How Federal Taxes Work

Any business that has employees must pay payroll taxes, also known as employment taxes. Payroll taxes include money withheld from each employee's paycheck and money paid directly by the employer.

As we mentioned earlier, businesses use an employee's W-4 form to calculate how much federal income tax should be withheld from each paycheck. The employer must also withhold Social Security and Medicare contributions from each check. These are collectively listed as FICA contributions. Employees are taxed 6.2 percent for social security (up to $106,800) and 1.45 percent for Medicare. But here's the kicker: The employer must match those contributions, raising the total FICA contributions to 15.3 percent [source: IRS].

In addition to federal income tax and FICA contributions, employers must pay Federal Unemployment Tax (FUTA) for every employee who makes at least $1,500 a year. In the case of FUTA, no money is withheld from the employee's paycheck. The employer pays the full 6.2 percent of the first $7,000 of income [source: IRS].

It's important to remember that all money an employer pays its employees is subject to payroll tax, not just standard salary, wages and tips. That includes vacation allowances, bonuses, commissions, back pay, sick pay, non-cash "in kind" payments (goods, lodging, food, clothing), tax-sheltered annuities, and fringe benefits like baseball tickets, country club memberships and discounted airline tickets [source: IRS].

As part of its payroll tax obligations, the employer must take all withheld funds and matching contributions and deposit the money in a bank or other financial institution authorized to receive federal tax funds [source: Business Owner's Toolkit]. Those deposits are made either monthly or semimonthly based on the amount of the money the employer withheld the previous year, known as the lookback period.

If you report $50,000 or less in withheld taxes during the lookback period (July 1 to June 30 of the previous year), you're a monthly depositor. If you report more, you're a semiweekly depositor. Deposits are usually made electronically through the Electronic Federal Tax Payment System, but can also be made by check. Since deposit dates carry strict deadlines and fines, many larger employers delegate this responsibility to a third-party payroll specialist.

To wrap things up, we'll discuss the federal tax obligations of people who are both employer and employee: the self-employed.