Payroll – Introduction to Basic Concepts

Payroll is envisioned as the simple employer employee agreement related to compensation for services. I often think of this as the simple handshake whereby the employer agrees to pay the employee a set rate per hour of work. This was true a hundred or more years ago, but over time; history and governmental regulations complicated this simple relationship.

Today, the employer is required to withhold taxes for both federal and state income taxes. In addition, the depression created a basic retirement system known as Social Security. The 1960’s saw the implementation of Medicare, another form of withholding from the employee. To complicate payroll, the federal government requires the employer to match this withholding to help fund the respective programs.

As the industrial revolution expanded so did competition for employees. Employers began to offer benefits to employees and these benefit programs became more convoluted with incentives, matching programs and time based vesting. Some of these associated costs were shouldered by the employer and others are a deduction from the employee’s regular wages; all in the battle to acquire and retain employees.

This article is written to introduce the reader to the basic math and the reasoning associated with the various elements of the payroll. The first section will explain the various costs and how to calculate those associated costs. The second section explains the various liabilities and the associated timing of those payments to the different governmental authorities and institutions. The final section reconciles the entire payroll to the various payments made thus tying the entire payroll process together.

Future articles will go into more detail and complexity associated with different types of employees and programs. This article is really designed to introduce payroll to a beginner and new accountants just starting out in bookkeeping.

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Calculating Gross Cost of Wages

The most simplistic payroll consists of three groupings of costs. The first group is the traditional arrangement between the employer and the employee – the agreed to wage. The second group of costs is the various taxes and the third is benefits paid by the employer. These three groups are combined to form the gross payroll cost. Wages – direct remuneration for services is referred to as wages. There are many different forms of compensation and include salaries, hourly pay, commissions, and bonuses. The following article goes into detail about the direct and indirect types of compensation: The Different Forms of Compensation .

Taxes

Governmental social welfare programs are funded via taxes on both the employee and the employer. The employee’s share is a deduction from his wages. The employer share is a direct obligation and is wholly tied to the wage. Therefore, these taxes are an additional cost of wages and consist of the following:

Social Security matching at 6.2% of the gross wage
Medicare matching at 1.45% of the gross wage (for an understanding of these two matching taxes, read: Form 941 – The Basics )
Federal Unemployment Tax (FUTA) at .6% of the first $7,000 of gross wages, for more information read: FUTA: An Explanation to the Federal Unemployment Tax Act
State Unemployment Tax (SUTA) varies from state to state and usually consists of a flat amount plus some percentage of gross wages
Health Insurance – typically a flat rate cost per employee per month, sometimes the employee pays a portion and this is a deduction from the wages
Retirement – most employers pay some type of a matching amount up to 5% of the wages of the employee, a good example is explained in this article – The SIMPLE Retirement Plan
Vacation/Sick Time with Pay
Dental/Vision/Cancer – similar to health insurance, the employer may pay a portion or provide the benefit as deduction from the employee’s wages
Life Insurance – the most common type of plan is a flat rate benefit in case of death, typically a $50,000 face value policy payable to the employee’s beneficiaries
Section 125 Plan – a unique type of plan encompassing many different pretax benefits to assist the employee in a better quality of life and include benefits.

Benefits

There are multitude of benefits paid by the employer to acquire and retain good employees. Much of the benefit cost paid by the employer is typically percentage based on the total wages. The following are the most common in order of the most likely to the least likely of benefits:

Health Insurance – typically a flat rate cost per employee per month, sometimes the employee pays a portion and this is a deduction from the wages
Retirement – most employers pay some type of a matching amount up to 5% of the wages of the employee, a good example is explained in this article – The SIMPLE Retirement Plan
Vacation/Sick Time with Pay
Dental/Vision/Cancer – similar to health insurance, the employer may pay a portion or provide the benefit as deduction from the employee’s wages
Life Insurance – the most common type of plan is a flat rate benefit in case of death, typically a $50,000 face value policy payable to the employee’s beneficiaries
Section 125 Plan – a unique type of plan encompassing many different pretax benefits to assist the employee in a better quality of life and include these benefits:
- Health Insurance
- Dental/Vision/Cancer
- Day Care for Children
- Disability Insurance
- Long-Term Care Insurance
- Education/Tuition

Education/Training – many larger employers offer this benefit to expand the knowledge pool of the existing employment base; pretty uncommon in your businesses with less than 100 employees

To understand how this works, let’s run through an example.

