a bank, which transmits the money to the IRS. Employees are solely responsible for paying federal income taxes. Your only responsibility is to withhold the funds and remit them to the government.

You must ask each employee you hire to fill out IRS Form W-4, Employee’s Withholding Allowance Certificate. The information on this form is used to help determine how much tax must be withheld from the employee’s pay.

By January 31 of each year, you must give each employee you hired the previous year, a copy of IRS Form W-2, Wage and Tax Statement, showing how much he or she was paid and how much tax was withheld for the year. You must also send copies to the Social Security Administration.

Paying payroll taxes

You pay FICA, FUTA and FITW either electronically or by making federal tax deposits at specified banks. The IRS will tell you how often you must make your payroll tax deposits. The frequency depends on the total taxes you pay. You must also report these payments to the IRS on Form 941, Employer’s Quarterly Federal Tax Return, after each calendar quarter that you have employees. Form 941 shows how many employees you had, how much they were paid and the amount of FICA and income tax withheld.

Once each year you must also file IRS Form 940, Employer’s Annual Federal Unemployment Tax Return or the simpler Form 940-EZ. This form shows the IRS how much federal unemployment tax you owe.

Figuring out how much to withhold, doing the necessary record keeping and filling out the required forms can be complicated. If you have a computer, accounting programs such as QuickBooks can help with all the calculations and print out your employees’ checks and IRS forms.

You can also hire a bookkeeper or payroll tax service to do the work. Payroll tax services are usually not expensive, especially if you only have one or two employees.

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