Module 4: Employment Taxes

Nearly everyone earning a salary or wage in the United States is subject to taxation simply by being employed. Employment taxes are an important source of public revenue, but they also burden both individuals and their employers with a suite of compliance requirements. Most Americans pay employment-related taxes to both state and federal governments, but when, how, and in what amount employment taxes must be paid varies based on the terms of employment and the laws of the jurisdiction. In this module, we will discuss the general structure of employment taxes and withholdings in the United States, as well as the circumstances in which wages can be legally garnished from a paycheck.

Types of Employment Taxes

 There are several types of employment taxes, including self-employment taxes, income taxes, Social Security taxes, and Medicare taxes.

Self-employed individuals, including sole proprietors, independent contractors, partners in a partnership or who otherwise work for themselves, must pay both self-employment tax and income tax on their taxable net earnings. These include gross income derived from a trade or business, minus the expenses necessary for it to operate. These net earnings are taxed at a rate of 12.4% for Social Security and 2.9% for Medicare taxes up to an income threshold of $125,000 for individuals or $250,000 for married couples (as of 2019). Self-employment earnings greater than $400 are also subject to income tax and must be reported on annual returns [1]

Employees are subject to different employment taxes than people who are self-employed. Unlike payments to independent contractors, businesses with employees must withhold income taxes and pay Social Security taxes, Unemployment tax and Medicare taxes on all wages paid to employees.[2] Sometimes, it can be difficult to know if a worker is an employee entitled to income tax withholding or an independent contractor subject to self-employment tax. This relationship is determined by the terms of an employment agreement. A worker is considered an independent contractor if she has discretion over how contracted work will be performed. While the business paying for the work is entitled to control the direct result of the contractor’s efforts, she is in control of what will be done to complete the project.[3] While the distinction is not always clear-cut, the more power an employer has over when, how and where a person will perform her tasks, the more she is likely to be considered an employee.

For employees, employment taxes are withheld from their paychecks by the employers. Employers are required to deduct taxes from gross wages, including salaries, tips, bonuses and other financial perks of employment. Typically, part of the onboarding paperwork for a new job includes a Form W-4, which instructs the employer to withhold employment taxes from the employee’s paycheck. These taxes typically include several employment taxes assessed on the federal, state, and local levels.

Common withholdings taxes must be deducted from each paycheck under the Federal Insurance Contributions Act (“FICA,” pronounced “FY-Kah”), as well as federal, state, and local unemployment insurance taxes.[4] FICA taxes include a 6.2 percent tax on gross wages that goes to fund the federal Social Security program and a 1.45 percent tax that supports Medicare. Most states also assess taxes to fund the workers’ compensation program.[5] This is half the FICA employment tax. The employer is responsible for paying the other half. Note that, in the case of the independent contractor, nothing need be withheld, and the contractor/employee is responsible to pay both “halves” of the tax.

Employment taxes generally apply to all compensation from employment, including wages, salaries, bonuses, commissions, vacation allowances and many fringe benefits.

Wage Garnishment and Other Withholdings

 Employers withhold taxes from their employee’s paychecks, but they are entitled (and in some cases, required) to make other deductions as well. Common payroll deductions include health insurance premiums for company plans, job-related expenses like uniforms or personal equipment, union dues and employee contributions to pensions and retirement accounts. Some companies offer employees the option of deducting life insurance premiums directly from their paychecks. Many of these deductions amount to valuable benefits that employees can claim tax-free or tax-deferred. In some cases, an employer may be required to withhold funds from a worker’s paycheck as a wage garnishment.[6]

Wage garnishment is the result of a legal process that results in a court order for deducting a portion of an employee’s monetary wages to resolve an outstanding debt. Wage garnishments are involuntary, and employers are entitled to withhold them from a worker’s pay by Title III of the federal Consumer Credit Protection Act, which applies in all U.S. jurisdictions.[7] Garnishments may continue until the entire debt is resolved or until the worker arranges with the entity entitled to payments from the garnishment to resolve the debt.

