Income tax to set aside, and payroll

Tax on an owner's profit and the amount to set aside for each quarterly estimated payment, an employee's net pay after income tax and FICA are withheld, and the full cost of an employee to the business.

Paper packet. Every task here also exists on screen, where it is checked automatically; answers written on paper are not assessed by Nydus. When you are back at a device, enter your answers there.

1. What you will learn

You will work out the tax on an owner's profit and how much to set aside for each estimated payment, turn an employee's gross pay into net pay, find the full cost of an employee to the business, and work out the extra sales a hire needs.

2. What you already have

You can build a year's profit on the accruals basis, set sales tax aside as money that belongs to someone else, and size a cash buffer against a named risk. Income tax and payroll are two more sums of that kind: known well in advance, paid later, and dangerous only to the owner who forgets them.

3. Words this lesson uses

4. Profit is taxed; drawings are not

A sole proprietor is not paid a wage by the business. The business's profit for the year is reported on the owner's own federal return, on Schedule C, and taxed as their income whether they drew all of it, some of it or none. Drawings are simply the owner moving their own money, and the tax does not follow them.

Term	What it means
Sole proprietor	An owner who runs the business in their own name; its profit is their personal income.
Self-employment tax	A sole proprietor's Social Security and Medicare, paying both the employee's and the employer's share.
Estimated tax	Income tax and self-employment tax paid in four installments during the year rather than all at the end.
FICA	Social Security at 6.2 percent and Medicare at 1.45 percent, withheld from wages and matched by the employer.
Withholding	The employer taking income tax and FICA out of each paycheck and depositing them with the IRS.
Net pay	What the employee receives after the withholding.

Two taxes fall on that profit. Income tax, at rates that rise in brackets. And self-employment tax, which is the owner paying Social Security and Medicare as both employer and employee: the IRS sets it at 15.3 percent of 92.35 percent of the net profit, with the Social Security part stopping at a yearly wage base. On Tomasz's profit of 36,000:

In this example his income tax is 20 percent above a tax-free 12,000, which is 4,800. The federal government expects the total, about 9,887, to be paid during the year in four quarterly estimated payments, due around April 15, June 15, September 15 and January 15, with a penalty for paying too little too late. So the tax is set aside as the profit is made: about 2,472 each quarter, into a separate account.

Payroll. Hiring an employee adds a second set of figures. The employer withholds federal income tax, based on the employee's Form W-4, and the employee's share of FICA — 6.2 percent for Social Security and 1.45 percent for Medicare — from each paycheck, pays its own matching 7.65 percent, and pays federal and state unemployment taxes. The employee receives the net pay; the business pays the gross plus its own share.

Texas has no state income tax; in most states a state income tax is withheld too.

Barista's month, in Texas	Amount
Gross pay	2000
Federal income tax withheld (example)	−150
Social Security withheld, 6.2 percent	−124
Medicare withheld, 1.45 percent	−29
Net pay received	1697
Employer's Social Security and Medicare	+153
Unemployment insurance (example)	+40
Retirement match (example)	+60
Cost to the café	2253

Another way: steps

Work the income tax and self-employment tax on the year's profit.
Divide by four for each quarterly estimated payment.
For a paycheck, withhold income tax and 7.65 percent FICA.
The rest of the gross is the net pay.
Add the employer's FICA, unemployment taxes and benefits for the full cost.

5. The method, step by step, and how to check it

Tax on the owner's profit. Start from the profit on the accruals basis, not from what was drawn. Work the income tax at the year's brackets and the self-employment tax at its rate, add them, and divide by four for the estimated payments. If the profit changes during the year, adjust the later payments rather than waiting for April.

A paycheck. Start from the gross pay. Work the income tax withheld from the IRS tables for the employee's W-4, work FICA at 7.65 percent of the gross, add any state income tax, and take them all off: that is the net pay. The employer then pays the net to the employee and deposits the withheld amounts, with its own FICA, with the IRS on its deposit schedule.

The full cost. Add the employer's FICA, federal and state unemployment taxes, any retirement match or health insurance the employer pays, and the costs that come with employing someone: equipment, training, workers' compensation insurance and the time spent on payroll.

