Accounting: The Language of Business (Part 68)

Debt is one person's liability, but another person's asset.

Paul Krugman

 Current Liabilities (Part C)

by

Charles Lamson

Payroll and Payroll Taxes

We are all familiar with the term payroll. In accounting, the term payroll refers to the amount paid to employees for the services they provide during a period. A business's payroll is usually significant for several reasons. First, employees are sensitive to payroll errors and irregularities. Maintaining good employee morale requires that the payroll be paid on a timely, accurate basis. Second, the payroll is subject to various federal and state regulations. Finally, the payroll and related payroll taxes have a significant effect on the net income of most businesses. Although the amount of such expenses varies widely, it is not unusual for a business's payroll and payroll-related expenses to equal nearly one-third of its revenue.

Liability for Employee Earnings

Salaries and wages paid to employees are an employer's labor expenses. The term salary usually refers to payment for managerial, administrative, or similar services. The rate of salary is normally expressed in terms of a month or a year. The term wages usually refers to payment for a manual laborer, both skilled and unskilled. The rate of wages is normally stated on an hourly or weekly basis. In practice, the terms salary and wages are often used interchangeably.

The basic salary or wage of an employee may be increased by commissions, profit sharing, or cost-of-living adjustments. Many businesses pay managers an annual bonus in addition to a basic salary. The amount of the bonus is often based on some measure of productivity, such as income or profit of the business. Although payment is usually made by check or in cash, it may be in the form of securities, notes, lodging, or other property or services. Generally, the form of payment has no effect on how salaries and wages are treated by either the employer or the employee.

Salary and wage rates are determined by agreement between the employer and the employees. Businesses engaged in interstate commerce must follow the requirements of the Fair Labor Standards Act. Employers covered by this legislation, which is commonly called the Federal Wage and Hour Law, are required to pay a minimum rate of 1 1/2 times the regular rate for all hours worked in excess of 40 hours per week. Exemptions are provided for executives, administrative, and certain supervisory positions. Premium rates for overtime or for working at night, holidays, or other less desirable times are fairly common, even when not required by law. In some cases, the premium rates may be as much as twice the basic rate.

To illustrate computing an employee's earnings, assume that John T. McGrath is a salesperson employed by McDermott Supply Co. at the rate of $34 per hour. Any hours in excess of 40 hours per week are paid at a rate of 1 1/2 times the normal rate, for $51 ($34 + $17) per hour. For the week ended December 27, McGrath's time card indicates that he worked 42 hours. His earnings for that week are computed as follows:

Deductions from Employee Earnings

The total earnings of an employee for a payroll period, including bonuses and overtime pay, are called gross pay. From this amount is subtracted one or more deductions to arrive at the net pay. Net pay is the amount the employer must pay the employee. The deductions for federal taxes are usually the largest deduction. Deductions may also be required for state or local income taxes. Other deductions may be made for medical insurance, contributions to pensions, and for items authorized by individual employees.

Income Taxes

Except for certain types of employment, All employers must withhold a portion of employee earnings for payment of the employee's federal income tax. As a basis for determining the amount to be withheld, each employee completes and submits to the employer an "Employee's Withholding Allowance Certificate," often called a W-4. Exhibit 2 is an example of a completed W-4 form.

Exhibit 2 Employee's Withholding Allowance Certificate (W-4 Form)

You may recall filing out a W-4 form. On the W4, an employee indicates marital status, the number of withholding allowances, and whether any additional withholdings are authorized. A single employee may claim one withholding allowance. A married employee may claim an additional allowance for a spouse. An employee may also claim an allowance for each dependent other than a spouse. Each allowance claimed reduces the amount of federal income tax withheld from the employee's check.

The amount that must be withheld for income tax differs, depending upon each employee's gross pay and completed W-4. Most employers use wage bracket withholding tables furnished by the Internal Revenue Service to determine the amount to be withheld.

