Payroll Tax vs. Income Tax: What’s The Difference?

Managing payroll taxes and income taxes is an important responsibility for every business owner, but the complexity of tax regulations and calculations can be overwhelming. Whether you're a new entrepreneur or an experienced business owner, understanding the distinct roles of payroll and income taxes is essential for maintaining compliance and managing your company's finances effectively.

What is payroll tax?

Payroll taxes include income taxes and taxes assessed for Social Security, Medicare, and unemployment compensation. It’s important to note that both the worker (employee) and the employer generally have to pay these taxes. 

The key components of payroll taxes include: 

• Federal income tax withholding: Businesses must deduct federal income taxes from wages. The amount depends on the worker’s annual income and other information reported on their Form W-4. 
• Social Security taxes: The current rate for Social Security is 6.2% for the employer and 6.2% for the employee—totaling 12.4%. Up to $168,600 for 2024 ($176,100) of taxable wages are subject to Social Security tax.
• Medicare tax: The current rate for medicare tax is 1.45% for the employer and 1.45% for the employee, or 2.9% total. 
• Unemployment taxes: Most employers must pay both federal (FUTA) and state (SUTA) unemployment taxes. Currently, the FUTA tax rate employers pay is 6% on the first $7,000 paid to each employee in gross wages during the year.
• State and local income taxes: Most states require employers may also need to withhold state and sometimes local income taxes from employees' wages.

The Federal Insurance Contributions Act (FICA) taxes fund Medicare and Social Security, while the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) provide temporary income for workers who lose employment.

What is income tax?

Income tax is a type of tax the federal government (and most states) impose on the income or profits of individuals, businesses, and entities based on their income or profits. Taxes on individual income typically include salary, interest, dividends, rents, royalties, lottery and gambling winnings, unemployment benefits, and earnings from businesses they own, like solopreneurships. 

The key components of income taxes include:

• Taxable incomes: The portion of a worker’s or entity’s income subject to taxation, including wages, salaries, and business profits.
• Tax rates: Income tax is typically imposed at progressive rates, so higher income levels are generally taxed at higher rates. Tax rates can vary by state. 
• Deductions and credits: Taxpayers may qualify for tax breaks credits that can reduce their taxable income. Some examples include charitable contributions and certain business expenses. 
• Withholding: Employers must also withhold a portion of employees’ wages for income tax purposes. Self-employed individuals and businesses are often responsible for making quarterly estimated tax payments.

Payroll processing requires businesses to withhold income taxes on employee wages. Then, the taxes are sent to the appropriate taxing authority (the federal, state, or local department of revenue).

Differences between payroll tax and income tax;

Payroll tax and income tax are distinct types of taxes that serve different purposes and have different applications. Here are some key differences between payroll taxes vs. income taxes:

• Application: Payroll tax applies to employees' wages and salaries. Income tax applies to various income sources, including wages, salaries, and business profits. 
• Tax rates: The current federal payroll tax rate is 15.3%, which includes both the employer and employee’s contributions. The federal income tax rate ranges from 10% to 37%.
• Tax levies: The government levies payroll tax on employers and employees, while income tax is levied on individuals’ salaries, wages, and other incomes. 
• Usage: Payroll taxes generally fund three specific programs: Social Security, Medicare, and unemployment benefits. Income taxes fund a wider array of public services and expenditures. 

The employer is responsible for withholding the employer’s share of payroll taxes, reporting employee earnings, and remitting deductions from employees’ wages. The employee is responsible for paying federal and state payroll taxes, as well as their income tax.

Key challenges in managing payroll and income taxes; 

Managing payroll and income taxes comes with complex challenges for small business owners and self-employed individuals. 

Some of the biggest challenges include: 

• Complying with multiple tax laws: One of the biggest challenges businesses face is complying with various federal, state, and local tax requirements. Different tax authorities often have distinct filing schedules and requirements. 
• Managing remote workers: The rise of remote work has introduced new complexities in tax management. When employees work across state lines, businesses must navigate complex tax obligations. 
• Recordkeeping challenges: Accurate recordkeeping is important for tax compliance but can be overwhelming. Businesses must maintain employee tax forms (W-2s, W-4s, 1099s), payroll records and pay stubs, tax payment documentation, and state and federal tax filings. 

Addressing these key challenges means having a system that streamlines paying your salaried and 1099 employees. Source