Payroll Tax Penalties Small Businesses Should Know About

Payroll taxes are an inescapable responsibility for small employers. To complicate matters, they come in federal, state, and local forms. Just interpreting the different laws can be overwhelming, let alone adhering to them. But if you don’t comply with the rules, you risk penalties — regardless of whether you intended to break the law.

Unintentional vs. intentional noncompliance

If you inadvertently made a mistake when administering payroll taxes, then the blunder is unintentional. However, if you knowingly made the error or willfully engaged in payroll tax fraud, then it’s intentional.

The Internal Revenue Service (IRS) says these are some of the most common types of payroll tax fraud:

• Employee leasing, where the leasing company pockets the taxes withheld from client employees’ paychecks instead of sending the money to the taxation agencies
• Paying employees in cash, to escape paying taxes on the payments
• Filing false payroll tax returns, such as by understating the amount of taxes owed
• Not filing payroll tax returns
• Not remitting payroll taxes withheld from employees’ wages

An employer can face investigation, criminal prosecution, and imprisonment for these violations. Under Section 7202 of the Internal Revenue Code, willful failure to meet employment tax obligations is a felony, punishable by fines of up to $10,000 and/or imprisonment of up to 5 years.

Taxation agencies tend to go easier on first-time unintentional offenders. However, employers can face penalties regardless of whether the violation is intentional or unintentional.

Taxation agencies tend to go easier on first-time unintentional offenders. However, employers can face penalties regardless of whether the violation is intentional or unintentional.

Over the next sections, we cover penalties your small business might face for failing to comply with applicable payroll tax laws. They include:

• Deposit penalties
• Failure-to-file penalties
• Form W-2 penalties
• Interest
• Trust fund tax penalty
• Tax lien and levy
• State and local payroll tax considerations

We also discuss penalty waivers and technology for avoiding payroll tax penalties.

Deposit penalties for federal payroll taxes

As a small employer, you’re required to withhold federal income tax, Social Security tax, and Medicare tax from your employees’ wages plus pay your own share of Social Security tax and Medicare tax. Typically, employers must collectively remit these taxes to the IRS electronically, on either a semiweekly or monthly basis, depending on their established deposit schedule.

Additionally, the vast majority of employers must pay federal unemployment (or FUTA) tax on wages paid to employees.

If your FUTA tax deposit is less than $500 for the quarter, you can carry the amount over into the next quarter — and then pay the tax when you accumulate at least $500 for the quarter.

Late deposit penalty amounts are figured based on calendar days, starting from the due date of the tax liability. Data Source: IRS Publication 15 (2021)

Failure-to-file penalties for federal payroll taxes

You’re required to report your federal payroll tax liabilities to the IRS, using the appropriate payroll tax forms. To report federal income tax, Social Security tax, and Medicare tax liabilities, employers must typically file quarterly returns via IRS Form 941. However, if your small business has a federal payroll tax liability of $1,000 or less for the year, you may be allowed to file IRS Form 944 annually (instead of quarterly 941s).

Additionally, you must file annual Form W-2s with the Social Security Administration, for each employee to whom you paid wages and withheld taxes for.

Failure-to-file penalties for Forms 941, 944, and 940

• For each whole or partial month that a return is not filed, a 5% penalty is assessed on the total tax due
• For each whole or partial month that you file and pay late, an additional penalty of 0.5% is assessed on the total tax due
• The maximum penalty cannot be more than 25% of the total tax due

Interest on federal payroll taxes

Along with penalties, you must pay interest on the payroll taxes owed. Interest starts accruing from the first day the tax was due. Generally, interest ranges from 3% – 6% of the taxes owed.

Penalties for trust fund taxes

The portion of employees’ wages that you withhold for federal payroll taxes is called “trust fund taxes,” because it is essentially held in a trust, to be remitted to the IRS.

The IRS imposes a trust fund recovery penalty on employers that fail to withhold federal payroll taxes from employees’ wages or remit payroll taxes withheld. Per the IRS, “The penalty is 100% of the unpaid trust fund tax.”

Tax lien and levy for unpaid federal payroll taxes

If you ultimately fail to pay your payroll tax liability, the IRS may file a federal tax lien against your business assets, including your receivables. The tax lien becomes public record and is used as collateral (or security) for the debt.

Ignoring the federal tax lien will result in the IRS notifying you of its intent to levy your business assets. Failure to respond to the levy notice will lead to actual seizure of your assets, such as your business bank accounts, company officer wages, and accounts receivable.

IRS Penalty Waiver

The IRS says that it will waive penalties for employers that can establish reasonable cause for failure to file a return or failure to pay payroll taxes due.

The IRS says that it will waive penalties for employers that can establish reasonable cause for failure to file a return or failure to pay payroll taxes due. Reasonable cause is determined by the facts and circumstances of the situation.

The following situations may constitute reasonable cause:

• Natural disaster, fire, casualty, or other catastrophic interruptions
• Inability to obtain business records
• Serious illness, incapacitation, death, or unavoidable absence of the taxpayer (i.e., the employer) or the taxpayer’s immediate family member
• Other reasons that show you took all measures possible to meet your federal payroll tax obligations, but were unable to do so

The IRS makes clear: “A lack of funds, in and of itself, is not [a] reasonable cause for failure to file or pay on time. However, the reasons for the lack of funds may meet reasonable cause criteria for the failure-to-pay penalty.”

Considerations: State and local payroll taxes

Along with meeting your federal payroll tax obligations, you must withhold and remit applicable state and local payroll taxes to the state and local taxation agencies. You must also file applicable state and local wage and tax reports with the administering agencies by the mandated deadlines. Penalties for noncompliance with state and local payroll taxes vary widely by jurisdiction and type of tax.

Types of state and local payroll taxes:

• State income tax
• Local income tax (e.g., city, county, or school district taxes)
• State disability insurance tax
• Employment training tax
• State unemployment, or SUTA, tax
• Transit payroll tax
• Occupational privilege tax

Contact your state taxation agency to determine which state or local payroll taxes apply to you and your employees.

Mitigating the risk of payroll tax penalties

One of the best ways to avoid payroll tax penalties is to use payroll software that automatically calculates employee and employer payroll taxes plus enables timely, automated payroll tax filings. The software is designed to meet federal, state, and local payroll tax requirements — making compliance easy to reach.