Before we dive in: startup founders, the IRS really wants you to payroll taxes - failure to do so can result in painful penalties. Read on:

Payroll Taxes for Startups: What Founders Need to Know

As a startup founder, understanding your payroll tax obligations is crucial for maintaining compliance and avoiding penalties. At Kruze Consulting, we often advise VC-backed startups on navigating the complex world of payroll taxes. This guide will cover key aspects of payroll tax, common questions we receive from founders, and strategies to optimize your startup’s tax position.

Payroll is by far the largest expense for most startups, fully loaded 68% of all expenses, according to our analysis of payroll costs, and since most startups are unprofitable, payroll taxes usually represent the largest tax expense most VC-backed companies will face. For a typical startup, payroll taxes will be about 3.4% of all expenses that a company incurs any given year.

What Are Payroll Taxes?

Payroll taxes are taxes withheld from employees’ paychecks and paid to the government to fund various public programs. They also include taxes paid by employers based on their employees’ wages. The main components of payroll taxes in the United States include:

• Employee withholdings: While this isn’t an expense for your company, as an employer, you must withhold income taxes from employee wages and remit them to the appropriate government agencies. This includes:
  • Federal, state, and local income tax withholdings
  • The employee’s share of Social Security and Medicare tax

   

• Federal Insurance Contributions Act (FICA) taxes: FICA taxes fund Social Security and Medicare programs. These taxes are paid by both employers and employees.

   

• Federal Unemployment Taxes: Under the Federal Unemployment Tax Act (FUTA) employers must pay this tax, which funds unemployment benefits for workers who lose their jobs. The good news is that it only applies to the first $7,000 of taxable wages per employee per year.

   

• State Unemployment Taxes: Like FUTA, most states have state-level unemployment tax laws. The terms SUTA or SUI (State Unemployment Insurance) are often used to refer to these taxes, though some states have a more specific name. For example, it’s known as Reemployment Tax in Florida or Unemployment Compensation (UC) in Pennsylvania.

Regardless of the terminology, the basic function of the tax remains the same across all states - to fund unemployment benefits for eligible workers who have lost their jobs.

Every company’s situation is unique, so always consult with a tax professional when making decisions about payroll taxes!

Can Founders Avoid Payroll Taxes?

One of the most common questions we get from startup founders is whether there’s a way to avoid payroll taxes. The short answer is no. Attempting to circumvent payroll taxes is not only illegal but can lead to severe consequences for both the company and its founders.

As a VC-backed startup, it’s important to note that even if you’re the founder and sole employee of your startup, you still need to pay payroll taxes on your salary. The IRS classifies founders who actively work in their business as employees, subject to the same tax requirements as any other employee. You cannot pay yourself as a contractor as a way to avoid payroll taxes!

Quite a few times a year we meet founders who are paying themselves as contractors as a way to try to avoid startup payroll taxes. The IRS is sophisticated - they are onto this trick - and they don’t allow it. Fixing payroll tax problems can be much, much more expensive than just getting it right from the start, so we always recommend using one of the best payroll systems for startups, setting yourself up on payroll, and paying the appropriate taxes. It will end up being easier and, most likely, cheaper - not just in the long run, but pretty quickly!

Strategies to Reduce Payroll Taxes for Startups

While employer payroll taxes are unavoidable, there are legitimate strategies to lower your startup’s tax position:

1. Utilize the R&D Tax Credit: One significant opportunity for many startups is the R&D Tax Credit. This incredibly valuable credit can be applied as a payroll tax deduction to offset up to $500,000 of your startup’s payroll taxes each year, providing substantial savings for qualifying companies. Our clients have collectively saved over $100 million in payroll taxes through our R&D tax credit work! Use our R&D Tax Credit Calculator to estimate your potential savings.
2. Consider equity compensation: Stock options and other forms of equity compensation can help reduce cash compensation and resulting payroll taxes.
3. Implement a 401(k) Match: Offering 401(k) benefits is a great way to attract top talent. Adding a company matching plan takes it to the next level! Not only will employees appreciate additional pay, but contributions made by the business are exempt from both the employer and employee portions of payroll tax.
4. Other Tax-advantaged Benefits: A company can offer several other tax-advantaged benefits, including Health Savings Accounts (HSAs), Flexible Spending Accounts (FSAs), Education Assistance, Dependent Care Assistance, Transportation Benefits, Group Life Insurance, and others. Working with a knowledgeable benefits broker or payroll provider is crucial to successfully implementing these programs.

Are Relocation Expenses Paid to Founders Taxable?

Yes, relocation expenses paid to founders are generally considered taxable income. Before the Tax Cuts and Jobs Act (TCJA) of 2017, certain moving expenses were tax-deductible and could be excluded from an employee’s taxable income. However, this provision has been suspended for tax years 2018 through 2025.

This means that if your startup pays for a founder’s relocation expenses, those payments are subject to payroll taxes. The amount should be included in the founder’s W-2 as taxable wages, and the startup must withhold and pay the appropriate payroll taxes on this amount.

