Payroll tax vs income tax: What's the difference?

Income taxes are tax liabilities based on income, and these taxes are assessed at the federal, state, and local level. Payroll taxes include income tax withholdings and a number of other taxes that are assessed on employers and workers. If you understand the relationship between income taxes and payroll taxes, managing payroll is much easier.

Processing payroll requires you to post accounting entries using accrual accounting. To complete payroll, you must calculate withholdings and submit withholdings to third parties. You have to complete tax forms, report wages to workers, and post journal entries.

Use the links below to jump to the section that best covers your query, or read end to end for an in-depth overview on the topic.

• What is payroll tax?
• What is income tax?
• Accounting for payroll liabilities and expenses
• Steps to process payroll expenses

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 taxes may be paid by the worker, the employer, or both parties.

What is income tax?

Individuals are assessed taxes on many forms of income, including dividend income and interest income. Payroll processing requires businesses to withhold income taxes on employee wages. After income tax dollars are withheld, they are forwarded to the taxing authority (the federal, state, or local department of revenue).

Dealing with other withholdings

Employers may have to withhold additional amounts that are not related to taxes, such as the worker’s share of health insurance premiums. To pay workers, you start with gross pay (unpaid wages) and deduct withholdings to calculate net pay. Some withholdings are for taxes, others are not.

Not all workers have taxes withheld from pay, and you need to classify workers as either employees or independent contractors.

Categorizing employees and independent contractors

A worker’s classification determines how the worker is treated for tax purposes. If the worker is an employee, you’ll incur the payroll expenses discussed in detail below. Independent contractors, on the other hand, are personally responsible for all tax withholdings, and the company’s only expense is the gross amount paid for services.

The Internal Revenue Service (IRS) provides a guide that explains how to assign workers to a particular category. The control you have over a worker determines if the worker is an employee or an independent contractor.

The guidelines consider how much control the business has over what the worker does, who provides tools and supplies, and if there is a written contract in place. If you have a large amount of control over the worker, the individual should be categorized as an employee

• Regardless of how a worker is classified, the payroll process starts with gross wages.

Starting with gross wages

Gross wages may be calculated based on an annual salary or determined using an hourly rate of pay and hours worked. The gross wages paid is your largest payroll expense and includes payments to workers and independent contractors.

Now you’re ready to calculate the other payroll tax liabilities. Payroll taxes can be separated into income taxes and taxes that are not directly related to income.

Reviewing income taxes

Workers and employers must pay income taxes and taxes for Medicare, Social Security, and unemployment compensation. Each of these taxes is based on the worker’s gross income.

Deducting income taxes

Companies are required to deduct federal income taxes from wages, and possibly state and local income taxes as well. The amount deducted is based on the worker’s annual income and the number of allowances computed on Form W-4. Withholding amounts are passed through to each taxing authority, and the amounts are not an employer expense.

FICA taxes and unemployment taxes

Federal Insurance Contributions Act (FICA) taxes fund Medicare and Social Security. Currently, the employer’s payroll expense is a 6.2% Social Security tax and a 1.45% Medicare tax (7.65% in total). Each worker pays the same 7.65% tax through payroll withholdings.

The Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) were passed to provide temporary income for workers who lose employment.

The current employer’s FUTA tax rate is 6% on the first $7,000 in gross income earned by the worker. If the wages are subject to a state unemployment tax, the employer can use a 5.4% FUTA credit, which reduces the FUTA tax to 0.6%. The total federal and state unemployment taxes will vary depending on each state’s unemployment program.

Incurring other payroll costs

Processing payroll requires a business to deduct other costs that are not calculated solely on a worker’s income. Some of these costs are payroll expenses, while other amounts (workers’ compensation and voluntary deductions) are simply collected and passed on to a third party.

Computing workers’ compensation

Businesses that employ workers must purchase workers’ compensation insurance. This form of insurance is determined by state law, and most states require coverage. If a worker is injured on the job, the insurance policy pays for medical costs and lost wages due to injury.

Workers’ compensation premiums are paid by the employer, and the cost is determined by the number of employees and the industry. A construction company, for example, pays more for insurance than an accounting firm. This is because workers on a construction job site have a higher risk of injury than accountants in an office setting.

Voluntary deductions

If a company offers benefits, a portion of the costs may be withheld from the worker’s pay. The employer’s share of the costs is a payroll expense. Here are some examples:

• Retirement plan : The worker’s contributions are deducted from pay and are not an employer expense. The employer’s share of contributions, however, are a payroll expense for the business. Employer contributions are not deducted from pay.
• Health, dental, vision, life insurance premiums: Premiums paid by the employer are not withheld from pay and are included as business expenses. The worker’s share of premiums are deducted from pay and are not a payroll expense.
• Union dues: Dues are deducted from pay and forwarded to the union on the worker’s behalf. The payments are not a payroll expense.
• Loan payments: If a worker has a loan from the business, repayments may be deducted from pay and are not a payroll expense.

The cost incurred to retain an accountant or a payroll service company is a business expense. Once you understand the payroll expenses you must incur, create a written procedure that documents how you process payroll.

Now you need to post all of the activity to your accounting records. You’ll use the accrual method of accounting, and you’ll post both payroll liabilities and expenses.

