What is Payroll Tax?

Payroll taxes are taxes withheld or ‘held back’ by the employer before distributing a salary or wages to employees. Commonly, payroll taxes include social security taxes (in the US, ‘FICA taxes’) and medicare taxes. In this Guide, we look at four common definitions of payroll tax, explain how to calculate it, and answer a range of commonly asked questions with respect to payroll tax. 

Key Takeaways

1. Payroll tax, in the United States, usually refers to federal social security and medicare taxes which both employers and employees must pay a share of. 

2. Outside the United States, the term ‘payroll tax’ is commonly used differently, to refer to all taxes that employers incur, as employers. There are at least four definitions of payroll tax when looked at through an international lens.  

3. All employers need to work out how to calculate payroll tax in the country in which they operate. 

4. The complexity of processing, withholding and remitting payroll tax, as well as reporting obligations, means it is worth considering outsourcing this task. This is especially useful when operating in multiple countries. 

What is the Definition of Payroll Tax? 

We live in a global marketplace. With businesses hiring across national boundaries, businesses need an excellent understanding of their tax obligations in each location they operate in. Alongside income taxes, it is essential that any business employing workers overseas considers their international payroll processing and the impact of payroll tax. 

It should be noted that this Guide provides general information only, and any business operating internationally should seek professional advice on their individual circumstances to ensure compliance with payroll tax obligations

There is no consistent definition of ‘payroll tax’ that applies internationally. We discern at least four definitions that might apply, depending on where you are located.  We consider each possible definition below: 

  • Employee Income Taxes
  • In some countries, ‘payroll tax’ simply means ’employee income tax’. 
  • Generally, income earned as an employee is subject to income tax. Usually, this income tax is withheld by the employer from an employee’s ‘gross’ wages or salary. 
  • Where ‘payroll tax’ refers just to employer-withheld income tax, it is sometimes called Pay as You Go (PAYG) or Pay as You Earn (PAYE) tax. 
  • Under this definition, other compulsory deductions such as social security, workers’ compensation and pension contributions are not referred to using the term ‘tax’. 
  • Social Security and Medicare Taxes
  • In the United States, ‘payroll tax’ is a technical term, usually used to refer specifically to federal social security (under the Federal Insurance Contributions Act, or ‘FICA’) and medicare taxes. Part of this payroll tax is withheld from the employee’s gross salary or wages by the employer, while the other component is paid directly by the employer as a ‘matching amount’. 
  • In addition to federal payroll taxes, US employers are responsible for federal income tax withholding and the payment of federal unemployment insurance tax. Furthermore, employers are often required to withhold state and local taxes, which may include state income tax, state disability insurance tax, and school district taxes.
  • The collective term for all taxes withheld by employers in the United States and submitted to tax authorities is ‘Employment taxes’. 
  • France uses a similar definition of ‘payroll tax’, referring to compulsory social security taxes paid by businesses that do not charge value-added tax (VAT). 
  • State/Territory Income Taxes 
  • In Australia, ‘payroll tax’ is a technical term referring to a tax levied on employers (rather than employees), who reach a certain income threshold, based on a percentage of employee wages.
  • The Australian payroll tax, unlike the US payroll tax, is not a federal tax. Rather, it is set by each individual state or territory, remitted to the state or territory tax authority, and is used as a ‘general’ tax for any state or territory government purpose: It is not specifically tagged for social security, old age care or medicare. 
  • All Employment Taxes, Withheld Taxes, and Employee Contributions
  • A fourth definition of ‘payroll tax’ means the same as ’employment taxes and contributions’. It covers everything that the employer deducts from the employee’s gross salary or wages before distributing pay checks, as well as anything additional that a business has to pay because they are an employer. Under this definition, ‘payroll tax’ may cover income tax, solidarity tax, church tax, public or private health insurance contributions, workers’ compensation contributions, student loan repayments, child support payments or wage garnishments. 
  • Usually, all of these amounts are processed by the payroll department of a company. And given that, from the employees’ perspective, their wages are ‘taxed’ by these amounts, it is perhaps natural that many use the term ‘payroll tax’ for these amounts. 

How is Payroll Tax Calculated, Withheld and Remitted? 