What Are Social Security Taxes That Startups Pay?

Social Security taxes are a significant component of the employment taxes that startups must pay. These taxes fall under the Federal Insurance Contributions Act (FICA) and are split between the employer and the employee. The total Social Security tax rate is 12.4%, which means:

• Employees pay 6.2% of their wages, withheld from their paycheck
• Employers pay 6.2% of an employee’s wages

An important aspect of Social Security taxes is the annual wage base limit. For 2024, the Social Security tax applies only to the first $168,600 of an employee’s wages.

How Social Security Taxes Are Used

The funds collected are crucial for supporting various Social Security benefits:

1. Retirement Benefits: Monthly cash payments sent to eligible retired workers
2. Disability Insurance: Support for workers who become disabled and are unable to work
3. Survivorship Benefits: Payments to surviving spouses and dependents of deceased workers who were eligible for Social Security.

What is the other component of FICA taxes?

In addition to Social Security, startups must also pay Medicare taxes:

• The total Medicare tax rate is 2.9% of an employee’s wages
• Like Social Security, this is split evenly between the employer and employee
• There’s no wage base limit for Medicare taxes
• An Additional Medicare Tax of 0.9% applies to employees earning over $200,000 per year

For startups, understanding that these taxes directly contribute to their employees’ future financial security can be a valuable perspective. It’s not just a tax burden, but an investment in their workforce’s long-term well-being and a contribution to a broader social safety net.

How to start paying payroll taxes

Paying payroll taxes manually is complex and error-prone - sign up for a system! These systems can cost as little as $50 per month and will save you valuable time and potential headaches. For guidance on setting up your payroll system, check out our guide on implementing startup payroll.

It’s equally important to account for payroll transactions the right way - which is not as easy as it sounds. Accurate reporting offers insights into labor costs, helping with budgeting, forecasting, and cost control.

Want to see if your payroll transactions are recorded correctly? Use this simple test to check.

How to budget for payroll taxes

Now let’s talk budgeting for those payroll taxes because we get this question a lot. As a general rule:

• The tax rate for employees is usually ~30%.
• The company then gets taxed ~10% on the gross payroll.

So for an employee who is getting $100,000 in wages:

• $70,000 goes to the employee’s bank account
• $30,000 goes to taxes, from the employee
• $10,000 goes to taxes, from the company

And those two bank debits you see after using a payroll processor? Using this example, the first debit will be $70K going to your employees’ bank accounts. The second bank debit will be $40K going to tax payments (which is the sum of both employee and employer taxes).

How to model it

Our team has a lot of financial modeling experience - it’s best practice for startups to carefully model/budget out their expenses. Wages are the number one expense for most startups, so this is an important component to get right. We recommend starting with the employees’ wages; so if you are paying someone $150,000, start with that. Then add in an additional line at 10% of their salary for taxes.

Of course, those aren’t the only extra expenses you’ll have as a startup founder related to wages. In general, we’ve found that 25% to 30% gross up (the additional line we just mentioned) is the right amount to estimate a new startup’s benefits and payroll tax expense.

Common Payroll Tax Pitfalls for Startups

Avoid these common mistakes to prevent payroll tax penalties:

• Misclassifying employees as contractors: Some founders mistakenly believe they can classify employees as independent contractors to avoid payroll taxes. This is a dangerous misconception! The IRS has strict guidelines for determining worker classification, and misclassifying employees can result in significant back taxes and severe penalties.

   

• Incorrect calculation of taxable wages: Ensure you’re including all forms of taxable compensation, including bonuses, commissions, and taxable fringe benefits.

   

• Failing to deposit taxes on time: Deposit due dates often differ from the filing due dates of tax returns. Late deposits can result in penalties of up to 15% of the unpaid tax and can be a pain to correct.

   

• Neglecting to file required forms: Failing to file forms like Form 941 (Employer’s Quarterly Federal Tax Return) can result in penalties of up to 25% of the tax due. Additionally, interest accrues on any unpaid balance!

   

• Overlooking state and local tax obligations: Don’t forget about state and local payroll tax requirements, which vary by jurisdiction. This is another reason to use a good payroll provider.

The Importance of Professional Guidance

While this guide provides a solid foundation, payroll tax management can be complex, especially for rapidly growing startups. Working with a CPA firm experienced in serving VC-backed startups can help ensure compliance, optimize your tax position, and allow you to focus on growing your business.

Pro tip: Outsource your payroll processing. Don’t even think about doing it yourself. If you do it incorrectly you can incur serious penalties, and even the best people and accountants make mistakes. Payroll processing companies will handle the payroll taxes, and also make sure your employees get paid. The software out there has become so robust and efficient that no human fingers can keep up! Using a payroll processor will save you time and money. I’ve used just about every system out there, and my team reviews the best payroll software for startups here.

At Kruze Consulting, we specialize in helping VC-backed startups navigate the complexities of payroll taxes and other financial challenges. From implementing efficient payroll systems to maximizing tax credits, our team is here to support your startup’s financial success!