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For most businesses, payroll is perhaps the most significant cost of doing business. And, correctly planning for and managing these costs is enormously important to a business. Employees don't tend to stay long if a payday is missed, so payroll is truly the life's blood of the business.

Before looking at the special issues pertaining to payroll accounting, you should first understand who is an "employee." Many services are provided to a business by other than employees. These services may include janitorial support, legal services, air conditioner repairs, audits, and so forth. An employee is defined as a person who works for a specific business and whose activities are directed by that business - the business controls what will be done and how it will be done. In contrast, an independent contractor is one who performs a designated task or service for a company - the company has the right to control or direct only the result of the work done by an independent contractor. The distinction is very important because the payroll tax and record keeping requirements differ for employees and independent contractors. As a general rule, amounts paid to independent contractors do not involve any "tax withholdings" by the payer; however, the payer may need to report the amount paid to the Internal Revenue Service (IRS) on a Form 1099, with a copy to the independent contractor. But, the obligation for paying taxes rests with the independent contractor.

The employer's handling of payroll to employees is another matter entirely. Let us begin by considering the specifics of a paycheck. You may have some work experience, and if you do, you know that the amount you receive is not the amount you have earned. Your check was likely reduced by a variety of taxes, possibly including federal income tax, state income tax, and FICA (social security taxes and Medicare Medicaid). Additionally, your check might have been reduced for insurance costs, retirement savings, charitable contributions, special health and child care deferrals, and other similar items. Before you feel singled out, you also need to know that your employer paid additional FICA contributions on your behalf, unemployment taxes, and maybe insurance costs, workers compensation costs, matching contributions to retirement programs, and other items. A business must correctly account for all of this activity.

Gross Earnings

The total earnings of an employee is the "gross pay." For hourly employees, it is the number of hours worked multiplied by the hourly rate. For salaried employees, it is the flat amount for the period, such as $3,000 per month. Gross pay might be increased for both hourly and salaried employees based on applicable overtime rules. Employers are well advised to monitor statutes relating to overtime; by law, certain employees must be paid for overtime.

Net Earnings

Gross earnings less all applicable deductions is the "net pay." Let's examine a representative paycheck, and the attached stub, as shown on the next page:

You will notice that I. M. Fictitious earned $3,000 during the month, but "took home" only $1,834. The difference was withheld by Unreal Corporation. The withholdings pertained to:

Income taxes - Employers are required to withhold federal, state (when applicable), and city (when applicable) income taxes from an employee's pay. The withheld amounts must be remitted periodically to the government by the employer. In essence, the employer becomes an agent of the government, serving to collect amounts for the government. Withheld amounts that have yet to be remitted to the government are carried as a current liability on the employer's books (recall the earlier mention of amounts collected for third parties). The level of withholdings are based on the employee's level of income, the frequency of pay, marital status, and the number of withholding allowances claimed (based on the number of dependents). Employees claim withholding allowances by filing a form W-4 with their employer.

Net Earnings

It is very important for you to know that the employer's obligation to protect withheld taxes and make certain they are timely remitted to the government is taken very seriously. Employers who fail to do so are subject to harsh penalties for the obvious reason that the funds do not belong to the employer. Likewise, employees who participate in, or are aware of misapplication of such funds can expect serious legal repercussions. You should never be a part of such an activity. The government has made it very simple for employers to remit withheld amounts, as most commercial banks are approved to accept such amounts from employers. Further, there are online systems that allow easy funds transfer. The frequency of the required remittance is dependent upon the size of the employer and the total payroll.

Social Security/Medicare Taxes are also known as "FICA." FICA stands for Federal Insurance Contributions Act. This Act establishes a tax that transfers money from workers to aged retirees (and certain other persons who are in the unfortunate position of not being able to fully provide for themselves due to disability, loss of a parent, or other serious problem). The social purpose of the tax is to provide a modest income stream to the beneficiaries. This component is the social security tax. Another component of the Act is the medicare/medicaid tax, which provides support for health care costs incurred by retirees (and designated others). You are perhaps aware that these taxes present an actuarial problem, as the aged population is growing relative to the number of workers. And, the tax is a transfer of money from one group to another, rather than being based upon an established insurance-like fund.

The social security tax is presently a designated percentage of income, up to a certain maximum level of annual income per employee. After the maximum is reached, no further amounts are due for that year for that employee. The history of both the rate and maximum level is one of consistent increases over time. For illustrative purposes, I am assuming a 6% social security tax, on an annual income of $100,000. In the above pay stub, you will note that I. M. Fictitious paid $180 in social security tax for the month (6% X $3,000). Since Fictitious has not yet exceeded $100,000 in gross income for the year-to-date, the annual maximum has not been reached. Once Fictitious exceeds the annual limit (for most employees that never occurs), the tax would cease to be withheld - only to resume anew in January of the following year. If this tax seems high, you need to know that the employee's amount must be matched by the employer. Thus, the burden associated with this tax is actually twice what is apparent to most employees.

The medicare/medicaid tax is also a designated percentage of income. Unlike the social security tax, there is no annual maximum. This tax is levied on every dollar of gross income, without regard to the employees total earnings. I have assumed a 1.5% rate in the above illustration (1.5% X $3,000 = $45). This is another tax the employer must match dollar-for-dollar.

Other Employee Deductions typically occur for employee cost sharing in health care insurance programs, employee contributions to various retirement or other savings plans, charitable contributions, contributions to tax-advantaged health and child care savings programs ("flex accounts"), and so forth. In each case, the employer is acting to collect amounts from the employee, with a resultant fiduciary duty to turn the monies over to another entity.

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