How Payroll Impacts Your Business Taxes (and What to Watch Out For)

If you're a small business owner, startup founder, or solopreneur, you've probably discovered that payroll isn't as simple as handing over a check at the end of the week. Behind every paycheck lies a complex system of tax responsibilities that—if overlooked—can lead to significant financial and legal trouble.

Payroll is more than just compensation. Every time you pay an employee, you also take on the role of tax collector, administrator, and reporter. That means managing withholdings, submitting forms on time, calculating employer taxes, and staying in compliance with state and federal laws.

Getting it wrong can cost your business in penalties, back taxes, and even audits. The IRS and state agencies expect timely, accurate reporting and payments. Failing to meet these expectations can lead to wage garnishments, legal complications, and significant fines—even for honest mistakes.

In this guide, we'll break down how payroll impacts your business taxes, what you need to watch out for, and how a payroll company like Down to Basics Payroll can help simplify the process. Whether you're hiring your first employee or managing a larger team, understanding payroll tax responsibilities is key to staying compliant and protecting your bottom line.

Understanding the Link Between Payroll and Business Taxes

Every time you run payroll, you're triggering a chain of tax-related tasks. You're not just paying your employees—you're also calculating, withholding, depositing, and reporting taxes on their behalf. As an employer, you essentially act as a middleman between your employees and government agencies.

This dual role is where things get complicated. You must:

• Deduct the correct amount of taxes from each employee's paycheck based on their W-4
• Match specific tax contributions (like Social Security and Medicare)
• Deposit withheld taxes and your own contributions on a set schedule
• File payroll tax forms regularly (quarterly and annually)

Even small businesses with only one or two employees are held to the same standards. There are no shortcuts, and ignorance of the law doesn't exempt you from penalties.

Proper payroll management also impacts your ability to retain employees. Employees expect accurate paychecks and timely tax documents like W-2s. Mistakes or delays can cause frustration, mistrust, and even legal complaints.

What Are Payroll Taxes? A Quick Breakdown

Payroll taxes are the taxes both employees and employers pay based on wages and salaries. These taxes fund important programs like Social Security, Medicare, and unemployment benefits.

Employee Payroll Taxes (Withheld from Paychecks):

Federal Income Tax: This is based on the employee's earnings and the information they have provided on their W-4 form (marital status, dependents, extra withholdings).

State and Local Income Tax: This tax varies by state and municipality; Pennsylvania, for instance, withholds a flat 3.07% for state tax.

FICA Taxes:

Social Security Tax: 6.2% of employee wages up to an annual limit

Medicare Tax: 1.45% on all wages

Additional Medicare Tax: 0.9% on wages exceeding $200,000 (only for high earners)

Employer Payroll Taxes (Paid by Employer):

Social Security Tax: 6.2% match of employee's wages

Medicare Tax: 1.45% match of employee's wages

FUTA  (Federal Unemployment Tax): 6.0% on the first $7,000 of each employee's wages (with a credit up to 5.4%)

SUTA  (State Unemployment Tax): Rate and wage base vary by state and employer experience

Gross Pay vs. Net Pay: What's the Difference?

Gross Pay is the total amount that an employee earns before any deductions. This includes not only hourly wages or salary but also bonuses, overtime pay, and commissions.

Net Pay (also known as take-home pay) is what remains after all deductions are subtracted. These deductions include federal and state income tax withholdings, health insurance premiums, retirement contributions, Social Security and Medicare taxes, and any other voluntary or court-ordered deductions (such as wage garnishments).

Employers must calculate both accurately: gross pay determines the basis for tax withholdings, while net pay is what gets deposited into the employee's bank account. Any errors in these calculations can result in overpayment or underpayment, both of which can lead to compliance issues and unhappy employees.

Federal Payroll Tax Obligations for Small Businesses

Federal payroll tax responsibilities are the same regardless of business size. They include withholdings from employees and contributions made by the employer.

Federal Income Tax Withholding

Employees must complete a W-4 when hired. You use this information to calculate the correct amount of federal income tax to withhold. This tax is then deposited with the IRS and reported quarterly.

FICA Taxes: Social Security and Medicare

Both the employee and employer contribute equally—these payments fund benefits for retirees, disabled workers, and Medicare beneficiaries. Underpayment or misreporting can lead to IRS penalties.

FUTA Tax

This federal tax supports state unemployment programs. It's not deducted from employee wages. Employers typically pay 0.6% after the 5.4% credit on the first $7,000 per employee.

Key Federal Forms:

• W-4: Determines employee withholdings
• W-2: Sent to employees and the IRS each January to report total earnings and taxes withheld
• 941: Quarterly report of income tax and FICA withholdings
• 940: Annual report of FUTA taxes

Failing to file these forms correctly and on time can result in fines and audit flags.