Jim was hired and agreed to a $12 per hour compensation and he immediately was entitled to the retirement plan. His employer agreed to match up to 3% of Jim’s personal contribution to the retirement plan. Jim elected to have 4% of his pay withheld for retirement purposes. In addition, the employer agreed that Jim is qualified to participate in the health insurance program. His employer explained that to have access to the health insurance, he must pay $15 per 40 hours of employment and the employer pays the balance of the $147 monthly premium (group rate policy) for individual (male) plan. Jim is recently divorced and the terms of his divorce require him to pay $45 per week to the state for child support. Jim is not entitled to vacation time until he has worked a minimum of 90 days.

The following walks through a typical payroll for Jim for one week’s worth of wages (40 hours):

Wages

Jim’s base wage of $12 per hour for 40 hours equals $480.00

Taxes

Social Security Matching at 6.2% of gross wages 29.76
Medicare Matching at 1.45% of gross wages 6.96
FUTA at .6% of first $7,000 2.88
SUTA at 2.38% of first $5,000 of gross wages 11.42
Total Taxes $51.02

Benefits

Jim is withholding at 4% of his pay for retirement, therefore a match of 3% = $14.40
Jim’s health insurance is $147 per month and is offset by his deduction of $15 per 40 hours of work; therefore the cost to the employer is ($147/4.2 weeks per month) minus $15 which equals $20.00 ($147/4.2 = $35, then $35 – $15 = $20; in effect the employer pays $20 times 4.2 or $84 per month of the premium, Jim pays $15 times 4.2 or $63 per month) = $20.00
Total Benefits costs to the employer is $34.40

Total Costs for Jim’s one week of work to the employer is $565.42

On the employer’s profit and loss statement there will be three lines of data as noted above and will look like the following:

Direct Costs of Services (Cost of Goods Sold Section)

Payroll
Wages/Salaries/Other Compensation $480.00
Payroll Taxes 51.02
Payroll Benefits 34.40
Sub-Total Payroll $565.42

Some P&L statements may break out the taxes and benefits sections into more detail, but you get idea of the presentation format.

Now the gross cost of the wages is accumulated by adding in the other employees and summing the totals for each of the respective groups. To fully grasp the meaning, now we have to actually pay the employee and the respective taxes and benefits. The next section continues this example and how all these costs are accumulated and paid out to the respective authorities.

Understanding the Various Liabilities

Now you have a basic understanding of all the costs involved in a payroll.

Notice from above, that a $480 gross wage equates to $565 in total costs! Most of the additional costs are matching taxes and other taxes the employer must pay as a function of law. Before we pay these taxes, we need to pay Jim. Let’s take a look at his paycheck:

Gross Wage (40 hours X $12 per hour) $480.00
Federal Income Taxes Withholding (41.40) *
Social Security (29.76) 6.2% of gross wages
Medicare ( 6.96) 1.45% of gross wages
State Income Taxes Withholding (23.97) Note ‘1’
Retirement Contribution (19.20) Note ‘2’
Child Support (45.00) Per his divorce decree
Health Insurance Premium (15.00) Note ‘3’
JIM’S NET CHECK $298.71

*How this is calculated is based on the Form W-4 Employee’s Withholding Allowance Certificate

Note ‘1’ – Based on the tax tables of the state assuming income taxes are a state requirement
Note ‘2’ – Jim agreed to have 4% of his wages withheld for his retirement contribution
Note ‘3’ – Jim pays $15 per week for health insurance that covers him as a single male

Interesting how $480 of gross wages ends up at $298.71 in net wages. The $181.29 difference relates to the taxes he must pay, benefits he is purchasing and legal obligations he has created. The total owed to all parties is $565.42, but we have only paid $298.71 so far. The remaining balance of $266.71 is various liabilities and consist of three groups. The first are taxes, the second are benefits and the final group consists of legal compliance. The following sub-sections describe each and illustrate the calculations.

Taxes

The taxes comprise the employee payments and the employer’s required payments and are grouped by the respective authorities as follows:

Federal Taxes – reported to the federal government via Form 941 at the end of each quarter, paid via electronic payment at the IRS EFT website and annually via Form 940

Employee’s Deductions
Federal Income Taxes Withheld $41.40
Social Security 29.76
Medicare     6.96
Sub-Total Employee’s Deductions $78.12
Employer’s Matching Requirements
Social Security Matching 29.76
Medicare Matching    6.96
Sub-Total Employer Matching   36.72
Total Form 941 taxes owed $114.84

FUTA required payment via Form 940 (filed annually), but paid quarterly via EFT website $2.88

Total for all Federal Taxes $117.72

State Taxes – reported to your state department of revenue and/or unemployment commission via your state’s documentation guidelines (typically monthly), most states are online with receiving payments and require payments no less than monthly.