EXHIBIT 3 Wage Bracket Withholding Table

Exhibit 3 is an example of a wage bracket withholding table. This table is for a single employee who is paid weekly. Other tables are used for employees who are married or who are paid in time periods other than weekly. In using the withholding table, the amount of federal income tax withheld each pay period is determined by the following computational procedure:

1. Identify the appropriate subsection for the number of allowances claimed by the employee.

2. Read across the selected subsection and locate the applicable wage bracket in columns A and B.

3. Subtract the amount shown in column C from the employee's gross wages.

4. Multiply the result by the withholding percentage rate shown in column D to obtain the tax to be withheld.

For example, assume that John T. McGrath, who is single and has declared one withholding allowance, made $1,462 for the week ended December 27. Using the computational procedure and information in Exhibit 3 would yield the following federal income tax withholding:

In addition to the federal income tax, employees may also be required to pay a state income tax and a city income tax. State and city taxes are withheld from employees earnings and paid to state and city governments.

FICA Tax

Most of us have FICA tax withheld from our payroll checks by our employers. Employers are required by the Federal Insurance Contributions Act (FICA) to withhold a portion of the earnings of each of the employees. The amount of FICA tax withheld is the employee's contribution to federal programs. Tax is withheld separately under each program. The first program, called Social Security, is for old age, survivors, and disability insurance (OASDI). The second program, called Medicare, is health insurance for senior citizens.

The amount of tax that employers are required to withhold from each employee is normally based on the amount of earnings paid in the calendar year. Although both the schedule of future tax rates and the maximum amount subject to tax are revised often by Congress, such changes have little effect on the basic payroll system. In this analysis, we will use a social security rate of 6% on the first $100,000 of annual earnings and a Medicare rate of 1.5% on all annual earnings.

To illustrate, assume that John T. McGrath's annual earnings prior to the current payroll period total $99,038. Assume also that the current period earnings are $1,462. The total FICA tax of $79.65 is determined as follows:

Other Deductions

Neither the employer or the employee has any choice in deducting taxes from gross earnings. However, employees may choose to have additional amounts deducted for other purposes. For example, you as an employee may authorize deductions for retirement savings, for contributions to charitable organizations, or for premiums on employee insurance. A union contract may also require the deduction of union dues.

Computing Employee Net Pay

Gross earnings less payroll deductions equals the amount to be paid to an employee for the payroll period. This amount is the net pay, which is often called the take-home pay. Assuming that John T. McGrath authorized deductions for retirement savings and for a United Way contribution, the amount to be paid McGrath for the week ended December 27 is $1,077.84, as shown below.

Liability for Employer's Payroll Taxes

So far, we have discussed the payroll taxes that are withheld from the employees' earnings. Most employers are also subject to federal and state payroll taxes based on the amount paid their employees. Such taxes are an operating expense of the business. Exhibit 4 summarizes the responsibility for employee and employer payroll taxes.

FICA Tax

Employers are required to contribute to the social security and Medicare programs for each employee. The employer must match the employee's contribution to each program.

Federal Unemployment Compensation Tax

The Federal Unemployment Tax Act (FUTA) provides for temporary payments to those who become unemployed as a result of layoffs due to economic causes beyond their control. Types of employment subject to this program are similar to those covered by FICA taxes. A tax of 6.0% (irs.gov) is levied on employers only, rather than on both employers and employees. It is applied to only the first $7,000 of the earnings of each covered employee during a calendar year. Congress often revises the rate and maximum earnings subject to federal unemployment compensation tax. The funds collected by the federal government are not paid directly to the unemployed but are allocated among the states for use in state programs.

State Unemployment Compensation Tax

State Unemployment Tax Acts (SUTA) also provide for payments to unemployed workers. The amounts paid as benefits are obtained, for the most part, from a tax levied upon employers only. A few states require employee contributions also. The rates of tax and the tax bases vary. In most states, employers who provide stable employment for their employees are granted reduced rates. The employment experience and the status of each employer's tax account are reviewed annually, and the tax rates are adjusted accordingly. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 439-445*

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