Accounting Simplified

Federal Payroll Tax

Wages subject to federal tax include pay given to an employee in exchange for services performed for the employer, whether or not the payments are in cash. Taxable wages also includes bonuses, vacation pay, and fringe benefits such as memberships, tickets, and property determined at the fair market value.

Expense reimbursements to employees, on the other hand, do not generally fall under taxable income if accounted for properly per IRS rules.

Federal taxes on wages include federal income tax withholding, Social Security, Medicare, and federal unemployment taxes.

Federal Income Tax Withholding

Employers are required to withhold federal income tax based on the employee’s W-4, or the Employee’s Withholding Allowance Certificate. The W-4 bases federal withholding on marital status and withholding allowances. The goal of using the W-4 is to match the federal income tax withholding with federal income tax the employee owes on wages by year-end.

Social Security and Medicare Tax

The Federal Insurance Contributions Act (FICA) uses federal funding to provide old-age, survivors, and disability care and is financed by Social Security Tax.

Medicare provides for hospital insurance and is funded and reported separately under Medicare tax.

Effective in 2011, Congress lowered the employee Social Security tax rate from 6.2% to 4.2%. The employer Social Security tax rate is still 6.2%. The Medicare tax rate is 1.45% for both employees and employers, unchanged from 2010.

Social Security has a wage base limit, or a maximum wage that is subject to the tax per employee. For 2011, the wage base limit for Social Security remains unchanged at $106,800.

Medicare tax does not have a wage base limit.

An employer is required to withhold the Social Security and Medicare tax from employee pay, and to also pay a matching amount for these taxes.

Reporting Federal Taxes on the 941

Federal income tax, Social Security, and Medicare amounts are reported on form 941on a quarterly basis. The total that should be reported on the 941 equals all federal withholding for the quarter, 10.4% of Social Security wages (employee withholding of 4.2% plus employer matching of 6.2%) and 2.9% for Medicare wages (employee withholding of 1.45% plus employer matching of 1.45%).

Depositing Federal Payroll Taxes

Employers must deposit federal income tax withheld from employees pay, and pay both the employer and employee portion of Social Security and Medicare taxes either monthly, semi-weekly, or by the next business day.

To determine the deposit schedule, look at the total taxes on line 8 from July 1 to June 30 of last year, called the “lookback period.” You are a monthly schedule depositor if you reported a total of $50,000 or less on line 8 of form 941 for the four quarters in the “lookback period.” You are a semiweekly depositor if you reported more than $50,000 total for all four quarters.

New Employers and Federal Tax Deposits Requirements

You are a monthly schedule depositor if you are a new employer because your tax liability was zero during the four quarter lookback period. Monthly depositors deposit tax on the 15th of the month following the payroll date.

$100,000 Next-Day Deposit Rule

Regardless of your deposit schedule, if you accumulate $100,000 or more of federal taxes on any day during a deposit period, you must deposit the tax by the next banking day. This is required whether you are a monthly or a semiweekly schedule depositor.

Federal Deposit Schedule and Required Returns

Tax Type	Lookback Period July 1 – June 30	Deposit Schedule	Tax Return Requirement
Social Security, Medicare, federal withholding	$50,000 or less for all four quarters	Monthly	941 Quarterly, W-2’s and W-3 annually
	More than $50,000 for all four quarters	Semiweekly
	$100,000 on any one day	Next-Day

Federal Unemployment Tax (FUTA)

Federal unemployment tax is paid only by the employer and is not withheld from employees’ wages. The FUTA tax rate is 6.2% for the first $7,000 in wages for each employee. However, you can generally take a credit of 5.4% for the amounts you pay for state unemployment. Therefore, the FUTA rate is generally .8% (6.2% – 5.4%) for the first $7,000 in wages for each employee, or $56 annually for each employee that makes $7,000 or more.

After June 30, 2011, the FUTA tax rate is scheduled to decrease to 6.0%. With the credit of 5.4% for state unemployment paid, the federal unemployment rate effectively becomes .6% (6.0% – 5.4%).

FUTA taxes are paid quarterly on the last day of the month following the quarter, and filed annually using form 940.

State Payroll Tax

State Unemployment Tax

Employers are required to pay state unemployment taxes for employees working within the state, regardless of where the employee lives. The state unemployment tax is paid quarterly and filed quarterly with the state Department of Labor. A separate account number is generally required for state unemployment filing than the account number used for state income tax filing since these taxes are reported to different departments.

The state unemployment rate will vary for each employer depending on the employer’s past activity in the state. However, the wages subject to unemployment tax are applied uniformly to each employer within the state, though the wage caps vary across each state (from $7,000 to over $30,000 in some states). Therefore, the employer pays the rate assigned to its account times the wage cap per each employee within the state.

For example, if your state unemployment rate is 5.4%, and you have 20 employees that made $50,000 working in the state for the year, and the wage cap is $7,000 per employee, you will owe $378 for the year ($7,000 x 20 x 5.4%).

Because of the wage caps, employers will generally incur greater state unemployment taxes in the earlier quarters during the year and less tax as the year progresses and the wage cap is exceeded per employee. New hires will generally generate more tax in the quarter hired.

