What are payroll liabilities? Definition and types

Payroll processing is complex, and you may find it difficult to stay on top of the process. It’s particularly important to track your payroll liabilities and to submit payments on time. When you have unpaid wages or withhold amounts from payroll, you’re creating payroll liabilities. Let’s start with the basics.

What are payroll liabilities?

In accounting, a liability is an obligation to pay an amount. When you manage payroll, your company incurs two types of payroll obligations:

• Employee compensation: The gross wages owed to employees and independent contractors are payroll liabilities.
• Withheld amounts : Amounts withheld from worker pay for income taxes must be forwarded to the IRS and state departments of revenue. Amounts withheld and not yet sent are payroll liabilities. However, note that when a business withholds amounts for an employee, the dollars are not a payroll expense.
• Payroll expenses : Some payroll liabilities are not withheld from worker pay. For example, the employer’s share of Social Security and Medicare taxes is a liability when payroll is processed. When the payments are submitted, the liability is reclassified into an expense account.

When you submit payments, you also provide reports that explain the purpose of the payments (employee name, amounts withheld, etc.). Your company’s payroll- liabilities chart of accounts may include dozens of balance-sheet account numbers.

Types of payroll liabilities

Employee compensation, taxes, and voluntary deductions all generate payroll liabilities. In addition, employers incur payroll liabilities for FICA (Federal Insurance Contribution Act) tax and other expenses.

Employee compensation

Gross wages owed to employees and independent contractors are payroll liabilities. There are several ways to calculate liability for a specific pay period:

• Salaried workers: The portion of annual salary owed for the pay period, plus bonuses and other incentive compensation.
• Hourly workers: This liability is total hours worked multiplied by the hourly rate of pay, including overtime hours. Hourly workers may also earn incentive compensation.
• Independent contractors (freelancers): Amounts owed based on an hourly rate agreement, or calculated using a flat fee.

No taxes are withheld on compensation paid to independent contractors. However, you’re required to withhold taxes on employee pay based on information the worker provides on Form W-4.

Payroll taxes and insurance

Taxes are withheld from pay to fund income tax, Social Security, and Medicare tax liabilities. Employers incur expenses for some of these taxes.

• Federal income tax withholdings: The amounts withheld are determined by the worker’s annual income and filing status (married, single, etc.).
• FICA taxes: The taxes collected to fund Social Security and the Medicare taxes. For tax year 2020, employers and workers each paid a 7.65% FICA tax rate on the worker’s gross wages, and the worker’s taxes were withheld from gross pay. The self-employed must pay both the employer and worker amounts (15.3%) and deduct one-half of the self-employment taxes on the personal tax return.
• State income taxes: Each state has different requirements for withholding and paying state income tax, and some states don’t impose a state income tax.
• Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Act (SUTA): Both were passed to provide temporary income for workers who lose employment—generally when the employee is not at fault. Businesses pay unemployment insurance taxes through a joint program between the federal government and the states, and only employers pay FUTA taxes.
• Workers’ compensation insurance: Businesses may have to purchase workers’ compensation insurance, depending on state requirements. 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.
• Wage garnishments: A garnishment is a court-ordered requirement to withhold employee pay and forward the amounts to a third party.

As your business grows, you may offer benefit plans to motivate employees. Workers can choose to voluntarily withhold payroll dollars to fund benefit plans.

Voluntary deductions

Health insurance premiums, retirement plan contributions, and other benefit programs are funded through payroll withholding. The employer’s share of the costs is a payroll expense.

• Retirement plans: The worker’s contributions are deducted from pay and are not an employer expense. The employer’s share of contributions, however, is a payroll expense.
• 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 is deducted from pay and is not a payroll expense.
• Union dues: Dues are deducted from pay and forwarded to the union on the worker’s behalf.

If a worker repays a loan from the employer, the loan payments withheld from pay are not a payroll liability or a payroll expense. Instead, the payment increases the employer’s cash account and reduces a loan-receivable (asset) account.

Payroll service costs

The cost incurred to retain an accountant or a payroll service company is a business expense.

As discussed above, some payroll liabilities are reclassified into a payroll expense account when payments are sent to a third party.

Payroll liabilities vs. payroll expenses

Every business must record payroll liabilities and payroll expenses using 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 (a payroll liability account).

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 restaurant employees worked the hours. 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 inflows and outflows, which is referred to as the cash basis method of accounting. No business should use the cash method because the method presents a distorted view of company profit.

Businesses must file a number of forms to pay payroll liabilities.

How to pay your payroll liabilities

Here are the most common payroll liabilities and how they are paid:

• Gross wages: Paid to workers by check or direct deposit.
• Federal income taxes: Businesses use Form 941 to report and submit federal tax withholdings.
• FICA (Medicare and Social Security taxes): Businesses use Form 941 to report and submit these tax payments.
• Form 940: The employer’s annual federal unemployment (FUTA) tax return is used to report and submit these payments.

Follow these steps to pay all payroll liabilities:

1. Collect employee data on Form W-4 (for employees).
2. Calculate gross wages using salary, hourly data, or a worker’s contract.
3. Compute amounts that must be withheld, if applicable.
4. Withhold amounts and pay each worker’s net pay.
5. Record payroll liabilities for amounts that will be a business expense. For example, employer’s share of FICA taxes.
6. Submit amounts to each third party, using the proper reporting form.
7. Reclassify payroll liability balances into payroll expense accounts.

The following variables may change your payroll calculations from one pay period to the next, which will also change payroll liabilities and expenses:

• 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
• Businesses must also comply with payroll record keeping requirements.

Keeping documentation

Make sure that you’re complying with these document requirements and other laws and regulations:

• The Fair Labor Standards Act (FSLA) establishes rules for the minimum wage, other pay rates, and overtime hours. FSLA also requires that payroll records be kept on file for a minimum of three years.
• If you employ union workers, you must comply with the pay and overtime rates required in the collective bargaining agreement with the union. Union pay records must also be kept on file.

Each state has its own employment documentation laws that must be followed.

How to adjust payroll liabilities

Accountants post adjustments for several types of payroll transactions:

• When withheld amounts are paid to a third party, you adjust the payroll records by reducing a payroll liability account and by reducing cash.
• In a similar way, businesses reduce wages payable and reduce cash when wages owed are paid to workers.

Use payroll software to generate a payroll-liability balance report each time you process payroll. Review the report, so you can post each adjusted journal entry. Accounting also requires account reconciliations.

Reconciling payroll liabilities

When you reconcile payroll liabilities, you match data from these sources:

• Employee data (pay rates, hours worked)
• Payroll tax filings (income taxes, FICA taxes)
• Payroll tax dollars withheld from pay and submitted as tax deposits
• Banking activity (payment to workers and to third parties)
• Accounting records (transactions posted)

To correctly post payroll liabilities, the amounts generated throughout the payroll process must match. Consider, for example, federal income tax withholdings for an employee:

• The employee’s gross pay and Form W-4 information is used to calculate $150 in federal tax withholding on March 1.
• The business must withhold $150 and report the amount to the IRS.
• $150 must be deposited with the IRS.
• $150 must be added to the worker’s federal tax withholding for the year and reported on the employee’s Form W-2.
• The accounting records must record the amount withheld and paid to the IRS.

You can use payroll software to reconcile the payroll liability data and ensure you’re processing payroll correctly. Payroll is the most time-consuming accounting task, and you need the right tools to work efficiently. Automate the payroll process so you can save time and focus on growing your business.