State and Local Payroll Taxes: What You Need to Know

Each state has its own tax rules, and many municipalities add additional requirements. Pennsylvania, for example, has several layers that can be especially tricky for new or small business owners to navigate. One of the most common challenges is simply not knowing these taxes exist—or understanding how and when they apply. That's where many employers get caught off guard.

Some business owners assume local taxes are minimal or irrelevant until they receive a notice of noncompliance or penalty. Others are surprised to learn that they must register with separate local tax collection agencies or that local taxes must be withheld in addition to state and federal obligations. The confusion is understandable, but unfortunately, it doesn't protect you from the consequences.

Each state has its own tax rules, and many municipalities add additional requirements. Pennsylvania, for example, has several layers:

Pennsylvania State Taxes:

State Income Tax: Flat 3.07% withheld from employees

SUTA: Employers contribute to the unemployment fund, and new employers start at a set rate until they build an experience record. Some employees also contribute a small percentage.

Local Taxes in PA:

Local Earned Income Tax (EIT): Required in many municipalities and school districts, usually around 1%. Collected by third-party agencies like Keystone.

Local Services Tax (LST): A fixed fee, often $52 annually, deducted from paychecks of employees who work within specific jurisdictions.

Occupational Privilege Tax: Varies by township or borough; some charge both employer and employee.

Failing to stay on top of local requirements can result in missed payments, penalties, and additional administrative headaches. Even if you're diligent with federal taxes, overlooking state and local payroll taxes can create serious issues down the line. That's why proactive compliance and support from knowledgeable payroll professionals is so important.

The Employer's Role in Tax Withholding

Employers are legally responsible for withholding the correct taxes from employee pay and submitting them to the appropriate agencies. This includes both federal and state/local taxes.

Responsibilities Include:

Calculating correct withholding amounts based on W-4 forms

Depositing federal income, Social Security, and Medicare taxes to the IRS

Withholding and submitting state/local taxes as required

Understanding Worker Classification

Classifying someone as a W-2 employee versus a 1099 independent contractor affects your tax obligations. Misclassification can lead to:

Back taxes

Penalties and interest

Loss of trust with the IRS

Here are the key differences:

W-2 Employee:

• Works under your control and direction (you set their hours, dictate how work is performed, etc.)
• Uses tools and resources you provide
• Typically works only for your business or in a fixed schedule
• You are required to withhold income taxes, pay Social Security and Medicare taxes, and contribute to unemployment taxes
• Covered by labor laws (minimum wage, overtime, etc.) and may receive benefits like health insurance or paid time off

1099 Independent Contractor:

• Has greater independence in how and when the work is done
• Uses their own equipment or resources
• Often works for multiple clients
• You do not withhold or pay payroll taxes; they handle their own tax filings
• Not eligible for employee benefits or protections under most labor laws

The IRS provides a three-part test to help determine proper classification:

Behavioral Control: Do you control what, how, and when the worker does the job?

Financial Control:  Do you control how the worker is paid and whether expenses are reimbursed?

Type of Relationship:  Are there contracts or benefits suggesting an employer-employee relationship?

When in doubt, it's best to seek guidance from a payroll professional or use IRS Form SS-8 to request a formal determination.

Tax Deposit Deadlines

Your deposit schedule depends on the size of your payroll and the total tax liability you accumulate during a specific lookback period. The IRS generally places employers on one of two main deposit schedules:

Monthly Depositor: If you reported $50,000 or less in employment taxes during the previous four quarters, you are typically a monthly depositor. Taxes are due by the 15th of the next month.

Semiweekly Depositor: If you have reported more than $50,000 in employment taxes, you are usually a semiweekly depositor. Taxes must be deposited based on when your payroll was processed:

For paydays on Wednesday, Thursday, or Friday, deposit by the following Wednesday.

For paydays on Saturday, Sunday, Monday, or Tuesday, deposit by the following Friday.

Additionally, if you accumulate $100,000 or more in taxes on any given day, you must deposit them by the next business day—regardless of your regular schedule.

State and local agencies also set their own deposit deadlines, which can vary. For example, Pennsylvania employers may be required to remit state income tax and local wage tax withholdings monthly or semi-monthly, depending on the amounts withheld.

Missing any of these deadlines—even by a day—can result in penalties that escalate quickly based on how late the payment is. Consistent late deposits can also lead to increased scrutiny from the IRS or state agencies.

To stay compliant, it's crucial to know your assigned deposit schedule, monitor your payroll tax liability closely, and automate payments when possible.

Unemployment Insurance: FUTA, SUTA, and Your Responsibilities

Unemployment taxes fund temporary benefits for workers who lose their jobs. Both federal and state taxes apply, and they are strictly employer-paid (with some state exceptions).

