Tax liabilities based on income are known as income taxes, and they are levied at the federal, state, and local levels. Withholdings from income taxes and other taxes that are levied against both employers and employees are included in payroll taxes. Payroll management is significantly simpler if you understand the relationship between income taxes and payroll taxes. You must use accrual accounting to post accounting entries in order to process payroll. You must calculate withholdings and submit them to outside parties in order to complete payroll. You need to post journal entries, submit tax forms, and report wages to employees.
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What is Payroll Tax?
Payroll taxes include income taxes for social security, Medicare, and unemployment compensation. It’s important to remember that taxes may be paid by either the company or the employee, or by both.
What is Income Tax?
Taxes are assessed on a variety of sources of income, including interest and dividend income. Businesses must withhold income taxes from employee wages in order to process payroll. After being withdrawn, income taxes are sent to the taxing authority (the federal, state, or local department of revenue).
Dealing with other withholdings
Additional amounts that are not related to taxes, including the employee’s share of health insurance premiums, may need to be withheld by employers. When paying employees, you start with Gross Pay (unpaid wages) and calculate net pay after deducting withholdings. Depending on the withholding, taxes may or may not be withheld. You must categorize workers as either employees or independent contractors because not all employees have taxes withheld from their salary.
Differentiating Between Employees and Independent Contractors
The classification of a worker affects how they are treated for tax purposes. You will be responsible for the payroll expenses described in more detail below if the worker is an employee. While the only expense for the business is the gross amount paid for services, independent contractors are personally liable for all tax withholdings.
How to categorize employees is covered in Guidance offered by the Internal Revenue Service (IRS). Whether a worker is an employee or an independent contractor depends on the level of influence you have over them.
The guidelines consider who provides tools and supplies, how much control the employer has over the work performed by the employee, and whether a written contract is in place. If you have a lot of control over the person, you should classify them as an employee.
- Gross wages are the first step in the payroll process, regardless of how a worker is classified.
Starting with Gross Wages
Gross wages can be calculated using either an annual salary or an hourly rate of compensation and the number of hours worked. Your highest payroll expense, which covers payments to both workers and independent contractors, is the gross wages paid. You are now prepared to calculate the remaining payroll tax liabilities. Income taxes and taxes not directly related to income might be separated into payroll taxes.
Reviewing Income Taxes
Income taxes, as well as taxes for Medicare, Social Security, and unemployment benefits, must be paid by both workers and employers. The worker’s gross income serves as the basis for each of these taxes.
Deducting Income Taxes
Federal income taxes must be withheld from employee wages, and perhaps state and local taxes as well. Based on the worker’s annual salary and the number of allowances calculated on Form W-4, a deduction is made. Each taxing authority receives the withholding amounts, which are not employer expenses.
FICA Taxes and Unemployment Taxes
Medicare and Social Security are financed by FICA taxes, or Federal Insurance Contributions Act (FICA). Currently, a 6.2% Social Security tax and a 1.45% Medicare tax (7.65% total) are paid by the employer. Payroll withholdings equal a 7.65% tax for each employee. In order to give people who lose their jobs a temporary source of income, the Federal Unemployment Tax Act (FUTA) and the State Unemployment Tax Act (SUTA) were passed.
The employee’s first $7,000 in gross income is subject to a 6% FUTA tax from the current employer. If a state unemployment tax is applicable to the wages, the employer may use a 5.4% FUTA credit to reduce the tax to 0.6%. Depending on the unemployment program in each state, the combined federal and state unemployment taxes may change.
Incurring other Payroll Costs
In order to process payroll, a business must deduct other expenses that are not calculated exclusively by a worker’s pay. Payroll expenditures make up some of these expenses, while others (such as workers’ compensation and voluntary deductions) are just collected and given to a different party.
Computing worker’s compensation
Employers who have employees are required to carry workers’ compensation insurance. State laws govern this type of insurance, and most of them call for coverage. When a worker is hurt at work, the insurance plan covers medical expenses and lost wages. Employers are responsible for paying workers’ compensation premiums, and the price depends on the sector and the number of employees. For example, a construction company will spend more on insurance than an accountancy office. This is so because construction workers are more likely to have an injury than accountants working in an office setting.
A percentage of the cost of any perks that the employer provides may be deducted from the employee’s wages. The cost shared by the employer is a payroll expense. Here are a few examples:
- Retirement Plan: The employee’s contributions are subtracted from salary; they are not an expense of the business. However, the employer’s share of the contributions is a payroll expense for the company. There is no deduction from wages for employer contributions.
- Health, Vision, Dental, and Life Insurance Premiums: Employer-paid insurance premiums are considered business expenses and are not deducted from employees’ paychecks. The employee’s portion of premiums is taken out of salary; they are not a payroll expense.
- Union Dues: Pay is withheld from dues, which are then sent to the union on the worker’s behalf. Payroll expenses do not apply to the payments.
- Loan Payments: Repayments on a loan from the business to a worker may be withheld from pay and are not considered a payroll expense.
A business expense is a cost of hiring an accountant or a payroll service provider. Create a written procedure that details your payroll processing once you understand the payroll expenses that you will have to pay. All of the activities must now be recorded in your accounting records. You will post both payroll liabilities and expenses using the accrual method of accounting.
Accounting for Payroll Liabilities and Expenses
The accrual method of accounting, which balances revenue received with expenses incurred, should be used by all businesses. Regardless of when the costs are paid in cash, the accrual method tracks payroll expenses in the month they are incurred. A more accurate representation of company profit is provided by the matching concept.