Employee’s Deductions for State Income Taxes 23.97
SUTA per state’s schedule 11.42
Total for all state taxes owed 35.39
TOTAL FOR All PAYROLL TAXES $153.11

Benefits

Similar to taxes, there are the employee’s deductions and the employer’s required payments.

Employee’s Deductions
Health Insurance $15.00
Retirement Contribution @4% 19.20
Sub-Total Employee’s Deductions 34.20

Employer Provided
Health Insurance 20.00 ($147 Monthly Premium/4.2 Weeks Less $15/Week Employee)
Retirement Matching up to 3% 14.40
Sub-Total Employer Provided 34.40
TOTAL FOR BENEFITS $68.60

Legal Compliance

Legal obligations are generally submitted to the employer by the court system or via an agreed deduction between the employee and some outside third party. In this case, Jim has a legal decree from a court requiring him to pay $45 per week to the state’s child support system. Other examples of legal compliance include automatic withdrawals for auto payments, garnishments, or back taxes.

Child Support 45.00

TOTAL FOR ALL PAYROLL LIABILITY GROUPS $266.71

The above liabilities are shown on the balance sheet for the payroll date in the Current Liabilities section of the balance sheet after Accounts Payable and Credit Card Debt as illustrated here:

Liabilities Section of the Balance Sheet
  Accounts Payable $Z,ZZZ.ZZ
Credit Card & Vendor Revolving Debt Accounts Z,ZZZ.ZZ
Payroll Liabilities
Taxes                                                   $153.11
Benefits                                                  68.60
Legal Compliance    45.00
Sub-Total Payroll Liabilities       266.71
Sub-Total All Current Liabilities $Z,ZZZ.ZZ

As you pay the respective parties their predetermined amounts, you decrease the liability amount and once all parties are paid, your total actual cash out equals $565.42 ($298.71 for Jim’s net check and $266.71 for the various liabilities). The following schedule reconciles the gross costs to the actual payments.

Reconciling the Gross Costs to Payments

To fully appreciate the payroll, you must first see the series of checks written to pay all the associated costs. Let’s take a look at the reconciling of the payroll for Jim based on the checks written:

Jim’s Net Check $298.71
IRS via EFT Payment online 114.84 Note ‘1’
IRS via EFT Payment online 2.88 Note ‘2’
State Payment for Income Taxes 23.97 Note ‘3’
State Unemployment Commission 11.42 Note ‘4’
Health Insurance Company 35.00 Note ‘5’
Retirement Plan 33.60 Note ‘6’
State Child Support Com/Dept/Bureau 45.00 Note ‘7’
TOTAL FOR ALL PAYMENTS $565.42

Note ‘1’ – This is the 941 payment portion associated with Federal Withholding, Social Security, Medicare and Matching
Note ‘2’ – This is usually paid in one lump sum at the end of a quarter because no legal requirement to pay per payroll run
Note ‘3’ – Most states require this payment online via an electronic payment, some allow a physical check to the Revenue Dept
Note ‘4‘ – Every state is different in this payment frequency and method, some states require larger employers to pay electronically
Note ‘5’ – Includes the employee and employer portions
Note ‘6’ – Includes the employee and employer portions
Note ‘7’ – Most states require immediate transfer of withholdings, some states allow monthly payments for combined withholdings

Notice there are eight physical payments for one single payroll. As you have more employees, the payments are combined for each of the respective liabilities. Each payment typically requires a report detailing the sourced employees for the respective payments. Most governmental authorities and benefit providers provide a form with the respective employee’s name and social security number to assist in recording the information correctly.

Summary – Introduction to Payroll

Two of the keys to understanding payroll are recognizing the terminology and appreciating the core concepts of a payroll. At first, it appears intimidating but once you understand that there are three groups of costs: compensation, taxes and benefits; then you will realize that these costs are paid via different systems. Compensation is paid directly to the employee or to a third party for legal compliance (child support, court ordered payments, or automatic payroll deductions for loan payments). Taxes are paid directly to the respective governmental authorities for both the employee’s withholdings and the required employer matching and unemployment taxes. The final group is benefits. These payments are made to the benefit provider based upon the agreed terms between all three parties (employee, employer, and benefit provider). Act on Knowledge.