Understanding Payroll Expenses
Businesses need to understand payroll costs because they make up a sizable amount of any organization’s operational expenses. Payroll expenses are an area that many businesses don’t completely understand. Simply put, they are expenses that a business is responsible for and must pay for when they process their payroll. This includes the employer’s portion of employee benefits, as well as unemployment insurance taxes, the employee’s gross income, and FICA taxes.
The biggest payroll cost is employee gross wage
The largest payroll expense—as you surely already know—is employee compensation. It is important to keep in mind that employee gross compensation contributes to a company’s payroll costs. Some businesses mistakenly calculate their overall payroll costs using employee net wages. When a business does this, they are greatly underestimating their overall payroll costs. Instead, the employees’ gross pay is what the company is required to pay. Deductions and taxes that are taken out of an employee’s paycheck are not paid by the employer, but rather are come out of other accounts.
Employers are liable for FICA taxes
Another significant category of payroll expenses is FICA taxes. The company and the employee are both required to contribute equally to FICA taxes. The Medicare tax is the lone exception to this rule. Employees who earn more than $200,000 annually must contribute an additional 0.9% of their salary to Medicare. However, this is not included in the business’s payroll costs. Payroll expenses only include contributions made by the employer.
Employers are responsible for paying a percentage of Social Security and Medicare taxes for their employees – 6.2% towards Social Security and 1.45% for Medicare. Employees are taxed at the same rate. The only ones exempt from paying FICA tax are a few students and a small subset of non-resident aliens.
Companies must also pay taxes for unemployment insurance
Federal unemployment insurance taxes, which are 6% of the first $7,000 in wages paid to employees, must be paid by employers. Employers are liable for paying the unemployment insurance taxes in several states. These state unemployment taxes have different rates, but they often have the same amount as the federal unemployment insurance tax. A 5.4% credit for the federal unemployment tax may be available to your business if it is based in a state that levies a state unemployment insurance tax. As a result, the federal unemployment tax is reduced to 0.6%.
What the company pays for employee benefits
For many businesses, their total cost for employee benefits is the highest payroll expense they have, after paying employee wages. The expense of an employee’s health care is heavily subsidized by many businesses, and larger organizations typically match or contribute to 401k plans. Other perks are that are sometimes provided are memberships to gyms for employees. All of these expenses outside of wages are payroll expenses. When companies are considering what their total payroll expenses are, they should remember to not count any withholdings or deductions that don’t come out of their own accounts but are being covered by the employees.
Payroll costs for self-employed individuals
For companies who hire independent contractors, computing their payroll expenses is substantially easier than for employees. The reason for this is because businesses are not required to pay into or even offer benefits to independent contractors. Additionally, independent contractors are responsible for covering the whole cost of FICA taxes themselves. The wages or compensation being paid to an independent contractor is the only payroll expense the business will have. They are not even liable for unemployment insurance since the contractor isn’t “employed”.
Maintaining records of payroll costs
It is important to keep meticulous records of all payroll expenses. Companies are required by law to keep their records for a period of two years in the event they are audited and the IRS needs to see the files. It is, however, recommended to keep them for three years.
Should an employee challenge or dispute what they have been paid or their benefits, records are critical for an employer to prove those amounts. Records are also needed for bookkeeping and to produce a Profit and Loss statement at the end of the year showing a total for payroll expenses.
Calculating payroll costs
For tax planning purposes, many businesses work up an estimate for their payroll expenses at the beginning of the year or for each quarter, since the expense is one of the largest expenses they have. That way they can be prepared for the bill when payroll comes due.
This can be a challenge during the first year of business, as manually calculating what the payroll expenses will be isn’t easy. Once payroll has been processed for a cycle or two this becomes easier, as long as the number of employees stays the same. The easiest way to compute costs is by using a payroll software that can give an estimate. It’s also safer because the software will be using the current tax laws.
Jeffrey Ressler owns a boutique, full-service accounting firm in Boca Raton, Florida that provides individualized financial services, expert tax preparation, tax planning for individuals and companies, and finding solutions to IRS problems.