Understanding the Accrual Accounting Method
Assume that the next paycheck date is April 5 and that a restaurant owes workers $3,000 in wages for the last five days of March. Using the accrual technique, a $3,000 increase in wages payable and a $3,000 wage expense are reported on March 31. Payroll processing on April 5 resulted in a $3,000 reduction in cash and a $3,000 reduction in wages payable. When the restaurant staff worked the hours in March, the expense was recorded. The $3,000 in payroll costs is included in the match between revenue and spending for the month of March.
Accounting for Payroll Expenses and Payroll Liabilities
Payroll Liabilities and expenses are posted using the accrual technique in the same period. In the restaurant example, on March 31 there is a $3,000 wage expense and a $3,000 wage obligation balance. The liability balance is reduced on April 5 when cash is received. This accounting system connects income generated with payroll expenses incurred, rather than posting expenses based on cash outflows.
Let’s get everything together and outline the procedures involved in processing payroll.
Nine Steps to Process Payroll Expenses
You must collect data, make calculations, pay employees, and submit withheld funds to third parties as part of the payroll process. With Form W-4, payroll processing can begin.
1. Collect Information on Form W-4
Employees who are newly hired must complete Form W-4. Employers are informed by the information provided in the form of how much salary should be withheld from a paycheck for tax purposes. The amount of tax withheld depends on the gross pay and the number of allowances listed on the W-4. Employees with multiple jobs or spouses who are working might also find help in the W-4. Also, schedules are offered to figure out withholdings in these situations.
2. To Determine Gross Pay use the Payroll Cycle
Payroll starts with gross wages, and the number of pay periods determines the amount of salary paid on each payroll date. The pay period indicates the start and end days for calculating hourly payroll if an employee is paid on an hourly basis.
3. To Calculate Net Pay use Gross Pay and Other Data
The amount a worker earns after all withholdings and deductions is referred to as net pay. Use the data you have collected to calculate net pay. This example shows how to calculate payroll and includes the usual deductions from wages:
Example of Payroll Calculation
Payroll is processed 26 times a year in this case. Payroll deductions for FICA and income taxes are made in addition to payments for health insurance. Finally, employers pay unemployment taxes rather than having them deducted from employees paychecks.
4. Pay Workers
By direct deposit or with a physical you can pay workers.
5. Submit Payroll Tax Deposits
The following tax withholding deposits are due from business owners. The frequency of deposits varies based on the amount and other elements.
Online tax deposit payments make it simpler to submit the deposits by the due dates.
6. Complete Payroll Tax Forms
Payroll tax returns are complex, so the data you provide must be correct. In order to avoid late filing costs, make sure you submit the forms on time. The most typical payroll tax forms that businesses must file are shown below:
- Form 941: Reports quarterly federal income taxes and FICA contributions to the IRS.
- Form 940: Annual Federal Unemployment Tax Return by Employer.
- Form W-3: Uses W-2 Forms to detail each employee’s total wages and tax withholdings. Each year, the report is submitted to the Social Security Administration.
- Form 1096: The amount paid to independent contractors using 1099 Forms is reported on Form 1096. This report is submitted yearly.
You can automatically generate these reports using accounting software.
7. Report Pay Amounts to Workers
To report the income made by independent contractors, businesses issue Form 1099-NEC. Each contractor who received $600 or more in compensation throughout the calendar year must receive a 1099 form. Even though 1099 is not issued, earnings of less than $600 are nonetheless taxable to the contractor as income. A W-2 form is sent to employees, which reports gross salary and any annual tax withholdings.
8. Keep Payroll Records on File
Records used to calculate pay are required to be kept for two years under the Fair Labor Standards Act (FLSA). Businesses must also maintain time cards and payroll calculation records under the FLSA.
Your payroll calculations may vary from one pay period to the next depending on several variables:
- Personnel who have been hired, elevated or discharged
- Tax law changes
- Employees who change their tax and benefit withholdings in response to changes in their salaries or families
The most time-consuming accounting work you complete can be payroll accounting, so it’s important to understand some of the basic journal entries.
9. Posting Journal Entries for Payroll Liabilities
Below you will see three common payroll journal entries that businesses should post:
- Accrued Payroll: Payroll expenses are recorded by debiting accrued wages (also known as wages expense) and crediting wages payable.
- Pay Accrued Payroll in Cash: Payroll accrual results in a debit (reduction) to wages payable and a credit (reduction) to cash when workers are paid in cash.
- Pay Income Taxes withheld: A liability for the amount withheld is recorded by the business when taxes are withheld. When the withheld taxes are paid, a debit is made to the Tax Liability Account and a credit is made to the cash account.
Although payroll liabilities are the same for all businesses, the chart of accounts for payroll liabilities may use account names that are unique to the company. For example, a business might create subaccounts to manage payroll by the department. Adjustments are frequently made to payroll accounts before financial statements are generated by accountants. Using technology and creating a documented plan will help you process payroll accurately while saving time.
Although there are differences between the two taxes, employers withhold both tax amounts when paying compensation. Be aware of how much tax you pay and how it is splitted because both taxes are levied for various purposes. Understanding the differences it will help you to figure out each type of tax and how they work. In this blog, you can clearly know the differences between tax and Income Tax. If you face any issues or have any queries then you can connect with Dancing Numbers team via LIVE CHAT.
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Frequently Asked Questions (Faqs)
Where are there Income Tax and Payroll Tax?
Payroll tax and Income tax serve different purposes. Income taxes can be used for any purpose that is decided by the state, local, or federal government, and payroll taxes fund the specific programs.
Is Federal Income Tax a Payroll Tax?
Simply, Income tax is a tax on an employee’s salary or wage. Although it may have a similar sound to the payroll tax, the primary distinction is who is in charge of paying the tax. The employee is responsible for paying income tax. Income taxes include state, federal, and local income taxes.
Is Federal Income Tax the Same as an Income Tax?
The federal government collects federal income taxes, and state income taxes are collected by individual states where a taxpayer earns income and lives.