There are many reasons a taxpayer might be subject to wage garnishment. The most common reasons wages are garnished include unpaid child support, unpaid court costs, consumer loans in default and outstanding taxes. The amount subject to garnishment is based on the employee’s earnings after legally required deductions. There are, however, important limitations on wage garnishments. For example, the Consumer Credit Protection Act limits the amount that may be garnished from a person’s earnings[8] and it protects people from being fired from their jobs as a result of an order for wage garnishment.[9] Ordinary garnishments – those that are not ordered for a type of support (such as child or spousal), bankruptcy or tax payments – are limited to the lower of:

-       25 percent of the employee's weekly “disposable” earnings (which means earnings over and above certain minimum levels of income)

-       or the amount by which weekly disposable earnings exceed 30 times the federal minimum wage.

Wage garnishment is a subject of federal regulation, but some states discourage the practice as a matter of fairness. [10] For example, Pennsylvania, Texas and North and South Carolina do not allow wage garnishment unless it is necessary for the repayment of a tax-related debt, child support, court-ordered fines or restitution or federal student loans.[11]

Income Taxes

 Income taxes are important components of federal, state and local tax revenues. However, federal income tax liability is typically far greater than state or local income taxes that may apply to individual wages. Together, individual and corporate income taxes typically account for almost 60% of federal tax revenue.[12]

Unless exempt, all taxpayers in the U.S. earning a wage must pay federal income tax. Likewise, with the exception of people living and earning a wage in the handful of states without income tax, workers must file state income tax returns as well. Most working adults are familiar with the process of filing annual federal tax returns, which are due to the IRS each year on April 15. However, whether a taxpayer owes taxes with a return or is entitled to a refund depends on the taxes withheld from her paycheck over the course of the year, as well as other factors.

For the self-employed, the employers must send them Form 1099s at the end of the year. This form shows how much the contractor earned from the engagement, and the form must also be sent to the IRS. Self-employment income is reported by the taxpayer using Form 1040, Schedule C, but self-employed individuals and small business owners with annual expenses of $5,000 or less can use a Schedule C-EZ instead. Typically, this tax is paid in quarterly estimated tax installments using the Form 1040-ES. [13] Estimating this tax liability in advance is helpful because self-employed people do not have employers to withhold these taxes for them.

Any employee who has filed a Form W-4 with her employer can have income taxes withheld from her paycheck, which is reported at the end of the year on the Form W-2 sent to the employee, typically during January. Income tax withholdings are based on the taxpayers’ marital status and withholding allowances, which are exemptions that employees can claim from their tax liability on their W-4s, and how many allowances an employee wants to take is largely discretionary. When taxpayers claim fewer allowances, a larger percentage taxes are withheld from wages. As a result, taxpayers that are particularly cautious about their tax liability may choose to claim fewer withholding allowances than the number to which they are actually entitled. This can result in a larger refund at the end of the year, or a reduced income tax bill if the worker has sources of taxable income that are not subject to withholding.[14] Employees who claim an unreasonably large number of exemptions to decrease withholdings may be subject to tax penalties.

Income tax liability is calculated as a proportion of gross taxable income. The Tax Cuts and Jobs Act of 2017 changed federal income tax laws and affected nearly everyone who files individual or corporate tax returns. For starters, the new law changed the progressive tax rates applied to individual income earners. Most of the seven income tax brackets were adjusted down between 1 and 4 percent, but these reductions were set to expire by 2025 unless renewed by Congressional action. The law also decreased the federal corporate income tax rate from 35 percent to 21 percent.[15]

In rare circumstances, workers can be exempt from income tax. An employee may claim to be exempt from federal income tax withholding because he had no income tax liability last year and expects none in the coming year. If those circumstances apply, a worker can claim an exemption from tax withholding requirements when filing a Form W-4. This form is only effective for one calendar year, and it must be updated annually by February 15 to ensure the exemption remains in place. [16]