The quarterly returns must be filed quarterly regardless of the total tax liability in order to account for each employee’s wages and calculate the total unemployment tax.

State Unemployment Reports and Payments Schedule

Quarter #	Dates of Quarter	Tax Reports and Payments Due
1	Jan. 1 – March 31	April 30
2	April 1 – June 30	July 31
3	July 1 – Sept. 30	Oct. 31
4	Oct. 1 – Dec. 31	Jan. 31

State Disability Tax

Disability insurance provides coverage to employees for injuries and illnesses that are not related to work.
Some states require disability insurance payments either from the employee, the employer, or both. The following states have a disability tax: California, Hawaii, New Jersey, New York, and Rhode Island. Employers must also make a contribution to disability insurance in the states of Hawaii, New Jersey, and New York. Disability taxes are generally paid monthly.

State Withholding

Employers are required to withhold state income tax similar to federal income tax. The withholding is either based on the federal W-4 form, or on a separate withholding allowance form required by the state. State withholding is generally paid monthly or quarterly, with tax filing due at the end of each quarter. Additionally, states require the state copy of the W-2’s with an annual summary of state wages and withholding.  The annual return should reconcile with the four quarterly returns filed during the year to account for total state wages and withholding.

Seven states do not have a state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Two others, New Hampshire and Tennessee, tax only dividend and interest income.

Local Payroll Tax

Some localities require tax withholding or tax the employer based on the number of employees. The most common local payroll taxes are cities, boroughs, and townships located throughout Pennsylvania, including Philadelphia, parts of Ohio, cities within New York, and San Francisco.

Local taxes can be based on either resident or nonresident status, and require withholding and deposits, quarterly and annual filings, and a separate account number similar to state and federal guidelines. Check with the city where you operate a business or have employees residing for any local tax filing requirements.

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Managing payroll effectively requires a comprehensive system that is capable of handling the myriad of legal and tax issues associated with processing payroll.

Small business payroll can hum along happily like a finely tuned engine that requires an occasional tune-up, such as updating tax rates and software, or it can operate in perpetual crisis-mode that subjects the employer to tax notices, legal issues, and unwanted communications with the IRS and other governmental regulators.

The difference is in maintaining a comprehensive payroll system that covers all of the legal and tax requirements stemming from processing a payroll check.

The easiest solution is to simply outsource payroll. This allows the company to ensure timely payments, proper tax filing and deposits in various jurisdictions, and to maintain adequate recordkeeping. This is especially true when employees are working in multiple states or localities that trigger various tax filing obligations.

Payroll Companies and Small Business Payroll Services

The largest payroll companies are ADP, Ceridian, and Paychex. Each handles large payroll functions and tax filing. For smaller companies, small business payroll software includes a complete set of small business payroll services. For example, QuickBooks, PeachTree, and AccountEdge (MYOB) offer complete and cost-effective small business payroll services for both processing payroll and for filing payroll taxes.

Enterprise level or small business payroll services can handle the entire payroll process for you. When the business submits employee hours, the payroll companies can handle deductions, benefits, retirement programs, direct deposits, in addition to computing, depositing, and filing local, state, and federal payroll taxes. At the end of the year, the payroll service will also generate W-2’s for employees and local, state, and federal governments, and file annual payroll tax returns.

Some companies elect to process payroll internally, while outsourcing only the payroll tax service. Whatever you choose to outsource, payroll companies offer a complete menu of services, from managing the check processing, to payroll tax to outsourcing the entire payroll.

The cost of outsourcing payroll and payroll tax filing can be well worth the benefits of maintaining proper records, fulfilling payroll and tax requirements, and preventing costly penalties for nonfiling or late deposits.

Regardless of how you decide to manage your payroll, there are several issues employers should be aware of when hiring employees. The below sections cover the main issues employers should be aware of when managing enterprise, medium-sized, or small business payroll, and the steps required to properly set up payroll.

Small Business Payroll and the IRS Employee Handbook

Every employer should have the latest version of Circular E employer’s federal tax guide and employee handbook available at the IRS website to review federal withholding, deposit, and reporting requirements.

Small Business Payroll Steps for Setup

1. Whenever you hire an employee, you are required to have an EIN (employer identification number). The employer identification number is a nine – digit number that provides a federal account number for your employer federal tax payments. To get an EIN, fill out form SS-4 that only takes a few minutes and mail, fax, or e-mail it to the IRS.

2. When you hire an employee, you must provide the employee with a W-4 and an I-9 form. The W-4 form must be filled out and signed by the employee for federal withholding requirements. The objective of the W-4 is to withhold an amount equal to what the employee will owe by the end of the year.

The I-9 form is used to verify that the employee is authorized to work in the U.S. Employers must retain completed form I-9s for three years after the date of hire or one year after the date employment ends, whichever is later.