To check a paycheck, net pay plus everything withheld must equal the gross. To check the full cost, it must exceed the gross by exactly the employer's own additions; if the employee's withholding has been added too, the cost is overstated.

6. Where the rules live

The Internal Revenue Service publishes the federal rules for employers in Publication 15, often called Circular E: how to withhold income tax, the FICA rates and the Social Security wage base for the year, and when to deposit. Employers report each quarter on Form 941 and give each employee a Form W-2 after the year ends. Federal unemployment tax is 6 percent of the first 7,000 of each employee's wages, reduced by a credit of up to 5.4 percent for paying state unemployment tax on time; state rates and wage bases are set by each state's workforce agency. Sole proprietors find the estimated-tax rules in Publication 505 and the 1040-ES worksheet.

The brackets, the wage base and many state figures change most years, so a business reads them for the current year, not from memory. Most small employers run payroll through software or a payroll service that holds the current tables and files the returns; the method in this lesson is what that software is doing, and knowing it lets an owner check a paycheck and budget for a hire before making it.

7. Timing: why tax needs a separate account

Both kinds of tax have the same shape as sales tax: earned or withheld now, paid over later. Payroll taxes are the most dangerous of all, because the amounts withheld are the employees' money held in trust. If a business fails to deposit them, the IRS can hold the people responsible for paying them — often the owner — personally liable through the trust fund recovery penalty.

The cash forecast should show each payment on its due date: the payroll deposits, the monthly sales tax return, the quarterly estimated payments. The owner who sets each aside in a separate account as it arises never has to find a large sum at once, and can read the main account's balance as money the business really has.

8. Brackets, and the rate on the next dollar

Federal income tax rises in brackets: a low rate on the first slice of taxable income, higher rates on each slice above. Suppose, in an example, nothing is charged on the first 12,000, 20 percent on the next 38,000 and 40 percent on anything above 50,000. A profit of 60,000 is then taxed 38,000 × 0.2 = 7,600 on the middle slice and 10,000 × 0.4 = 4,000 on the top: 11,600 in all.

Two rates describe that result. The average rate is the tax over the profit, 11,600 ÷ 60,000, a little under 20 percent. The marginal rate is the rate on the next dollar earned, here 40 percent. The marginal rate is the one that matters for a decision: a job that adds 1,000 of profit adds 400 of income tax, not 193, plus self-employment tax. A higher bracket never taxes the whole income at the higher rate, only the slice above the bracket's start, so earning more never leaves anyone with less after tax.

9. Costs that lower the tax

Because the tax falls on profit, every genuine cost of the business lowers it: inventory, rent, wages, the van's running costs and, through the IRS's rules for depreciation, some share of what equipment costs. Personal spending does not, even if it passes through the business account. Keeping receipts for every business cost, as the cash-book lesson asked, is what lets them be counted.

A cost is still a cost, though. Spending 1,000 on something the business does not need, to save 300 of tax, leaves the owner 700 poorer. The tax saving is a reason to record every real cost, never a reason to create one.

10. Sole proprietor, LLC or corporation

The legal form changes who pays. A single-owner limited liability company is taxed like a sole proprietor by default: its profit passes through to the owner's return. A C corporation pays federal corporate income tax on its own profit, at a flat 21 percent, and the owner pays tax again on any dividends. An S corporation's profit passes through to its owners, who must pay themselves a reasonable salary through payroll. Which arrangement leaves an owner better off depends on the year's rules and on how much the business makes, and it is a question for the owner's accountant with the current figures. What does not change is the habit this lesson teaches: work out what will be owed, and put it aside before it is spent.

11. In the world: the first tax bill

A self-employed web designer had her best year: a profit of 48,000 after a slow start. She paid herself generously through the year, drawing 3,500 a month, made no estimated payments, and in April the bill arrived. Her self-employment tax was 48,000 × 0.9235 × 0.153, about 6,782, and in this example her income tax came to 7,200: about 13,982 in all, plus a penalty for not paying during the year. Her business account held 6,000.

She had drawn 42,000 of a 48,000 profit; the tax had never been anyone's but the government's. She set up an IRS payment plan, paid interest on it, and for the next year worked the tax on her forecast profit at the start, divided it by twelve, and moved about 1,170 a month into a savings account on the day she paid herself. Each quarterly estimated payment then came out of that account on time.