FUTA:

Taxed on the first $7,000 of each employee's wages

The standard rate is 6.0%, but most employers receive a credit of 5.4%, reducing the effective rate to 0.6%

FUTA is reported annually on IRS Form 940

SUTA:

Your specific state determines state Unemployment Tax Act (SUTA) rates, and they depend on several factors, including:

Your industry classification

Your experience rating, which is the number of unemployment claims filed by former employees

Whether you are a new or established employer

New employers are generally assigned a standard rate, which may increase or decrease over time based on your claims history.

Wages subject to SUTA tax also vary by state; Pennsylvania, for example, taxes up to a set wage base (which can change annually)

Timely and accurate reporting can help maintain a lower rate over time.

Common Misconceptions:

Many small business owners mistakenly believe unemployment taxes are optional or don't apply to them, especially if they have few, part-time, or family-member employees. However, most states require unemployment contributions if you pay more than a certain threshold in wages or employ someone for a set number of weeks in a calendar year. Even if you're only employing a single part-time worker, you may still be responsible.

Failing to pay unemployment taxes can result in:

Retroactive back payments

Interest and late penalties

State audits and increased scrutiny

Loss of eligibility for state tax credits

Understanding how your rate is determined and staying compliant with payment and filing requirements is critical. Keeping a clean record with few or no unemployment claims can help reduce your SUTA rate, saving your business money over time.

Common Payroll Tax Mistakes (And How to Avoid Them)

Mistakes in payroll taxes are common, especially for small businesses without dedicated accounting departments. Payroll errors can cause more than just financial losses—they can affect employee trust, trigger IRS scrutiny, and damage your company's reputation. Here are the most frequent issues, what they look like in practice, and how to avoid them:

1. Misclassifying Workers

Misclassification occurs when a business treats a worker as an independent contractor (1099) when they should have been classified as a W-2 employee. This mistake often stems from the desire to save on payroll taxes, but it can backfire quickly.

Why It's Risky:  You could be liable for unpaid employment taxes, back wages, and penalties. Misclassified workers may also file complaints if they feel they were denied benefits or legal protections.

Avoidance Tip:  Use IRS Form SS-8 to request a classification determination or consult with a payroll expert familiar with the IRS's behavioral, financial, and relationship tests.

2. Late or Missed Tax Deposits

Missing a payroll tax deposit deadline can result in immediate penalties, whether it's a simple oversight or a cash flow issue.

Why It's Risky:  The IRS imposes escalating penalties based on the payment's lateness, ranging from 2% (1–5 days late) to 15% (over 10 days after receiving a notice). State and local agencies may apply similar or additional penalties.

Avoidance Tip:  Automate your payroll deposits or use a payroll service provider who makes timely deposits and files on your behalf.

3. Incorrect Tax Calculations

Payroll tax rates and wage caps can change each year. Manual miscalculations or outdated payroll software can result in the wrong amounts being withheld or paid.

Why It's Risky: Incorrect calculations can result in over- or under-withholding, which may lead to amended filings, audits, and tax notices. Employees could also owe taxes at year-end or get smaller refunds.

Avoidance Tip:  Use up-to-date payroll software or outsource your payroll to a provider that uses current tax tables and handles changes for you.

4. Filing Errors

Filing the wrong forms, filing late, or omitting crucial information (like SSNs or employer identification numbers) can create administrative delays and trigger compliance issues.

Why It's Risky: Late filings or incorrect forms can result in rejected submissions and added penalties. It may also delay employee tax refunds and impact year-end reporting.

Avoidance Tip: Maintain a tax calendar with all important filing deadlines. Consider using a payroll provider that automates form filing and double-checks data before submission.

5. Ignoring Tax Law Updates

Tax laws and thresholds change regularly at the federal, state, and local levels. These changes affect withholding tables, wage limits, deposit frequencies, and form deadlines.

Why It's Risky:  Ignorance of new regulations won't exempt you from penalties. Failure to comply with updated laws can cause systemic errors across multiple payroll cycles.

Avoidance Tip: Stay subscribed to IRS and state revenue department newsletters or partner with a payroll company that tracks changes and updates systems in real-time.

Avoiding these common mistakes not only protects your business but also ensures smoother payroll operations and better relationships with your employees.

Keep Payroll Simple, Stay Compliant, and Avoid Surprises

Payroll and taxes go hand in hand. Even if you only have a few employees, failing to manage payroll taxes properly can cost your business in penalties, stress, and lost time.

By understanding how payroll affects your tax obligations—and working with a trusted small business payroll company like Down to Basics Payroll—you can protect your business, support your employees, and stay in good standing with tax authorities.

Contact Down to Basics Payroll today to simplify your payroll process and stay ahead of tax obligations—without the stress.