Payroll

Payroll is the process of giving a company’s employees money for the work that they do for the business. However, many companies farm out their payroll processing to firms that specialize in payroll due to the ever-changing complexities of payroll tax law. In this chapter, I will cover the basics of accounting for the payroll process.

Gross Pay

Gross Pay is a pretty simple calculation. Some employees get paid a fixed amount per week regardless of the number of hours they work. Other employees get paid hourly for all of the hours they work, possibly getting extra money if they work overtime. While this is a bit of a simplification, the concept is straightforward. Compute the money the employee is owed and pay him or her. The amount owed could consist of:

• Base Pay
• Overtime Pay
• Commissions
• Bonuses
• Misc.

Unfortunately, figuring out how much the employee is actually owed after all of the deductions is much more complicated.

Net Pay

Net Pay is the Gross Pay amount minus all of the taxes, benefits, and other expenses that the employee pays out of his or her Gross Pay. These deductions from Gross Pay need to be recorded in the journals and posted to the ledger in order to keep track of payroll, to whom taxes should be reimbursed, and which insurance companies to pay, etc.

Payroll Taxes—Employee

When the government first introduced income tax (back in 1862 to support the Civil War and then, formally, in 1913 as an amendment to the U.S. Constitution), income tax was paid by the person receiving the income. However, in 1943, it was decided that corporations would withhold the income tax from an employee’s paycheck and directly pay that money to the government. In essence, the government made companies acts as “collection agents” for the IRS.

Since then, when companies compute their employees’ paychecks, they withhold federal, state, and (possibly) local income taxes for their employees rather than expecting their employees to send the money to the government. Other types of taxes can be withheld as well depending upon current laws.

In addition to income tax, Social Security and Medicare taxes are also withheld from an employee’s paycheck by their employer. An employee may also have money withheld due to court order provisions such as garnishments and child support.

Payroll Taxes—Employer

The government requires that businesses who hire people pay additional taxes as well, as part of the cost of having employees. While employee withholdings are simple liabilities (temporarily holding money for the government), employers’ payments are considered expenses of the business. In general, employers are expected to contribute to the employee’s Social Security and Medicare taxes, to pay unemployment taxes (both Federal and state), and to pay Worker’s Compensation insurance. The last three taxes are to provide funds to unemployed or injured workers.

The following chart shows how the tax burden of a payroll system is treated:

While the tax amount, the maximum tax liabilities per employee, and the rules change frequently, the general journal entry looks as follows (in this example, we see a $60,000-a-year employee who is paid twice a month):

You have probably seen similar levels of detail on your pay stub. Most paychecks provide a detailed breakdown of how Net Pay is computed from Gross Pay.

The employer journal entry for above looks like the following example:

While the tax percentages will vary from agency and from year to year, the basic journal entry to handle payroll taxes will look the same—possibly with more taxes being withheld and also being paid by the employer.

Due to the tax rules and agencies involved (particularly when employees live in different states and cities), many companies farm this accounting out to specialized payroll companies. The penalties imposed by taxing agencies for missed or wrong payments can be substantial.

Other Deductions

Most business offer employees benefits in addition to their base pay. Although there are a variety of benefits offered, two common ones are health insurance payments and contributions to retirement plans.

Let’s assume that the company offers to pay 80 percent of health insurance costs (this is typically done because a company can get a better health insurance rate than individuals) and will match the employee’s contribution to a pension plan up to five percent. This employee puts seven percent of her salary away to her pension plan:

Here is an employee’s journal entry (using the example from above) with a monthly insurance cost of $250 and with the following deductions added:

The employer is simply withholding money from her paycheck, to be paid to the health insurance agency and the pension account at a later date.

When the payment is made, the journal entry for the employee might look like this (assuming the payment was made monthly):

The company expenses 80 percent (i.e., $200) of the money premium and has taken 20 percent (i.e., $50) from the employee for her contribution.

Assuming a quarterly pension contribution into the employee’s 401K account, the journal entry would look like this:

Summary

Payroll processing is a simple process that is made complex by tax laws and the taxing agencies involved, as well as by the variety of benefits an employer might offer employees. I covered the very basic type of payroll entries in this chapter and suggest that, due to the complexities involved on the tax side and the legal ramifications of taxes, many companies let a payroll service stay on top of the ever-changing tax laws and handle payroll for them.