Payroll introduction covers the basic math of a payroll, how taxes are calculated and how to reconcile an employee’s check. You must first understand these basic relationships before continuing with this lesson.
Summary of a Payroll
In a typical paycheck the employee has the following taxes withheld to create a net payment from his gross wages:
- Federal Income Taxes
- Social Security Taxes (6.2% of Gross Wages)
- Medicare Taxes (1.45% of Gross Wages)
- State Income Taxes (Seven states do not have income taxes)
The employer also has responsibilities. The employer must pay the following taxes for payroll:
- Matching Social Security (6.2% of Gross Wages)
- Matching Medicare Tax (1.45% of Gross Wages)
- FUTA (.6% of First $7,000 of Gross Wages)
- State Unemployment Tax (Each state uses a different formula)
The rule of thumb is that for every $1,000 of gross wages paid to employees, the employer will pay about $1,100 combined for wages and payroll taxes.
Organization of Payroll
In a payroll run (an actual payroll processing) the small business pays the production workers, office staff and management team. Within the management team is traditionally the officer(s)/owner(s) of the company. There are several compliance requirements necessitating modifications to the chart of accounts to make reporting easier. Below are the two general requirements.
At year end the tax preparer reports to the Internal Revenue Service four distinct pieces of information related to payroll:
- Cost of Sales – Production labor is reported on Schedule 1125, labor line. From a business perspective the primary information is essentially all field labor and production management. Sometimes this production management includes the officer/owner. So as a note to the tax preparer, the bookkeeper may indicate that a certain percentage of the owner’s salary is a function of cost of sales.
- Officer’s Compensation – In the expenses section of the tax return is a separate line for officer’s compensation. The IRS expects a list of all officers and their corresponding compensation. This should match up against an officer’s W-2 report. The only exclusion to the dollar amount reported is the portion of the officer’s salary assigned to cost of sales for production work.
- Office Wages and Salaries – Immediately after the officer’s compensation line in the expenses section of the tax return is an information line for office wages paid. This refers to the office staff. Customarily this includes professional staff (non-officers), office manager, receptionist and clerks. The total here should match the total aggregate gross wages as reported for the same personnel on their W-2’s.
- Tax & Licenses – Tax compliance includes the total amount of employer taxes paid for payroll. This consists primarily of two tax groups. The first is matching taxes for Social Security and Medicare. The second group is the unemployment taxes (FUTA and SUTA) paid.
The IRS desires this information reported as a function of taxes and licenses in the expenses section of the tax return. The problem with this is that this reporting presentation doesn’t work well for financial reporting purposes.
Financial Reporting of Payroll
Financial reporting is different than tax reporting. With financial reporting the goal is to sort data to accurately determine profits at various points of business operations. This includes gross profit, contribution margin, operational profit, profit and net profit. To achieve these various points of information along the income statement layout payroll data must be posted in the proper ledger accounts.
Cost of Sales – Labor includes production labor, field labor and retail sales personnel. In addition production management and the corresponding taxes associated with this labor group is reported here.
Management Expenses – Within expenses are the front and back office payroll. Just like labor in cost of sales, management costs should include this group’s cost of employer payroll taxes.
So how does a bookkeeper successfully achieve both tax compliance and financial reporting for payroll information?
Chart of Accounts Layout
The secret to successfully implementing both tax compliance and financial reporting is a properly designed chart of accounts. Use parent-child accounts to fully comply with tax requirements and financial decision models.
The following is a limited version of the cost of sales section with an expanded labor line (the parent account).
Cost of Sales
. Labor (Parent account)
. – Production Labor (Child Account)
. – Production Management (Child Account)
. – Production P/R Taxes (Child Account)
. – Production Labor Benefits (Child Account)
In condensed mode the financial report only identifies the value for all the child accounts of labor. In expanded mode labor is divided into the respective accounts for both tax compliance and financial decision making.
TO COMPLY WITH TAX REQUIREMENTS AND FINANCIAL REPORTING NEEDS USE PARENT-CHILD ACCOUNT STRUCTURES FOR BOTH COST OF SALES AND EXPENSES.
