How to Do Payroll Accounting for Your Business

Payroll accounting manages and records all financial activities related to employee compensation, including calculating wages, applying deductions, and meeting tax obligations. It is fundamental for any business, ensuring compliance, fostering employee trust, and preventing errors.

Understanding Payroll Fundamentals

Understanding the core elements of payroll is the first step in effective payroll accounting. Businesses must gather specific information from each employee, such as W-4 forms for federal tax withholding and benefit enrollment forms, to accurately process payroll.

Gross pay is the total amount an employee earns before deductions, including wages, salary, overtime, commissions, or bonuses. It is the starting point for all payroll calculations.

Deductions are amounts withheld from an employee’s gross pay, falling into several categories. Pre-tax deductions, such as health insurance premiums, 401(k) contributions, and Health Savings Account (HSA) contributions, reduce an employee’s taxable income, thereby lowering their tax liability.

Post-tax deductions are taken from an employee’s pay after all taxes have been calculated and withheld. These deductions do not reduce taxable income. Examples include Roth 401(k) contributions, wage garnishments for child support or other debts, and certain life or disability insurance premiums.

Mandatory deductions are required by law and include federal income tax, state income tax (where applicable), and Federal Insurance Contributions Act (FICA) taxes. FICA taxes consist of Social Security and Medicare contributions. Employers are legally obligated to withhold these amounts from employee paychecks.

Net pay, or take-home pay, is the amount an employee receives after all pre-tax deductions, taxes, and post-tax deductions are subtracted from gross pay. This is the amount deposited or provided as a physical check.

Beyond employee compensation, businesses incur employer payroll costs. These include the employer’s matching portion of FICA taxes, as well as federal unemployment tax (FUTA) and state unemployment tax (SUTA). These costs are separate from employee wages but are part of the overall payroll expense.

Calculating Employee Compensation and Withholdings

Calculating employee compensation begins with determining gross wages based on pay structure. For hourly employees, gross pay is hourly rate multiplied by hours worked, including overtime. Salaried employees have a fixed gross amount per pay period, derived by dividing annual salary by pay periods.

Commissions and bonuses are added to regular wages for total gross pay. These must be factored into the gross pay calculation before deductions.

Employee deductions begin with federal income tax withholding, determined using the employee’s Form W-4 and IRS tax withholding tables. The W-4 provides filing status and adjustments, influencing the amount withheld.

FICA taxes are a mandatory deduction. For Social Security, employees contribute 6.2% of their wages up to an annual wage base limit, which is $176,100 for 2025. The Medicare tax rate is 1.45% of all wages, with no wage base limit.

An Additional Medicare Tax of 0.9% applies to wages exceeding certain thresholds: $200,000 for single filers and $250,000 for married couples filing jointly. Employers must begin withholding this additional tax once an employee’s wages surpass $200,000 within a calendar year, regardless of their filing status.

Other deductions, such as pre-tax and post-tax contributions, are calculated based on employee elections or specific legal orders like garnishments. For instance, health insurance premiums are deducted according to the employee’s chosen plan, while 401(k) contributions are based on the percentage or amount the employee elects to contribute.

Finally, net pay is calculated by subtracting all determined deductions from the gross pay. This computation ensures employees receive the correct take-home amount and that all necessary withholdings are accounted for.

Recording Payroll in Accounting Records

Once all employee compensation and withholding calculations are complete, these figures must be accurately recorded in the business’s accounting system through journal entries. This process translates the payroll calculations into financial transactions, impacting various accounts on the company’s financial statements.

The initial entry records the gross payroll expense, typically by debiting a Wages Expense or Payroll Expense account. Concurrently, liabilities for all amounts withheld from employees’ pay and owed to third parties are credited. This includes crediting accounts such as Federal Income Tax Payable, State Income Tax Payable, Social Security Tax Payable, and Medicare Tax Payable for the employee’s portion.

Other employee deduction liabilities, like Health Insurance Premiums Payable and 401(k) Contributions Payable, are also credited. The net pay amount is recorded as a credit to Wages Payable or Cash, depending on whether the payment has been made.

A separate set of journal entries is required to record the employer’s payroll tax expenses and liabilities. This involves debiting Payroll Tax Expense for amounts such as the employer’s matching share of Social Security and Medicare taxes, Federal Unemployment Tax (FUTA), and State Unemployment Tax (SUTA). Corresponding credits go to separate liability accounts for each tax, reflecting amounts owed to government agencies.

Accruing payroll expenses is important when a pay period does not align perfectly with an accounting period, such as when a month ends mid-week. In such cases, the business must recognize the wages and related payroll taxes that employees have earned but have not yet been paid by the end of the accounting period. This ensures that financial statements accurately reflect all incurred expenses and liabilities.

Regular reconciliation of payroll records with bank statements and tax filings is a control measure. This process involves comparing amounts recorded in the accounting system to actual bank debits and tax forms. Reconciliation helps identify and correct discrepancies, ensuring data accuracy and compliance.

Managing Payroll Tax Payments and Filings

Managing payroll tax payments involves adhering to specific federal and state requirements for depositing withheld taxes. Federal income tax, Social Security, and Medicare taxes (Form 941 taxes) are typically deposited using the Electronic Federal Tax Payment System (EFTPS). Businesses are generally classified as either monthly or semi-weekly depositors, with the deposit schedule depending on the total tax liability accumulated over a lookback period.

Monthly depositors remit taxes by the 15th of the following month, while semi-weekly depositors have more frequent deadlines, generally Wednesday or Friday, depending on when payroll is paid. Failing to deposit taxes on time can result in penalties. State and local tax payment requirements vary by jurisdiction, often mirroring federal schedules or having their own specific deadlines.

Businesses are required to file several federal payroll tax forms throughout the year. Form 941, Employer’s Quarterly Federal Tax Return, reports income, Social Security, and Medicare taxes withheld and the employer’s share. It is due quarterly, by the last day of the month following the quarter’s end.

Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, reports the annual federal unemployment tax liability. It is typically due by January 31st of the following year, with quarterly deposits required if liability exceeds a threshold.

At year-end, businesses prepare Forms W-2, Wage and Tax Statement, for each employee, reporting annual wages and taxes withheld. These must be provided to employees by January 31st of the following year. Copies are submitted to the Social Security Administration with Form W-3, Transmittal of Wage and Tax Statements, by the same deadline.

In addition to federal obligations, businesses must comply with state-specific unemployment tax (SUTA) and income tax withholding requirements. This typically involves filing state quarterly wage reports and remitting state unemployment and income taxes according to the state’s established schedule. Many states also require annual reconciliation forms similar to the federal W-3.

A final year-end reconciliation compares total wages and taxes reported on quarterly Forms 941 with annual totals on Forms W-2 and W-3. This process helps ensure consistency and accuracy across all payroll tax filings, reducing discrepancies with tax authorities.