The process for calculating and processing payroll tax is slightly different in every country. In the United States, the processing of employment taxes, including payroll taxes, requires employers to take the steps set out below: 

  • 1. Gather Necessary Information
  • In order to process taxes there is a range of information you will need. This includes a copy of the employee’s withholding certificate, the ‘W-4 form‘, as well as internal information on gross salary or wages of employees.
  • Note, if you run a small business and have no employees (whether as a sole proprietor or through a limited liability company), you may not need to submit ‘payroll taxes’, but may need to cover the same matters through self-employment taxes, and submitting a tax return as a self employed person. 
  • 2. Calculate Federal Income Taxes Withheld
  • There are two federal income tax withholding methods for calculating the amount of employee federal income tax to withhold: The wage bracket and the percentage method. Each method sets out the applicable tax rate at different income levels. 
  • These amounts are withheld from employee pay checks and remitted to the IRS on a scheduled basis. Two deposit schedules are available; monthly and semi-weekly. 
  • 3. Calculate and Withhold Federal Payroll Taxes
  • FICA taxes for medicare and social security should be withheld and deposited to the tax authorities on the same schedule as federal income tax.
  • In addition, employers must submit a form quarterly (Form 941) detailing tax withheld and deposited. 
  •  4. Calculate FUTA 
  • Federal Unemployment Tax Act (FUTA) taxes should be set aside by employers and deposited with the IRS quarterly. Note, FUTA tax comes out of the employer’s earnings and is not withheld from employee wages. 
  • 5. Calculate and Withhold State and Local Income Taxes 
  • While not all states and localities (such as municipalities) charge income taxes, many do. Where there is a state or local income tax, it is the responsibility of the employer to withhold and submit withheld amounts to the relevant tax authorities. 
  • 6. Calculate and Withhold any State and Local Payroll Taxes 
  • In some states and districts/localities, employers need to withhold additional taxes alongside applicable federal payroll taxes. For example, in California, employers need to withhold both disability insurance and family paid leave contributions. 

How Do International Businesses Manage Payroll Tax? 

From the discussion so far, it should be clear that the laws and rules around payroll tax differ substantially in different countries. This complexity means that any business operating across international borders — and hiring workers — needs to carefully consider how to manage payroll and any applicable taxes across their operations

Sometimes this will need to be managed as part of a ‘shadow payroll‘.  This means ensuring tax compliance in one country (which may include payroll taxes), while paying the worker in another country. Shadow payroll can be managed by a payroll outsourcing provider. Read more about this option at The Top 5 Benefits of Outsourcing Payroll

Another possibility is for an organization to set up separate legal entities (such as subsidiary companies) in each country that they operate in, and run a separate payroll in that country through that entity. 

A third option is to engage a Global Employment Organization (GEO): They hire workers in-country through an ’employer of record’ solution and ensure that all essential employment taxes are withheld and remitted to tax authorities as required. 

A GEO (sometimes called a ‘Global Professional Employer Organization’ or ‘Global PEO services firm‘) can be particularly beneficial when operating across many different countries, states, provinces or territories: The GEO will ensure that, in each jurisdiction the business operates in, there is full compliance with employment and payroll taxes. 

Note, one additional advantage of engaging a GEO when dealing with international employment taxes is that, as ’employer of record’ with the tax authorities, they take on the compliance risk and liability for employment and payroll tax filing (note, however, that in the case of co-employment, liability may be shared with the client company). 

Payroll Tax, Income Tax and Independent Contractors 

Rather than hiring employees, many businesses value the flexibility of hiring independent contractors and/or freelancers. There is no requirement to withhold income or payroll taxes on behalf of independent contractors. Independent contractors are not employees, and their status is usually considered to be ‘self employment’. This means they are not technically ‘on the payroll’ (even if the payroll department does, in fact, process their pay). 

Independent contractors pay their own taxes and file their own tax returns.  Note, as well as income tax, in some jurisdictions this includes compulsory self employment tax (which is usually also a targeted tax covering social security and medicare).

In addition, independent contractors are often required to register for, and pay turnover taxes, often called ‘VAT’ or ‘Goods & Services Tax’. They may also be required to make separate workers’ compensation contributions (such as the Accident Compensation Corporation levy in New Zealand) or pension contributions. 