Accounting for payroll liabilities and expenses

Every business should use the accrual method of accounting, which matches revenue earned with expenses incurred. The accrual method records payroll expenses in the month they are incurred, regardless of when the expenses are paid in cash. The matching concept presents a more accurate picture of company profit.

Understanding the accrual accounting method

Assume that a restaurant owes workers $3,000 in payroll for the last five days of March, and that the next payroll date is April 5. Using the accrual method, $3,000 in wage expense is posted on March 31, along with a $3,000 increase in wages payable.

When payroll is processed on April 5, cash is reduced by $3,000 and wages payable is decreased by $3,000. The expense was posted in March, when the hours were worked by the restaurant employees. Revenue in March is matched with March expenses, including the $3,000 in payroll costs.

Accounting for payroll liabilities and payroll expenses

The accrual method posts payroll liabilities and expenses in the same period. In the restaurant example, a $3,000 wage expense and a $3,000 wage liability balance are posted on March 31. When cash is paid on April 5, the liability balance is reduced.

This accounting method does not post expenses based on cash outflows, and it matches revenue earned with payroll expenses incurred.

Let’s pull it all together and explain the steps required to process payroll.

Nine steps to process payroll expenses

The payroll process requires you to collect information, perform calculations, pay workers, and submit withheld payments to third parties. Processing payroll starts with Form W-4.

#1. Collect information on Form W-4

Newly hired employees must complete Form W-4. Information submitted on the form tells employers how much salary to withhold from a paycheck for tax purposes. The number of allowances on the W-4, along with the gross pay, determines the tax withholdings.

The W-4 also provides guidance for employees who have multiple jobs or who have working spouses. There are extra schedules provided to calculate withholdings for these situations.

#2. Use the payroll cycle to determine gross pay

Gross wages are the starting point for payroll, and the number of pay periods determines how much salary is paid on each payroll date. If an employee is paid hourly, the pay period indicates the start and ending days for computing hourly payroll.

#3. Use gross pay and other data to calculate net pay

Net pay is the amount the worker receives after all deductions and withholdings. Use the information you’ve collected to calculate net pay. This example provides a payroll calculation and includes the typical withholdings from pay:

Payroll Calculation Example

In this example, payroll is processed 26 times a year. Income taxes and FICA taxes are withheld from payroll along with health insurance premiums. Finally, unemployment taxes are paid by the employer and not withheld from pay.

#4. Pay workers

You can pay workers by direct deposit or with a physical check.

#5. Submit payroll tax deposits

Business owners must submit deposits for the following tax withholdings. The deposit frequency varies, depending on the dollar amount and other factors.

• Federal income tax
• State income tax
• FICA tax
• Federal and state unemployment tax (FUTA and SUTA)

You can pay tax deposits online, which makes it easier to submit the deposits by the required deadlines.

#6. Complete payroll tax forms

Payroll tax returns are complex, and the information you submit must be accurate. Make sure to submit the forms on time to avoid late filing fees. Here are the most common payroll tax forms that businesses must submit:

• Form 941: Reports federal income taxes and FICA taxes to the IRS each quarter
• Form 940: Employer’s annual federal unemployment (FUTA) tax return.
• Form W-3: Reports the total wages and tax withholdings for each employee using W-2 forms. The report is filed with the Social Security Administration annually.
• Form 1096: Reports the dollars paid to independent contractors using 1099 forms. This report is filed annually

Accounting software allows you to generate these reports automatically.

#7. Report pay amounts to workers

Businesses issue Form 1099-NEC to report income earned by independent contractors. You must issue a 1099 form to each contractor who is paid $600 or more during the calendar year. If the payment is less than $600, the earnings are still taxable as income to the contractor, even though a 1099 is not issued.

Employees receive a W-2 form, which reports gross pay and all tax withholdings for the year.

#8. Keep payroll records on file

The Fair Labor Standards Act (FLSA) requires that records used to compute pay must be kept for two years. The FLSA also requires businesses to keep time cards and payroll calculation records.

These variables may change your payroll calculations from one pay period to the next:

• Tax law changes
• Employees who have been added, promoted, or let go
• Workers who change their tax and benefit withholdings based on salary or family changes

Payroll accounting may be the most time-consuming accounting work you perform, and it’s important to understand some of the basic journal entries.

#9. Posting journal entries for payroll liabilities

Here are three common payroll journal entries that businesses must post:

• Accrued payroll: To expense payroll in the proper period, you debit accrued wages (or wages expense) and credit wages payable.
• Pay accrued payroll in cash: If you accrue payroll and then pay workers cash, you debit (reduce) wage payable and credit (reduce) cash.
• Pay income taxes withheld : When a business withholds taxes, the company records a liability for the amount withheld. When the withheld taxes are paid, the tax liability account is reduced with a debit, and cash is reduced using a credit.

Payroll obligations are similar from one business to the next, but the payroll liabilities chart of accounts may use account titles that are unique to the business. A company may create subaccounts to track payroll by department, for example. Accountants often post adjustments to payroll accounts before the financial statements are generated.

If you use technology and put a written plan in place, you can save time and process payroll correctly.

Plan your payroll processing

Minimize the time and effort required to process payroll. Discuss the payroll process with your staff, write a formal procedure, and store the document where your staff can access it. Use a payroll software or service to process payroll, and take steps to minimize the use of spreadsheets. With these tips in mind, you can save time and process payroll accurately.