What Is Payroll?
Payroll is the compensation a business must pay to its employees for a set period or on a given date. It is usually managed by the accounting or human resources department of a company. Small-business payrolls may be handled directly by the owner or an associate.
Payroll can also refer to the list of employees and their salaries. The cost of payroll is a major expense for most companies, and it is almost always deductible, which lowers the company’s taxable income.
Overtime, sick pay, and other factors can affect payroll from one pay period to another.
Payroll involves tracking employee hours, calculating employees’ pay, and distributing payments to employees via direct deposit or check.
Employees are often the single biggest expense a company can have. First, you have to pay them, and that’s usually a big expense in itself. On top of that, though, your business is responsible for extra taxes and some insurance.
Finally, your company has to comply with all local, state, and federal requirements, most of which are in place to protect your employees, and some come with a price tag. To escape the extra costs and responsibilities that come with employees, a lot of new and small businesses enlist independent contractors. This strategy can save you a lot of money and a lot of headaches.
Having employees can be pretty time-consuming all around and paying them is no different. You have to deal with state and federal taxes, multiple report filings, unemployment insurance, and a whole lot more. Even if you have only one employee, you have to fill out every form and meet every filing deadline.
Payroll Software Programs
Once you have the basics covered, you can use your accounting software to help you manage payroll. Most of these software programs come with a payroll module, and the rest often provide an add-on program that interconnects with the standard software. Using accounting software is by far the easiest and quickest way to do your own payroll. The setup is the most labor-intensive part, but even that takes less time than you would imagine.
Once that’s done, your part will be limited to telling the program everyone’s gross pay. The software can do all the rest. It will calculate every deduction, figure out the take-home pay, keep track of the tax payments you (as the employer) have to make, and even print out the paychecks. Before you get started cranking out the paychecks, though, there are several important steps you have to take.
You’ve probably gotten a paycheck at some point in your life, and were as dismayed as everyone else when you realized how much money was taken out. Now you will be the one taking the money out and sending it to the taxmen. In addition, employers have to kick in more payroll taxes on top of the ones they deduct from employee paychecks.
As the employer, you have to account for two sets of taxes:
- The withholding taxes are the employee’s own income taxes, taken directly out of their paychecks and sent to the tax office (by you). Withholding taxes include income tax (always federal, usually state, and sometimes local), Social Security, and Medicare.
- The employer taxes are additional taxes that you have to pay on behalf of your employees, and they include Social Security and Medicare as well as any state and federal unemployment insurance payments.
Yes, there are a lot of taxes, a lot of calculations, and a lot of paperwork. On the plus side, the payroll grand total is deductible from your company’s income, lowering the company’s income tax burden.
Again, any tax you deduct from an employee’s paycheck is called a withholding tax. The four most common withholding taxes are:
- Federal income tax
- State income tax
- Social Security
In some states, you may also have to withhold unemployment or disability insurance from employee pay.
In order to figure out how much to deduct for income taxes, you need to know some basic information about each employee. That includes his marital status and the number of allowances he’s claiming, both of which you can get from the W-4 form that the employee completes. You also need to know his gross salary for the period and the amount of any pretax deductions.
How often you need to file a payroll tax return and remit federal payroll taxes depends on the amount of the payroll tax liability. In most cases, you will need to deposit federal payroll taxes using electronic funds transfer (EFT); very small companies with payroll tax liabilities less than $2,500 per quarter may be allowed to file quarterly payroll tax returns and submit payments with them. The rules involving federal payroll taxes are very strict and detailed. To make sure you are handling them properly, read IRS Publication 15 at www.irs.gov.
Withholding taxes fall under a special set of laws, and they are different from virtually all other kinds of taxes. That’s because the money you withhold belongs to your employees, not to your company. In effect, you hold that money in trust for them until you turn it over to the government on their behalf. When your company doesn’t make the payments, both civil and criminal penalties (including heavy fines and jail time) may apply.
The biggest penalty a company can incur for not remitting payroll taxes to the government is the 100 percent penalty (officially called the Trust Fund Recovery Penalty), and you can be held personally liable for paying it. If the IRS can prove that your company willfully didn’t pay the taxes, you’ll have to pay both the taxes and the penalty, which can be equal to the total taxes that were due. Willful nonpayment means that you chose not to pay the taxes, for whatever reason; and not paying them because your company doesn’t have enough money counts as willful nonpayment.
When you have employees, chances are that you will be required to deal with the Federal Unemployment Tax (FUT), and possibly at least one state version of unemployment taxes as well. At the federal level, these taxes are paid only by employers (there’s no withholding from employee pay here), and they’re based directly on the total wages paid to employees. The FUT rate for 2016 was 6.0 percent, but that could be reduced if state unemployment insurance was also paid.
When it comes to state rules, though, there’s a lot of variation. Here are the general rules of state unemployment taxes:
- They are generally paid by employers only
- They reduce the company’s FUT burden
- The tax rate is based on how many employees have filed unemployment claims
- There’s a cap on the maximum tax you’ll owe for each employee
As you’d expect, the specifics vary pretty widely, especially when it comes to crunching the numbers. For example, the state unemployment insurance rate in Maryland in 2016 started at a standard rate of 2.6 percent, but the rate can vary from 0.3 to 7.5 percent, depending on the company’s unemployment claims experience; the rate assigned to a company gets applied to the first $8,500 of earnings for each employee. So if an employee (in Maryland) earned $15,000, for example, your company would only owe unemployment taxes on the first $8,500 and not on the rest. In a couple of states, employees as well as employers have to pay in to the system (which adds extra withholding responsibilities for employers).