Some businesses may consider it a benefit of engaging independent contractors that they do not have to deal with taxes and compulsory contributions relating to employment. However, it is essential that any business engaging independent contractors is not ‘misclassifying’ individuals who are really employees, as independent contractors

In case of audit, or possible grievances/disputes from workers, businesses need a robust audit trail, including written contracts or agreements, to confirm that any workers are legitimately self employed contractors, rather than employees in disguise. ‘Employee misclassification‘ by a business can result in hefty back-taxes and fines, including payroll taxes. 

Where workers have been correctly classified and a business seeks to engage independent contractors it is worth considering a contractor management outsourcing solution. 

For more information on paying international contractors see our guide on How to Pay International Contractors

Commonly Asked Payroll Tax Questions 

Which taxes are payroll taxes? 

”Payroll tax’ is a term that is not defined consistently. In the United States, it is commonly used to refer to federal employment taxes mandated under the Federal Insurance Contributions Act (FICA). For this reason, they are often called ‘FICA tax’. FICA taxes have three components: a social security tax, a medicare tax, and an additional medicare tax or ‘surtax’ which applies only to employees above a certain income threshold. 

It is worth noting that some state and local taxes in the U.S. are also referred to as ‘payroll taxes’. 

What is payroll tax vs income tax? 

In the United States, payroll tax is a targeted tax which partly funds medicare and social security. It is in paid by employees (and employers through a ‘matched contribution’).  It is paid in addition to, and is distinct from income tax, which is used for general government spending. 

What do payroll taxes fund? 

In the United States, payroll taxes are social security and medicare taxes. This means federal payroll taxes are used to fund social security and medicare programs across the country. This is intended to ensure a basic level of medical care and social support in old age, disability and various other cases. 

Note, in the United States payment of medicare and social security taxes does not negate the need for comprehensive health insurance. 

What is the legal basis for payroll tax?

In the United States, the Federal Insurance Contributions Act (FICA) sets out the legal power to set and levy payroll taxes across the country. For this reason, payroll taxes are often called ”FICA taxes’. 

As an employer, must I withhold federal income taxes in addition to payroll taxes? 

Yes. In the United States, employers (including small businesses) must withhold federal income and payroll taxes and remit those amounts on a regular, scheduled, basis to the Internal Revenue Service. 

Do payroll taxes cover unemployment tax, or just social security and medicare? 

In the United States, the term ‘payroll tax’ is often used to also include a compulsory tax under the Federal Unemployment Tax Act (FUTA). Note, unlike FICA taxes, FUTA tax is paid only by the employer, and not the employee. 

Do payroll taxes apply to both employer and employee?

Yes, in the United States, the federal government taxes both employers and employees through FICA taxes: Employers must match the employee’s contributions. Note, however, that in other countries this is not the case. For example, only employers pay payroll tax in Australia. 

What does tax withholding mean? 

Tax withholding occurs when the employer ‘holds back’ a certain proportion of the employee’s pay check in order to ensure all compulsory taxes and contributions are remitted to the relevant authorities. 

In the United States, this includes all employment taxes, such as keeping federal payroll taxes and federal income tax withholding. 

How much do I pay in payroll tax? 

As of the time of writing, FICA tax rates in the USA are set at:
  • 6.2 percent for social security tax
  • 1.45 percent for medicare tax
  • 0.9 percent for additional medicare tax for individual employees earning over 200, 000 per annum. 

When must additional medicare tax be paid?

Additional medicare tax is paid by some employees, in addition to the standard medicare tax. It is paid only by those employees who meet a certain income threshold.  For those filing tax returns as a single individual the threshold is $200,000. For those filing as a married couple the threshold is $250,000. 

Summary 

There is no single definition of ‘payroll tax’ that applies internationally. We have observed at least four definitions that are commonly in use internationally

However, as payroll tax is a key employer obligation in the United States we have focused on how payroll tax is calculated and processed there. 

The complexity of calculating and withholding payroll taxes and income taxes correctly means businesses should seriously consider the merits of outsourcing payroll.

Alongside payroll outsourcing solutions, New Horizons provides a range of different services to support employee payment and tax withholding internationally, protecting your business from liability for incorrect tax withholding or payment.

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