When a business hires an employee, the business generally becomes responsible for collecting and paying three federal taxes—the personal income tax (withholding), FICA, and FUTA. It also becomes liable for state and local employment taxes: in most states, these include a state income tax and a state unemployment tax. For businesses, each tax presents, in turn, its own set of rules and regulations with its own particular exceptions and unique regulatory requirements. For the small business owner just starting up, these employment tax rules make compliance with the taxes both complex and confusing. Many apparent inconsistencies among the various tax code provisions can be explained, to some degree, by reference to an actual purpose of the individual tax. Broadly speaking, employment taxes can be broken into two large groups—those whose primary purpose is to raise general revenues (e.g., the federal income tax) and those that provide social welfare insurance (e.g., FICA and FUTA). Accomplishing the different goals of the various taxes and the policy trade-offs made in their design requires different regulatory schemes. For example, in the interest of fairness and to reflect the ability of different individuals to pay, the federal income tax applies progressive rates to employee wages, taxing higher wages more than lower wages and exempting some lower wage earners from taxation. FUTA, on the other hand, ensures that employers contribute to state unemployment funds by taxing employers at a flat rate for all wages paid to employees (up to $7,000 per employee), but reducing the tax owed by amounts paid to state unemployment insurance funds (down to a federal tax rate of 0.8 percent). adverse affect on the state budget, it can choose to reject the provision as part of its state income tax code. The number and type of state and local tax assessments also vary. In New York City, for instance, an area with large amounts of commercial activity, a business may face as many as eight federal, state, and local employment taxes. Today we have brought along a chart to help illustrate the complexity of current employment taxes. Appendix III of this report is a copy of this chart. The chart is divided into two main parts: the left half of the chart covers federal taxes, and the other half covers state and local taxes. Along the bottom of the chart we list the different types of employment taxes, and in the middle of the chart we present the four major decision points an employer must come to before making actual tax payments. For state taxes, we have used as our examples those applied in Nebraska and Ohio. Aside from the fact that these are the home states of the Chairmen of this Commission, these states make a useful comparison for our purposes. Both states piggyback on federal income taxes. However, Nebraska has a primarily rural economy based mainly on agriculture and livestock. Ohio, on the other hand, has a more urban economy that includes over five times the number of businesses as Nebraska. Ohio law provides for more extensive business regulation than Nebraska—for example, three additional local employment taxes: city and village income taxes, school district tax, and workers’ compensation payroll tax. employee’s paycheck and pay it to the federal government, along with a matching amount imposed on the employer. 3. Federal Unemployment Tax (required by the Federal Unemployment Tax Act [FUTA]): FUTA imposes a tax on most employers. This tax, in conjunction with state unemployment taxes, supplies the funds to provide benefits for unemployed persons under the state law. The tax is imposed solely on the employer and is not deducted from the employee’s wages. In complying with federal, state, and local employment-related taxes, the business person must answer four questions: Is the worker an “employee” covered by the tax? Are the compensation payments to the employee “wages”? What is the employer’s employment tax liability? What are the deposit and filing requirements? Our chart provides detail on these issues for federal taxes and provides general information on the application of these issues to state and local taxes. We will discuss each issue in turn, with examples of application on hypothetical small businesses. Once a business decides to hire a worker, the first issue to be considered is whether the worker is an employee for the purpose of each different employment tax. Major factors affecting this issue for federal taxes are outlined in our chart in the lower left corner. The pivotal question on this point is whether the worker is an employee or an “independent contractor.” The standard “common law” test finds the worker to be an employee if the employer controls both what work is done and how it is performed. The Internal Revenue Service (IRS) augments this test with guidelines on the factors that can affect the final determination. and exceptions where businesses hiring employees not meeting the common law test are responsible for either FICA and FUTA, or only FICA. In effect, the first set of exceptions shifts the burden for tax compliance from the employer to the employee, while the second set puts the burden on the employer. These exceptions to the general rules can affect various types of workers: for example, ministers, news vendors under age 18, certain family members, and homeworkers in a cottage industry. Depending on conditions (as stated specifically by statute), these workers may be exempt from income tax withholding, FICA, FUTA, or some combination of the three taxes. As an example, consider a jeweler, operating from her basement as a small manufacturing sole proprietor. Pressed by the coming holiday season, the jeweler would like to hire a neighbor to make small metal pieces, working in his own home with his own tools using material furnished by the jeweler. Even though this person—termed a “homeworker” in the federal tax code—will most likely not be considered an a common law employee, the jeweler will still find herself liable for FICA taxes, both deducted from the homeworker’s salary and matched by her business, if she pays the neighbor more than $100 in cash. Under the federal tax law, however, she will not be liable for FUTA taxes. Having determined that the worker is an employee covered by employment taxes, the next issue confronted by the employer is what compensation payments are taxable as wages. Compensation to an employee may take many forms—pension plans, health and life insurance plans, travel and business expenses, educational assistance, to list a few examples—as well as straight cash hourly wages. Arguably, the most difficult aspect of this issue is determining whether the compensation paid to the employee fits the category of nontaxable compensation. Certain employee benefits, such as pension plan contributions, health and life insurance, commuting passes, and educational assistance, can all be taxable or nontaxable compensation, depending upon whether such benefits are paid out and administered in compliance with complex tax regulations. Compliance with such regulations requires the employer to pay meticulous attention to detailed legal provisions. Because of the exceptions and preferences in the code, how an employee is compensated can affect the tax liability of both the employer and employee. For example, suppose the owner of a beauty salon hired a part-time hairstylist, a person who is also a full-time undergraduate student at a local college. To keep bookkeeping simple, the new employer would most likely pay the hairstylist a cash hourly wage. However, she might also consider including “educational assistance” as compensation to her employee as an offset to a higher hourly rate. Because a recent law (P.L. 104-188) reinstated a tax break for employer-provided educational assistance, the employee may be eligible for annual tax-free educational assistance up to $5,250. As the tax-free educational assistance payments are not subject to FICA or FUTA, the payments would reduce the salon owner’s overall payroll costs, as well as reduce the employee’s federal income tax liability. Including the educational assistance would, however, also complicate the employer’s recordkeeping. Concluding that the worker is an employee with compensation payments subject to employment taxes, the employer next must calculate his or her periodic tax liability. For the federal income tax, wages are withheld for each payroll period, and the amount withheld is based on the amount of wages and number of allowances claimed by the employee on his or her federal Form W-4. For FICA, the employer is to deduct 7.65 percent of the employee’s wages (for wages up to $62,700; for wages over that amount, the employer is to deduct 1.45 percent) for the same payroll period and pay over the same amount as the business’ matching share. FUTA is paid by the employer at a rate of 6.2 percent, but it can be reduced to as low as 0.8 percent with credit for payments to state unemployment tax. Similar calculations must be made for state tax liabilities. All these taxes are calculated independently of one another. For example, suppose two partners in a small gift shop in Lincoln, Nebraska, hire a part-time bookkeeper to work 10 hours a week at $10 an hour. The bookkeeper is paid $200 in cash twice each month, is single, and reports only 1 exemption on his Form W-4. When the partners consult the federal tax semimonthly withholding tables, they will find that they do not owe any withholding of federal income taxes for their employee. However, they will still owe payments for FICA, FUTA, Nebraska state income tax, and Nebraska state unemployment tax. although they pay the bookkeeper less than $1,500 per quarter, they still owe a flat percentage of 6.2 percent because the bookkeeper works once a week for over 20 weeks per year. However, as they will also be liable for 3.5 percent in Nebraska unemployment tax (as new employers), ultimately their federal FUTA liability will be reduced by the amount of state payments.