3. Notify the state where you have employees of your business activities. The state will request your federal EIN and will either use it as a separate state account number or assign you a new account number. The state account number is used for reporting any wages and withholding from your employees’ paychecks.  The department for state withholding is the Department of Revenue. Some states will also require their own version of the W-4 to be filled out, which you should keep on file with the W-4. Other states use the federal W-4 for state withholding purposes, unless the employee requests a different amount to be withheld for state purposes.

4. All of the authorization and tax forms must be on file in a personnel file at the employer’s place of business. When authorizing employees to work, the authorization to set up a new employee should be managed by a separate department such as Human Resources. The separation of authorizing and paying employees is an important internal control that prevents unauthorized checks and payments by creating “phantom” employees.

5. Apply for an account number with the Department of Labor in each state where an employee works. The Department of Labor manages the tax filing for state unemployment insurance payments. The State Department of Labor requires companies to pay unemployment tax payments each quarter for employees working in the state. The account number to pay state unemployment insurance with the Department of Labor is different than the state number for withholding purposes.

For federal and state deposit requirements, click the small business payroll tax section.

Small Business Payroll Tax

Payroll Accounting

Independent Contractor vs. Employee

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The matching principle means when revenues are generated, the expenses incurred to generate those revenues should be reported in the same accounting period (the same income statement).

This principle is central to accrual accounting, the method required by GAAP, since the cash accounting method merely reports expenses when paid. The matching principle is concerned with matching the revenue recognized for the period with the expenses that caused the revenue under the accrual accounting method, so that the net result is fairly reported for the period.

Since it is sometimes difficult to associate revenue with expenses used to generate it, general guidelines are used to match expenses with revenues.

The Matching Principle and Cause and Effect

The clearest and most straightforward example of matching expenses with revenue is the cause and effect relationship illustrated in cost of goods sold and revenue. When a product is sold, the most direct cost incurred is the cost of the product.

In the case of Sunny Sunglasses Shop, when Sunny sells a pair of sunglasses for $50, the immediate cost for the sunglasses incurred to generate the sale was the $15 paid for the sunglasses. The $15 cost of goods sold is recognized with the $50 sale so that the revenue and costs incurred to generate the sale are reported, or matched, in the same period.

The Matching Principle and Systematic and Rational Allocation

In the absence of such a direct cause and effect relationship, GAAP requires a systematic and rational method to allocate the cost of the asset used to generate income over several years. These other costs are more closely associated with specific accounting periods.

For example, the purchase of an asset with an estimated useful life of five years can be associated with the revenue it helped generate over that same five – year period. The cause and effect relationships between the cost of the asset and the revenue it generates may not be clear, but the estimated useful life of the asset and the periods that it benefits can be systematically and rationally measured.

Asset depreciation is the allocation method that is used to spread the cost and useful life of the asset against the revenue generated from its use. If an asset were purchased for $100,000, instead of reporting a one-time expense of $100,000, thereby under-reporting revenue for the first year, and over-reporting revenue for the following years for which no expense is taken against future revenues, the matching principle requires that depreciation allocate the cost of the asset over the useful life of the asset. In this case, a $100,000 asset with a useful life of ten years and no salvage value would allocate and match $10,000 of deprecation expense for ten years against those revenues for the same accounting periods.

The purpose of depreciation expense is therefore to allocate the cost of the asset over its useful life against the revenue it helped generate. This allocation method prevents revenue from being under reported in one year, and inflated in following years by properly matching reported revenue with the costs incurred to generate that revenue for the same period.

Similarly, prepaid expenses are recognized when consumed. When Sunny purchased a $2,400 insurance policy for the year and issued a January income statement, only the $200 that was consumed in January was reported as an insurance expense on the earnings statement. The balance of $2,200 remained on the balance sheet as a prepaid expense for remainder of the year.

Applying the Matching Principle by Allocation

The allocation method prevents revenue from being under reported in one year, and inflated in following years by properly matching reported revenue with the costs incurred to generate that revenue for the same period. Examples of costs recognized by systematic and rational allocation include: Depreciation expense for plant, property, and equipment Amortization of intangibles Allocation of prepaid expenses such as rent and insurance

The Matching Principle and Immediate Recognition

If the above measurement principles are unsuitable to the expense, then the costs are expensed in the period in which they are incurred. These include costs for which there is no clear future benefit, the benefit is not certain, and costs for which no allocation method can be devised.

For example, general administration expenses and salaries across departments are not easily identified with the future benefit of revenues, and are thus immediately expensed during the period they are incurred. Immediate recognition also includes accrued expenses such as payroll and rent incurred for the period but not yet paid. Accrued expenses are recorded in the adjusting entries process to match expenses incurred but not paid with revenue generated in the period.

Expenses or Expenditures?

An expenditure is an outlay of cash, while an expense is the portion of an expenditure that generates revenue for the period. Under the matching principle, expenses are reported with revenue and not necessarily entire expenditures for the period. In the above example, the $100,000 paid for equipment is an initial expenditure. The $100,000, however, is not an expense used to generate revenue for the same period in year one. Rather, the $10,000 allocated against the revenue for each period of the asset’s life is the expense. Similarly, expenditures made for items with future benefits are classified as prepaid assets and converted to expenses as they are consumed.

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