Withholding Tax for Contract of Service: Deposits, Filings, and Penalties

If you hire someone under a contract of service, federal law requires you to withhold income tax, Social Security tax, and Medicare tax from each paycheck and send those amounts to the IRS on the schedule the agency assigns you.1Office of the Law Revision Counsel. 26 USC 3402 Income Tax Collected at Source For 2026, that means running each pay period through the current wage brackets for income tax, taking 6.2 percent for Social Security on earnings up to $184,500, and taking 1.45 percent for Medicare on every dollar of wages.2Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates You also owe federal unemployment tax on top of those withheld amounts, and you file quarterly or annual returns to reconcile the numbers. Getting any piece of this wrong can reach past the business and hit you personally.

Make Sure It’s Actually a Contract of Service

A contract of service creates an employer-employee relationship, where the business controls not just what work gets done but how it gets done. The IRS looks at three categories to decide: behavioral control, financial control, and the overall relationship between the parties.3Internal Revenue Service. Topic No. 762, Independent Contractor vs. Employee If you set the schedule, dictate the method, supply the tools, and the worker carries no risk of financial loss, you have an employee, and the withholding rules in this article apply.

A contract for service is different: it describes an independent contractor who runs their own process, takes their own risk, and typically works for more than one client. The label the parties put on the paperwork doesn’t settle the question — substance controls.4Internal Revenue Service. Employee (Common-Law Employee) If you’re genuinely unsure, either you or the worker can file Form SS-8 for an official determination.5Internal Revenue Service. About Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding Treating a true employee as a contractor means you’ve been skipping mandatory withholding on every paycheck, and the back taxes, interest, and penalties compound quickly.

Paperwork Before the First Paycheck

Form W-4

Every new employee completes Form W-4 so you can compute the correct federal income tax withholding. It captures filing status, adjustments for multiple jobs, and dollar-amount credits for dependents, and it must carry a valid Social Security number and the employee’s signature under penalty of perjury.6Internal Revenue Service. Form W-4 – Employee’s Withholding Certificate The old system of withholding allowances was eliminated in the 2020 redesign; if your payroll setup still asks for a number of allowances, it’s out of date.7Internal Revenue Service. FAQs on the 2020 Form W-4

Form I-9

You also need Form I-9 to verify identity and work authorization. The employee completes Section 1 no later than their first day, and you have three business days from the start date to inspect their documents and complete Section 2.8U.S. Citizenship and Immigration Services. I-9, Employment Eligibility Verification Acceptable documents are listed on the form itself.9U.S. Citizenship and Immigration Services. Form I-9 Employment Eligibility Verification

If the Worker Won’t Give You a TIN

Backup withholding applies when an employee fails to provide a valid taxpayer identification number: you withhold a flat 24 percent of the gross payment until the issue is fixed.10Internal Revenue Service. Topic No. 307, Backup Withholding That’s almost always higher than what a properly completed W-4 would produce, so resolving the TIN quickly is in everyone’s interest.

Calculating Federal Income Tax Withholding

IRS Publication 15 — Circular E — is your working reference for regular wage withholding.11Internal Revenue Service. Publication 15 (Circular E), Employer’s Tax Guide Start with gross pay for the period, then apply either the wage bracket method or the percentage method using the employee’s filing status and W-4 entries. Do this every pay cycle; errors compound if you fall behind.

Supplemental wages — bonuses, commissions, severance — follow separate rules. If the payment is identifiable as separate from regular wages, you can withhold at a flat 22 percent instead of running it through the standard tables. Once an employee’s supplemental wages pass $1 million in a calendar year, the excess is withheld at 37 percent regardless of the W-4.11Internal Revenue Service. Publication 15 (Circular E), Employer’s Tax Guide

Social Security and Medicare (FICA)

FICA obligates both you and the employee to pay Social Security and Medicare tax. For 2026:

You match the 6.2 percent Social Security and 1.45 percent Medicare amounts out of your own funds. The Additional Medicare Tax is employee-only; there’s no employer match on that 0.9 percent.2Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates

Federal Unemployment Tax (FUTA)

FUTA runs alongside FICA and income tax. The gross rate is 6.0 percent on the first $7,000 of each employee’s annual wages. If you pay your state unemployment tax on time, you get a credit of up to 5.4 percent, which drops the effective FUTA rate to 0.6 percent, or a maximum of $42 per employee per year.12Internal Revenue Service. Topic No. 759, Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return FUTA is paid entirely by the employer. Nothing comes out of the employee’s paycheck for it.