A year later she hired a part-time assistant at 1,200 a month gross. Before advertising she worked the full cost — 1,200 plus about 92 of employer FICA and some unemployment tax, a little over 1,300 — and the extra work that cost needed: at 50 an hour of design contribution, about 26 more billable hours a month. She had a waiting list, so the hire paid for itself in its first month.

12. In the world: why payroll is taken seriously

Income tax and FICA withheld from employees' pay belong to the employees and the government from the moment they are withheld. The IRS treats unpaid payroll taxes more strictly than most other debts, and the people responsible for paying them can be made personally liable.

13. Where this goes wrong

An owner is taxed on what they draw. A sole proprietor is taxed on the business's profit.

Tax is due in April, so there is time. Estimated payments are due every quarter, and paying too little along the way brings a penalty.

An employee costs their salary. The employer's FICA, unemployment taxes and benefits come on top.

What is withheld from a paycheck is a cost to the employer. It comes out of the gross; the employer is only passing it on.

Last year's figures will do. Brackets, the wage base and state rates change; read the current year's.

14. Tomasz's year of tax

15. Corner Bean's barista's paycheck

16. What the barista costs, and what must pay for it

17. Your turn: profit 30000, the first 12000 free, 20 percent on the rest

18. Guided practice

Tomasz runs Long Row Gardens as a sole proprietor. Its profit for the year is $62000$ dollars. In this example the first $8000$ of profit is free of income tax and the rest is taxed at $20$ percent. Fill in his income-tax figures, in dollars.

19. Guided practice

Complete the worked solution: a shop hires its first employee at $2500$ dollars a month gross. The employer pays its own 7.65 percent of FICA on top of the wage and, in this example, matches 3 percent of the gross into the employee's retirement plan. Work out what the employee costs the shop a month.

20. Guided practice

Corner Bean's barista earns $2200$ dollars a month before deductions. In this example the first $600$ a month is free of income tax and the rest is taxed at 20 percent. FICA — Social Security at 6.2 percent and Medicare at 1.45 percent — is withheld on the whole gross. What is the barista's take-home pay for the month, in dollars?

21. Practice

Dan runs Fixit Mobile as a sole proprietor. For the year its profit was $39000$ dollars and he drew $29000$ out for himself. On what do his income tax and self-employment tax fall?

22. Practice

Fixit Mobile hires a technician at $2900$ dollars a month gross. The employer pays its 7.65 percent share of FICA on top; in this example state unemployment insurance costs 2 percent of the pay, and Dan budgets $90$ a month for the technician's tools and training. Fill in the cost, in dollars.

23. Practice

A café is thinking of hiring a second barista at $4800$ dollars a month gross. With the employer's FICA, unemployment insurance and a retirement match, the barista costs 1.13 times the gross in this example. Each extra cover sells for $10$ with $2$ of variable cost. Fill in what the hire needs.

24. Somewhere new

A self-employed electrician's profit for the year is $26000$ dollars. In this simplified example income tax is 20 percent of the profit above $11000$, and self-employment tax is 15 percent of the profit above $4000$. Both are paid in four quarterly estimated payments. Fill in his figures, in dollars.

25. Lesson test

Lesson test: one question per skill, one attempt each, no hints. Your answers are checked when you submit.

26. Test question

A florist hires an assistant on a salary of $60000$ dollars a year. The employer pays its 7.65 percent share of FICA and, in this example, a retirement match of 3 percent of the salary. Leaving unemployment taxes aside, what does the assistant cost the florist a year, in dollars?

27. What you can do now

You can set tax aside as profit is made and read a paycheck from both sides. Tell someone why an employee on 2000 a month costs the business more than 2000. Next: a loan's repayments, split into interest and principal month by month.

Working for the steps left to you

	Amount
Taxable profit
Income tax for the year
Profit left after income tax
Each quarterly estimated payment

	Amount
Employer's FICA
Unemployment insurance
Cost a month
Cost a year

	Amount
Barista's cost a month, dollars
Contribution from one cover, dollars
Extra covers a month to pay for the hire

	Amount
Income tax
Self-employment tax
Total for the year
Each quarterly estimated payment

17. Your turn: profit 30000, the first 12000 free, 20 percent on the rest, step 3

Before self-employment tax is added.