For the expenses section, management costs are the primary group for payroll as illustrated below:
. Taxes and Licenses
. Office Operations
Each of the primary groups of accounts are a parent account for sub accounts. Management is structured as following:
. Management (Parent Account)
. – Officers Compensation (Child Account)
. – Back Office Management (Child Account)
. includes HR Director, Finance Director, Engineering, Sales and Other Professional Staff
. – Front Office (Child Account)
. includes office manager, receptionist and clerks
. – Payroll Taxes (Child Account)
. cumulative total for all three management payroll accounts
. – Benefits (Child Account)
. Taxes and Licenses
. Office Operations
This chart of accounts structure works perfectly for financial reporting purposes, but how does it comply with tax reporting requirements?
Conversion of Financial Payroll Information to Tax Compliance
The fundamental reporting requirement of tax compliance is already built into the account structure. Notice in cost of sales, management costs are separated. Within this detail account will reside the value of any officer’s payroll used in production. This is very common in really small businesses where the owner is active in all aspects of operations.
Over in expenses, management splits out officer’s compensation from general management (professional staff) and staff compensation. The only difference for tax purposes is employer taxes. This is actually a simple task of combining both tax child accounts – one from cost of sales and the other from management expenses.
Successful completion of this task requires a schedule. I personally create a tab in an Excel spreadsheet, label the tab ‘Payroll Fin-Tax’ which means payroll financial to tax reporting. In this schedule I first create a list of all employees and identify the respective function in the business. In another column is the gross wages paid, employer taxes and a column identifying if the employee is an officer. See the illustration below:
Payroll: Financial Reporting to Tax Compliance
Employee Function Gross Payroll Taxes
Name Code Wages Matching FUTA/SUTA Officer
. Employee ‘A’ P $ZZ,ZZZ $Z,ZZZ $ZZZ No
. ‘B’ P Z,ZZZ ZZZ ZZ No
. ‘C’ F ZZ,ZZZ Z,ZZZ ZZZ No
. ‘D’ B ZZ,ZZZ Z,ZZZ ZZZ Yes
. ‘E’ P ZZ,ZZZ Z,ZZZ ZZZ No
Totals $ZZZ,ZZZ $ZZ,ZZZ $Z,ZZZ
P = Production
F = Front Office
B = Back Office
The next section in this spreadsheet keys to the respective financial lines; basically sorting the data:
Production – Cost of Sales/Labor/Production
. $ZZ,ZZZ (Matches the Financial Report)
Production Management – Cost of Sales/Labor/Production Management
Insert a note: ‘D’ serves two roles in business, the primary role is an officer/manager; a secondary responsibility is in production. It is estimated ‘D’ spends 25% of time in production; therefore, 25% of payroll compensation is allocated to labor in cost of sales.
‘D’s Gross Wages as reported on W-2 $ZZ,ZZZ
‘D’s Gross Wages allocated to cost of sales (ZZ,ZZZ)
‘D’s Gross Wages assigned to Officer’s Salary $ZZ,ZZZ
Salaries and wages for tax purposes:
‘C’ Gross Wages $ZZ,ZZZ
Employer Taxes from Cost of Sales $Z,ZZZ
Employer Taxes from Expenses Z,ZZZ
Total Employer Paid Taxes Per Form (1120, 1120S, 1065) $ZZ,ZZZ
Tax Summation of Employer Taxes:
Social Security Match $Z,ZZZ
Medicare Match Z,ZZZ
Total Employer Taxes (must match Section 1) $ZZ,ZZZ
Employer Match Social Security from Form W-3 $Z,ZZZ
Employer Match Medicare from Form W-3 Z,ZZZ
FUTA from Form 940 ZZZ
SUTA from all 4 Quarter Reports Z,ZZZ
Total All Employer Taxes $ZZ,ZZZ
Section 3 must match Sections 1 and 2 for totals.
Summary – Payroll Structure
The key to successful payroll processing and reporting is developing a structure that serves both financial and tax purposes. The best tool is using parent-child accounts in the cost of sales section and with the management group of expenses. To reconcile between the two reporting formats create a schedule for internal use. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.