Payroll Tax Cut & What It Means for Small Businesses

On Aug. 8, 2020, former President Trump passed an executive order freezing the 6.2% Social Security tax for eligible employees—those who make less than around $104,000 per year. While most employers were given the option of whether to pause employee withholding, federal employees and active-duty military personnel were required to take part in the deferral. Under the original order, deferred taxes were to be repaid beginning Jan. 1, 2021, until April 30, 2021, but this period was extended through the end of 2021.

Who the Payroll Tax Cut Impacts

President Trump’s executive order is formally referred to as the Memorandum on Deferring Payroll Tax Obligations in Light of the Ongoing COVID-19 Disaster. This temporary tax cut was only geared toward employees and not the employer-portion of Social Security taxes (the CARES act gives employers a payroll tax deferral that we’ll talk about later).

Because employers are essentially the payroll tax collectors, this executive order also affects your payroll process. If your business opted to defer employee Social Security taxes, you likely worked with your payroll department or third-party provider to adjust withholdings in the last quarter of 2020. This responsibility continues into 2021, as employers have to deduct additional payroll taxes from employee paychecks to make up for the deferred amounts.

When the Payroll Tax Cut Takes Effect

The payroll tax freeze began Sept. 1, 2020, and ran through Dec. 31, 2020. Under the original memorandum, employers were required to start withholding Social Security taxes again Jan. 1, 2021, and deferred taxes were to be repaid by April 30, 2021.

However, the Consolidated Appropriations Act, 2021 (signed Dec. 27, 2020) extended this repayment period through Dec. 31, 2021. As a result, the amount that must be withheld from each paycheck to collect the deferred taxes will be smaller and less detrimental to employees than under the original timeline.

Now, deferred Social Security taxes must be repaid by Jan. 3, 2022, at the latest, as Dec. 31, 2021, is a federal holiday. Any employer penalties and interest on unpaid deferred taxes begin to accrue Jan. 1, 2022.

How the Payroll Tax Holiday Affected Employee Paychecks

The original intention of the tax freeze was to increase employee checks during the economic strain brought on by COVID-19. However, because of the lack of guidance surrounding the order, many employers opted not to alter employee Social Security withholdings. In fact, a large number of employers—including businesses like UPS, Proctor & Gamble, H&R Block, and BlueCross BlueShield of Tennessee—chose not to take part in the payroll tax holiday.

Still, all federal employees and active-duty military personnel were impacted by the freeze, as federal employers were required to participate in the holiday. To illustrate the effect of the holiday on an employee, here’s an example of impacted paychecks in the last quarter of 2020:

Jennifer receives $2,500 in gross pay twice a month. Typically, her employee withholds $155 from each of her paychecks. Under the payroll tax freeze, however, her bimonthly check increased to $2,655 every two weeks. Ultimately, she received an extra $310 in her pocket every month, which is an additional $1,240 total during the payroll tax holiday.

Deferring Social Security Taxes vs Forgiving Them

While former President Trump’s payroll tax holiday is also referred to as a payroll tax cut, it’s actually just a tax deferral. The executive order did not explicitly state that the tax bill will be forgiven—in fact, it would take an act of Congress to forgive the deferred payroll taxes, not just an executive order. For this reason, your employees are still obligated to repay any Social Security taxes you didn’t withhold from Sept. 1, 2020, to Dec. 31, 2020.

This means that, as an employer, you’ll have to collect additional Social Security tax from employee paychecks to make up for the deferred amounts. So in the example we gave above, Jennifer would owe the IRS $1,240 in tax money that must be deducted from her paychecks from Jan. 1, 2021, to Dec. 31, 2021.

How to Collect Deferred Taxes From Employees

If you chose to participate in the payroll tax holiday, you’re required to make up for the deferred taxes by collecting additional Social Security tax over the course of 2021. Keep in mind that this process may differ if employment is terminated before an employee’s tax deferments have been repaid. In this case, you may subtract the employee’s outstanding Social Security taxes from his final paycheck. However, if the employee’s final paycheck is insufficient to cover the outstanding balance, you may be responsible for repaying those amounts.

If you handle accounting in-house, each deferral during the holiday should be reflected by both a receivable (from each employee) and a liability (to the IRS). This is why you’ll have to collect all of the deferred taxes from employees—or risk reflecting a loss. To learn more about doing payroll for your business, check out our guide on how to do payroll.

How Employers Handled the Tax Freeze

While some business owners originally speculated that individual employees could opt in or out of the deferment, the decision to participate in the holiday was ultimately left up to employers. And, because the payroll tax holiday was a deferral—rather than a full tax cut—many employers chose not to participate.

This was due in large part to concern that the change could expose their employees to future financial difficulties when the deferred taxes require repayment. Employers were also deterred by the fact that they could be on the hook if they are unable to recoup the deferred amount from future employee paychecks.

Not surprisingly, that concern was echoed by employees themselves. In fact, when the executive order was first announced, we surveyed 21 employees at Fit Small Business. Only one employee voted to have the company stop withholding the Social Security tax.

Payroll Tax Deferral for the Employer-Portion of Social Security Taxes

As a small business owner, you’re probably also interested in what tax relief you can get. In March 2020, after the onset of COVID-19, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act, or the Act) went into effect. Under the Act, all employers were granted a deferral of the 6.2% employer-portion of the Social Security tax, similar to the payroll tax cut issued for employees.

All Social Security taxes incurred from March 27, 2020, to Dec. 31, 2020, were eligible for deferral, meaning employers weren’t required to include the money in their quarterly employer tax payments.

Employers were also given the ability to opt out of the deferral altogether and continue including the funds in their regular tax payments.

Employers Who Were Eligible for the Employer Payroll Tax Deferral

All employers were able to take advantage of the payroll tax deferral, including those entitled to paid leave credits and employee retention credits. This was a change from the original terms of the Act, which barred employers who received tax credits under the CARES Act from participating.

Claiming the Payroll Tax Deferral

A revision to Form 941 (the IRS form employers file to report quarterly payroll taxes due) was implemented for Quarters 2 through 4 of 2020. To defer for that period, employers were required to enter any Social Security tax they intended to withhold on line 13b.

Employers who deferred any Social Security taxes incurred between March 27 and March 31 needed to short pay Quarter 2’s balance to receive a letter from the IRS showing the discrepancy. Business owners could then indicate that the discrepancy was due to a deferral.

Stay Tuned for Updates About the Employee Payroll Tax Deferral

If additional information about the payroll tax freeze is released, we will provide it and work with our experts on helping you figure out how to navigate the systemic changes this may require in your payroll process.