Sole Proprietor on Payroll?

A good question today for discussion:
“My husband is self-employed with no other employees.  I generate his paychecks.  This year, he has been doing a few jobs outside of our county; therefore, the local tax amounts vary from county to county.  The payroll program I use is a very basic program so there are not a lot of different options to use.  (This is a new program I started using this year.)  To keep local taxes correct, I have to issue him a check for each job completed outside of our county.  When I generated a paycheck to him for a small job in a different county, ($300 paycheck), I noticed there were no federal withholding taxes.  I didn’t know this before, but it appears tax calculations are different based on daily, weekly, monthly, etc. pay periods.  I played around with this in the program and noticed the variance each time I changed this option.  With the flexibility of him being self-employed, I generate a paycheck on an as-needed basis to cover our personal needs.  It is never a fixed amount and the frequency varies. Taking the issue of local tax variances out of the picture, I am now worried if the federal and state taxes are being calculated correctly because of the varied amounts and time frames of the paychecks.  I don’t know whether to choose the option of him getting paid daily, weekly, bi-monthly or monthly. The federal and state withholdings changes in each of these categories.  I feel that it is incorrect to have no federal withholding if I generate a paycheck to him for only $300.00.  Can you help?”

A.  Your question contains one of the most common misconceptions of those who are self-employed.  You did not state if you were an LLC, S corp or a C corp.  I assume by your use of the words “self-employed” that you are simply a Schedule C filer with the IRS.  Most of the included fact pattern is actually irrelevant to answer your question.  Simply put, schedule C sole proprietors do not receive paychecks.  The profit earned from the business each year is the “paycheck” for your husband for tax purposes.  You will pay income taxes based on the profit of the business, less any allowed personal deductions on the form 1040.  Self-employed individuals make estimated payments to the IRS based on their estimated tax liability each year.  These estimated payments are made on a quarterly basis.  Your CPA or tax adviser should be able to look at your situation and determine what estimated payments are required.

While you do not have employees now, it is important to note that when you do have employees, you should match your pay frequency with the way you pay.  If you are having employees work in a different city each day, and your payroll system cannot accommodate multiple city tax rates, you would pay based upon a daily frequency for federal, state and local purposes.  If you pay daily and use any other table, the amount of wages will be too low to trigger withholding for federal and state in most cases.  If you think about it, $300 per day is about $81,000 when annualized (assuming a 270 day work year).  If you annualized $300 using a weekly table, it only adds up to $15,600 of gross wages.  There must be a low-cost system available that could handle such a problem when you get to the point of actually having employees and needing it.

——-
Samuel Kerch, CPA

Yikes, A Big Tax Bill!!!

Q. My husband works for a large company, and I receive disability and do not work.  We just had our taxes done this week and got quite a shock!  We had a federal income tax refund of over $4000, but owed state tax of $1000 and local taxes of $600.  We are in PA.  How can we adjust our withholding so that this does not happen again next year?

A.  When payroll people hear the Pennsylvania, they run screaming from the room.  The local tax debacle there is the stuff legends are made of.  In most states, when someone has too little withholding, an employee can simply get a copy of the state’s W-4 equivalent, and reduce the number of allowances claimed.  This has the effect of increasing the amount of income subject to tax and thus increasing the tax withheld.  Unfortunately, in PA, there is no W-4 equivalent.  PA is calculated as a flat percentage of taxable income, 3.07% to be exact.  I’m not sure where to point you on this one.  Did you have non-wage income like dividends or capital gains that were not taxed?  Do you have a small business on the side where there were no estimated payments made?  Perhaps the payroll system at your husband’s employer has a way to allow for additional withholding beyond the standard percentage.

For the local tax, there is again no W-4 equivalent in most cases.  However, there is very likely an obvious cause for this under withholding.  In PA, employers are required to withhold where the employee works.  If he works in a different jurisdiction than the one he lives in, then the withholding rate will be lower.  He will have the non-resident rate applied to his wages.  In most cases for PA, the resident rate is 1% (could be higher) and the non-resident rate is half of that.  Therefore, he could have only half as much tax taken from his check as was required.  If an employer opts to withhold at the higher resident rate, it is called courtesy withholding.  Not all employers wish to do this because of the extra record keeping requirements.  Check with your employer to see what is possible with regards to increasing the local tax withholding as well.