In addition to federal income tax, most people must pay state income taxes. Every state that has an income tax enforces its income tax laws through a state revenue agency, which creates rules for the administration and enforcement of state tax law. State income taxes are either graduated – meaning that they increase with income levels – or assessed at a flat rate.[17]

In addition to state and federal income tax, over 20 million American taxpayers are assessed local income tax bills every year. In 2016, state governments collected a total of $1.9 trillion in general tax revenue nationwide, and over one-fifth of this amount is attributable to income taxes. Local governments were not far behind, collecting over $1.6 trillion in general tax revenues. However, income taxes accounted for a far lower proportion of local tax revenues, representing only around 2 percent of total local taxes collected.[18]

Local income taxes are assessed in nearly 5,000 municipal, district and county-level jurisdictions across 17 states. Every county in the states of Indiana and Maryland impose local income taxes, as do most local jurisdictions in Pennsylvania and Ohio. Local income taxes sometimes take the form of wage taxes, payroll taxes, local services taxes or other taxes associated with professional occupations. Most local income tax rates are low, typically between one and three percent, so local income taxes are usually passed to supplement other sources of local tax revenue such as sales and property taxes.[19]

Residency for Tax Purposes

 State and local lawmakers enforce income tax laws to ensure residents benefitting from the important public services the government offers pay their fair shares. Any state or local jurisdiction in which someone resides has the right to impose taxes on that person. Typically, residency is established by a person’s domicile, which is where she lives day-to-day. However, questions of residency can get complicated, particularly when people live or earn income in more than one jurisdiction.

Some states, such as Illinois, deem a person a resident only if she is in the state for a period that is not considered temporary or transitory. Other states, like California, have no statutory resident provision and instead follow guidance from the common law. These jurisdictions follow the traditional residency inquiry, which is a fact-intensive inquiry into whether someone has established herself in the state and – whether physically present or not – intends to return one day. Residency may also be determined by statute, which may take into consideration the jurisdiction that issued the taxpayer’s legal identification, where she lives during most of the year or where mail is received.

A person may establish residency in a new jurisdiction intentionally by moving her domicile, but some people become residents of a jurisdiction unintentionally. If someone spends a certain amount of time in a state, typically a number of months prescribed by statute, that state may claim the person as a statutory resident and assess income taxes regardless of intent to remain in the jurisdiction. What makes someone a state resident varies, but some states consider one to be a resident of the state if one maintains a home in that state for at least half of the year.[20]

For people who move often or earn income in multiple jurisdictions, multistate taxation issues can raise real challenges. For example, even if a person has homes in multiple states, she can have only one domicile. Certain members of the military and their spouses are entitled to exemptions from statutory residency determinations under the Servicemembers Civil Relief Act[21] and Military Spouse Residency Relief Act.[22] However, people with multiple homes or jobs that take them from place to place may struggle to understand the scope of their tax liability.

Most states regard a resident as someone who resides in the state for any purpose other than traveling, transit or other temporary reasons. Often, the taxpayer’s subjective intention to continue living in a jurisdiction weighs heavily on the domicile determination. Because this is a subjective determination, more than one state may claim someone as a resident. This happens when people move their permanent residence to a new jurisdiction well into a tax year.

However, in some cases, states will assess taxes against someone that has been deemed a resident by mistake. Mistaken dual residency often affects people who buy a second home in another state or live in one state but participate in business activities or interests in another.[23] Likewise, people who temporarily relocate work or those who have transitory lifestyles may struggle to establish domicile in any jurisdiction. Someone who has severed all ties with her home state does not establish residency in another state until legal residency determinations are met. These circumstances can raise tricky legal questions, as every citizen of the U.S must be a resident of some state for tax purposes.[24] Common issues in multistate taxation are the focus of the next and final module of this course.