Overall, dealing with payroll and payroll taxes can be very time-consuming, and the rules are complex and change fairly frequently. For most business owners, the smart choice is to use a payroll company to handle all of these details—especially because the consequences of getting it wrong can be costly.
How to Prepare Payroll and Post It In The Books
After you know the details of your employees’ withholding allowances and their benefit costs, you can calculate the final payroll and post it to the books.
Calculating payroll for hourly employees
When it comes time to prepare payroll for nonexempt employees, the first step is to gather time records from each person who is paid hourly. Whether your company employs time clocks, time sheets, or another method to generate the necessary time records, the manager of each department usually reviews the time records for each employee she supervises and then sends those time records to you, the bookkeeper.
With time records in hand, you have to calculate gross pay for each employee. If a nonexempt employee worked 45 hours and is paid $12 an hour, you calculate gross pay like so:
- 40 regular hours × $12 per hour = $480
- 5 overtime hours × $12 per hour × 1.5 overtime rate = $90
- $480 + $90 = $570
In this case, because the employee isn’t exempt from the FLSA, overtime must be paid for any hours worked over 40 in a seven-day workweek. This employee worked 5 hours more than the 40 hours allowed, so he needs to be paid at time plus one-half for those extra hours.
Doling out funds to salaried employees
In addition to paying employees based on hourly wages, you must prepare payroll for salaried employees. Paychecks for salaried employees are relatively easy to calculate; all you need to know are their base salaries and their pay-period calculations. If a salaried employee makes $30,000 per year and is paid twice a month (totaling 24 pay periods), that employee’s gross pay is $1,250 for each pay period.
Totaling up for commission checks
Running payroll for employees paid based on commission can involve the most-complex calculations because of the variety of commission scenarios available. To show you several variables, this section calculates various commission checks based on a salesperson who sells $60,000 worth of products during one month.
Straight commission: For a salesperson on a straight commission of 10 percent, you calculate pay by using this formula:
Total amount sold × Commission percentage = Gross pay
$60,000 × 0.10 = $6,000
Base salary plus commission: For a salesperson with a guaranteed base salary of $2,000 plus an additional 5 percent commission on all products sold, you calculate pay by using this formula:
Base salary + (Total amount sold × Commission percentage) = Gross pay
$2,000 + ($60,000 × 0.05) = $5,000
Although this employee may be happier having a base salary that he can count on each month, he actually makes less with a base salary because the commission rate is so much lower. By selling $60,000 worth of products, he made only $3,000 in commission at 5 percent. Without the base pay, he would’ve made 10 percent on the $60,000 or $6,000, so he got paid $1,000 less with a base-pay structure that includes a lower commission.
But the base-salary setup isn’t always less lucrative. If the same salesperson has a slow sales month of $30,000 worth of products sold, his pay is
$30,000 × 0.10 = $3,000 on straight commission of 10 percent
$30,000 × 0.05 = $1,500 plus $2,000 base salary, or $3,500
For a slow month, the salesperson makes more money with the base salary than with the higher straight commission rate.
Higher commissions on higher levels of sales: This type of pay system encourages salespeople to keep their sales levels over a certain level — in this example, $30,000 — to get the best commission rate.
Graduated commission scale: With a graduated commission scale, a salesperson can make a straight commission of 5 percent on her first $10,000 in sales, 7 percent on her next $20,000, and 10 percent on anything over $30,000. Here’s what her gross pay calculation looks like when you use this commission pay scale:
($10,000 × 0.05) + ($20,000 × 0.07) + ($30,000 × 0.10) = $4,900 Gross pay
Determining base salary plus tips
One other type of commission pay system involves a base salary plus tips. This method is common in restaurant settings in which servers receive between $2.13 and $5 per hour plus tips.
Businesses that pay less than minimum wage must prove that their employees make at least minimum wage when tips are accounted for. Today, that’s relatively easy to prove because most people pay their bills with credit cards and include tips on their bills. Then businesses can come up with an average tip rate by using that credit card data.
Employees must report tips to their employers on an IRS Form 4070, Employee’s Report of Tips to Employer, which is part of IRS Publication 1244, Employee’s Daily Record of Tips and Report to Employer. The publication provides details about what the IRS expects you and your employees to do if they work in an environment in which tipping is common.
As an employer, you must report an employee’s gross taxable wages based on salary plus tips. Here’s how you calculate gross taxable wages for an employee whose earnings are based on tips and wages:
Base wage + Tips = Gross taxable wages
($3 × 40 hours per week) + $300 = $420
If your employees are paid in a combination of base wage plus tips, you must make sure that your employees are earning at least the minimum wage rate of $7.25 per hour. Checking this employee’s gross wages, the hourly rate earned is $10.50 per hour:
Hourly wage = $10.50 ($420 ÷ 40)
Remember Taxes due are calculated on the base wage plus tips, so the check you prepare for the employee in this example is for the base wage minus any taxes due.
Outsourcing Payroll Work
Given all that’s required of you to prepare payroll, you may think that your small company would be better off outsourcing the work of payroll and benefits. Maybe so. Many companies outsource the work because this area is so specialized and requires extensive software to manage both payroll and benefits.
If you don’t want to take on payroll and benefits alone but don’t want to send them to an outside company, you can pay for a monthly payroll service from the software company that provides your accounting software. QuickBooks, for example, provides various levels of payroll services for as little as $25 a month. The QuickBooks payroll features include calculating earnings and deductions, printing checks, making direct deposits, providing updates to the tax tables, and supplying the data necessary to complete all government forms related to payroll. The advantage of doing payroll in-house in this manner is that the payroll can be more easily integrated into the company’s books.