Payroll is defined as the total amount of wages paid by a company to its employees and other workers. Your company’s payroll may be your firm’s largest business expense, and processing payroll is complicated. You must collect insurance premiums, retirement plan contributions and tax withholdings from employee pay.
While hiring full-time employees can help your business grow, it also adds complexity and cost to the operation. This shouldn’t deter from your hiring, but you should understand how much each worker will cost beyond their salary, as well as the work involved in managing payroll.
Here’s an overview of how payroll is processed and how to comply with federal and state requirements.
The Components of Payroll
Your firm’s payroll can be separated into these four component parts:
1. Gross Wages
The total dollar amount paid to the worker, before any deductions. The items listed below are deducted from gross wages to arrive at the worker’s net pay. Gross wages may include commissions, bonuses and other payment arrangements.
Your company may provide health insurance, retirement plans and other benefits to workers. While your business pays some of these costs, a portion of the benefits may be deducted from the employee’s gross wages. Many of these deductions are taken out of pay before taxes are calculated.
3. Social Security and Medicare
You must deduct the employee’s portion of Social Security and Medicare payments from gross wages. Your employees may have additional deductions that are required by federal or state law.
4. Tax Withholdings
The employer must withhold the employee’s share of federal and state income taxes from payroll. Depending on the location, the company may also need to withhold local or city income taxes from payroll.
The amount of money the employee actually receives in their paycheck is known called net pay.
It’s important to note that freelancers are treated differently than employees. Since a freelancer is not an employee, this type of worker receives his or her gross pay with nothing deducted. Freelancers are responsible for paying all of their own taxes and benefits.
Why Managing Payroll Is Complicated
Payroll taxes and income taxes are different, but are each an important part of managing payroll. In general, employers are responsible for paying payroll taxes and employees are responsible for paying income tax, but there’s more to it than that.
Calculating and Paying Federal and State Income Taxes
Employers must calculate federal and state income taxes and forward the payments to the appropriate government agency. Companies also submit tax withholding reports with the payments.
To start the process, each employee fills out IRS Form W-4 to compute withholding allowances. Allowances exempt a portion of an employee’s yearly salary from withholding. More allowances mean that less tax is withheld from gross pay. This system allows the worker to adjust his or her tax withholdings to fit the individual’s tax situation.
Once allowances are factored in, federal income taxes are calculated using the tax tables found in IRS Publication 15. Federal taxes withheld are generally paid at the same time that you make Social Security and Medicare payments, and are reported using IRS Form 941.
Here are the federal tax rates for tax year 2017:
- Social Security: 6.2% of an employee’s gross wages, up to a cap of $127,200 for each employee.
- Medicare: 1.45% of gross wages, with no earning limit.
The employer deducts the applicable percentages for Social Security and Medicare from each employee’s gross wages. Your firm must match each employee’s contribution, and those payments are an expense for your company. The business submits both the employee and the company’s contributions to Social Security and Medicare.
Assume, for example, that Frank is owed $1,120 in gross pay for the latest payroll period. Here is the calculation of Social Security and Medicare payments for Frank and the business:
- Social Security taxes withheld from Frank’s wages: $69.44 ($1,120 x 0.062)
- Company matching Social Security tax amount: $69.44
- Medicare taxes withheld from Frank’s wages: $16.24 ($1,120 x 0.0145)
- Company matching Medicare tax amount: $16.24
Total = $171.36
The total federal tax amount due for this pay period is $171.36. Social Security and Medicare tax payments are reported quarterly using IRS Form 941.
Calculating and Paying Federal and State Payroll Taxes
The amount of payroll taxes collected has changed dramatically over the past 100 years. In 1915, nearly half of all federal tax revenue was generated from excise (sales) taxes on liquor, tobacco and other products. Custom duties and tariffs on imported goods produced over 30% of tax collections.
In recent years, the vast majority of tax revenue is collected from individual income taxes and payroll taxes. In 2015, payroll taxes represented the second largest source of revenue for the federal government.
Employers also must pay 6% of gross wages, up to a cap of $7,000 per worker, to fund federal unemployment taxes (FUTA) for each employee. This is another business expense, and the amount is not deducted from the worker’s pay. Businesses complete IRS Form 940 when FUTA payments are submitted.
In addition to FUTA, each state has its own unemployment plan. If you have employees in more than one state, your firm may have to comply with multiple state unemployment requirements.
Taxes assessed by state employment agencies are a business expense paid by the employer. There are two factors that determine the tax calculation: the wage base and the tax rate. The wage base is the maximum amount of earnings taxed in a calendar year, and base is determined by each state. Both the wage base and the rate of tax may change from one year to the next.
Companies can take steps to minimize state unemployment taxes, because the tax rate assessed is based on the number of employees who have filed unemployment claims in the past. Businesses with high employee turnover generate more unemployment claims, so the system taxes those firms at a higher rate.
If your firm can reduce employee turnover, you may be able to keep the unemployment tax rate from increasing.
How to Run Payroll
Processing payroll correctly requires careful planning, because this task may be the most time consuming work your business performs each month. There are ongoing tasks that need attention, as well as setup procedures for new employee and changes to withholdings, benefits, commissions, etc. for current employees.
Typically, a firm’s human resources department collects the forms needed to compute payroll taxes, and the accounting department performs the tax calculations. Here are some common documents that most companies must obtain to process payroll:
- Health insurance plan: Each employee completes paperwork to document the type of health insurance coverage they want, or if they don’t want to participate in the insurance plan. The type of coverage and the deductible amount determine the insurance premiums that must be deducted from gross pay. The same documents are collected for dental and vision insurance, if applicable.
- Retirement plans: If a worker chooses to participate in a company retirement plan, the employee fills out paperwork to indicate the dollar amount of gross pay that will be invested into the retirement plan each pay period.
- Income tax withholdings: Each worker completes IRS Form W-4 to indicate the amount of tax withheld from gross pay for federal income taxes. Employees complete similar forms for state income tax withholding.
Your payroll may require you to collect other documents as well. Here are the steps required to process payroll for full-time employees:
- Determine gross pay rates
- Collect all required documents for tax withholdings and deductions
- Calculate taxes and withholdings
- Pay the net pay amounts to employees
- Forward deducted amounts to insurance companies and benefit providers.
- Submit taxes withheld to each taxing authority
- Complete all paperwork and submit paperwork to insurance companies, retirement plans and taxing authorities
Processing pay for freelancers is less complex. You determine the pay rate for each freelancer, compute the required pay amount and pay the freelancer. Insurance, retirement plans and tax withholdings are handled by each freelancer, not by your firm.
Don’t Go It Alone
Payroll is complicated and time-consuming even if you have a single employee. Luckily, software like QuickBooks’ payroll solution can do all the calculations, cut checks and even pay taxes and file the documents with state and federal agencies. Even better, it integrates perfectly with QuickBooks to keep your books in order.