State Withholding Runs on Top of This

Most states impose their own income tax withholding, and rates, brackets, and deposit schedules vary. A few states have no income tax; several require additional withholding for disability insurance or paid family leave. If you have employees in more than one state, each state’s rules apply to wages earned there, which can mean maintaining separate calculations and deposit calendars.

Deposit Schedules and Deadlines

Withholding the right amount doesn’t help if the deposit is late. The IRS assigns you either a monthly or semiweekly schedule based on total employment taxes reported during a four-quarter lookback period.13Internal Revenue Service. Topic No. 757, Forms 941 and 944 – Deposit Requirements

One rule catches employers off guard. If you accumulate $100,000 or more in taxes on any single day, you must deposit by the next business day regardless of your normal schedule, and hitting that threshold also moves you onto the semiweekly schedule for the rest of the current calendar year and all of the next.13Internal Revenue Service. Topic No. 757, Forms 941 and 944 – Deposit Requirements Federal tax deposits must be made electronically, typically through EFTPS.14Internal Revenue Service. Depositing and Reporting Employment Taxes

Quarterly and Annual Filings

Most employers file Form 941 after each calendar quarter, reporting total wages and the amounts withheld for federal income tax, Social Security, and Medicare.15Internal Revenue Service. Topic No. 758, Form 941, Employer’s Quarterly Federal Tax Return and Form 944, Employer’s Annual Federal Tax Return Very small employers whose annual liability for those taxes is $1,000 or less may qualify to file Form 944 once a year instead.16Internal Revenue Service. About Form 944, Employer’s Annual Federal Tax Return

By January 31, you must furnish Form W-2 to each employee and file copies with the Social Security Administration.17Social Security Administration. Deadline Dates to File W-2s Electronic filing is standard.18Internal Revenue Service. General Instructions for Forms W-2 and W-3 FUTA is reported separately on Form 940, filed annually.

How Long to Keep the Records

Employment tax records — W-4s, deposit receipts, payroll registers — must be kept at least four years after the due date of the return for the fourth quarter of the year, or four years after the tax was paid, whichever is later.19Internal Revenue Service. Employment Tax Recordkeeping

Form I-9 has its own clock. Keep it for the entire time the employee works for you, and after termination retain it for three years from the hire date or one year after the termination date, whichever is later.8U.S. Citizenship and Immigration Services. I-9, Employment Eligibility Verification The timelines overlap without matching, so a single retention calendar prevents destroying records you’re still required to hold.

Penalties and Personal Liability

Late deposits carry a graduated penalty:

  • 1 to 5 days late: 2 percent of the unpaid deposit
  • 6 to 15 days late: 5 percent
  • More than 15 days late: 10 percent
  • Still unpaid 10 days after the first IRS notice: 15 percent20Internal Revenue Service. Failure to Deposit Penalty

Interest accrues from the original due date on top of those percentages.

The bigger risk is personal. The income tax and employee share of FICA you withhold are treated as trust fund taxes, meaning the money belongs to the government the moment it leaves the employee’s paycheck. If those amounts don’t reach the IRS, any person who was responsible for collecting and paying them can be held personally liable for the full unpaid amount.21Office of the Law Revision Counsel. 26 USC 6672 Failure to Collect and Pay Over Tax, or Attempt to Evade or Defeat Tax The Trust Fund Recovery Penalty equals 100 percent of the unpaid trust fund tax, not a fraction. A responsible person is anyone with authority over the company’s finances: owners, officers, payroll managers, and bookkeepers who sign checks all qualify depending on actual control. Choosing to pay vendors instead of the IRS with available funds is treated as willful, even without bad intent.22Internal Revenue Service. Employment Taxes and the Trust Fund Recovery Penalty (TFRP)

At the far end, willful failure to collect, account for, and pay over withheld taxes is a felony carrying a fine of up to $10,000 and up to five years in prison.23Office of the Law Revision Counsel. 26 USC 7202 Willful Failure to Collect or Pay Over Tax Criminal cases are rare and reserved for deliberate evasion, but the civil penalties alone can close a small business. Treating deposit deadlines as non-negotiable is the simplest form of protection.