Introduction

Calculating payroll taxes may seem simple: determine an employee’s wages, apply the tax rates, subtract the taxes from the paycheck, and send the money to the proper agencies. In practice, payroll involves many separate calculations.

Federal income tax withholding, Social Security, Medicare, unemployment taxes, state withholding, local taxes, and employee deductions may all be handled differently where some amounts come from the employee’s pay, while others are an additional expense that is paid by the employer.

Even when a paycheck looks correct, it can still create a problem if the wrong settings were used, taxable wages were calculated incorrectly, or a required tax deposit was late.

What Are Payroll Taxes?

The term “payroll taxes” is often used to describe every tax that is connected to an employee’s paycheck. However, these taxes do not all work the same way.

Federal income tax and the employee portions of Social Security and Medicare are generally withheld from employee wages, and employers are also responsible for their own portions of Social Security and Medicare.

Additionally, federal and state unemployment taxes are generally paid by the employer. State income taxes, local income taxes, and other requirements may also apply depending on the location of the business and employee.

The amount withheld from an employee’s paycheck is not the business’s total payroll tax cost.

Start With Gross Pay

The first step to calculating payroll taxes is determining the employee’s gross pay for the pay period.

Gross pay may include items such as the following:

• Regular wages
• Salary
• Overtime
• Bonuses
• Commissions
• Tips
• Paid leave
• Taxable fringe benefits

For an hourly employee, gross pay could begin with hours worked multiplied by the hourly rate with overtime, bonuses, commissions, and other compensation that may need to be added separately.

An error at this stage affects every calculation that follows. If overtime is missed or a bonus is left out, the employee’s taxes, net pay, employer tax expense, and payroll reports may all be incorrect.

Gross Wages and Taxable Wages May Be Different

After gross pay is determined, the employer must identify the wages subject to each tax.

Certain employee deductions may reduce wages for one tax but not another. For example, a retirement contribution would reduce the wages subject to federal income tax while still being included in wages subject to Social Security and Medicare taxes.

A deduction being described as “pre-tax” does not necessarily mean it reduces wages for every payroll tax.

If a deduction is set up incorrectly, the employee’s check may be wrong even when the payroll software performs the calculation exactly as instructed.

Federal Income Tax Withholding

Federal income tax withholding is not normally calculated using one flat percentage. The amount generally depends on:

• The employee’s taxable wages
• The payroll frequency
• Filing status
• Information reported on Form W-4
• Dependents and credits
• Other income or deductions reported by the employee
• Additional withholding requested by the employee

Two employees earning the same gross pay may have different federal income taxes withheld because they completed Form W-4 differently.

The employee provides the form, but the employer must ensure that the information is entered correctly. If entered incorrectly, the incorrect filing status, pay frequency, or additional withholding amount can cause too much or too little tax to be deducted.

Social Security and Medicare Taxes

Social Security and Medicare taxes are commonly referred to together as FICA taxes.

The employer generally withholds the employee’s portion and pays an employer portion. Social Security is subject to an annual wage limit, while regular Medicare tax generally continues regardless of how much the employee earns. An additional Medicare tax may apply to wages above the applicable threshold.

Suppose an employee has $2,000 in wages subject to Social Security and Medicare taxes. The payroll system applies the current employee tax rates to calculate the amount withheld. The employer then calculates its own portion. This shows why the taxes deducted from an employee’s check are not the full cost to the business.

Federal and State Unemployment Taxes

Federal unemployment tax and state unemployment tax are generally employer-paid taxes.

Federal unemployment tax is calculated on wages up to an annual wage limit while state rules vary, and each state may use its own wage base and employer rates.

A business’s state unemployment rate may depend on its industry, claims history, and experience rating. The rate may change from year to year. Employers should not assume their rate is the same as another company’s or that last year’s rate is still correct.

State and Local Payroll Taxes

State and local payroll requirements depend on where the employee lives and works.

An employer may need to withhold state income tax, city income tax, or other local taxes. Some locations may also require employer-paid taxes or separate registrations. Remote employees can make this more complicated. A business located in one state may develop payroll obligations in another state when an employee works there.

When an employee moves or begins working remotely, the employer should review registration, withholding, unemployment tax, and filing requirements before the next payroll.

Why Small Businesses Get Payroll Taxes Wrong

Many payroll errors are not caused by difficult arithmetic. They happen because the information used in the calculation is incomplete, outdated, or entered incorrectly.

Common problems include:

• Using the wrong pay frequency
• Entering withholding information incorrectly
• Failing to include bonuses, tips, commissions, or taxable benefits
• Setting up a pre-tax deduction incorrectly
• Calculating overtime incorrectly
• Using an outdated unemployment rate
• Failing to register where an employee works
• Treating an employee as an independent contractor
• Depositing taxes late
• Failing to reconcile payroll reports to accounting records

A business may calculate every paycheck correctly and still receive a penalty if the related taxes are deposited or reported late.

Payroll deposit deadlines do not always match the company’s pay schedule. An employer that pays employees every two weeks may still be required to deposit taxes according to a different schedule.

Why Payroll Software Does Not Eliminate the Risk

Payroll software can perform calculations quickly, but it relies on the information entered.

The software may not know that an employee moved, an unemployment rate changed, a benefit was assigned the wrong tax treatment, or a payroll item was connected to the wrong account. It may continue using an incorrect setting until someone notices.

Business owners should review payroll reports, confirm tax withdrawals cleared the bank, investigate rejected payments, and compare payroll activity to the accounting records.

Using an outside payroll service can reduce administrative work, but it does not completely remove the employer’s responsibility. The business still needs to provide accurate information, maintain sufficient funds, review reports, and respond to notices.

Practical Steps for Small Businesses

Payroll settings should be reviewed regularly and whenever the business experiences a major change, such as:

• Hiring the first employee
• Adding a new benefit
• Hiring an employee in another state
• Changing banks or payroll providers
• Receiving a payroll tax notice
• Beginning to pay bonuses, tips, or commissions

Employers should retain withholding forms, time records, payroll registers, tax filings, payment confirmations, benefit elections, and correspondence from tax agencies.

Payroll reports should also be reconciled to the general ledger and bank account. The wages, taxes, deductions, and employer expenses in the payroll system should agree with the company’s accounting records.

How an Accounting and Consulting Firm Can Help

At Volpe Consulting & Accounting, we help businesses establish payroll procedures, review reports, reconcile payroll activity, and maintain accurate accounting records.

We can also help business owners understand which responsibilities remain with the employer when payroll software or an outside provider is used.

Professional assistance can be especially useful when a business is hiring its first employee, expanding into another state, adding benefits, changing payroll providers, or correcting prior payroll records.

The Bottom Line

Payroll taxes are calculated by starting with accurate wages, determining which amounts are taxable, applying the correct federal, state, and local rules, and separating employee withholding from employer-paid taxes.

Calculation is only one part of the process. Employers must also maintain current settings, deposit taxes on time, file required returns and reconcile payroll to the company’s books.

Remember that small mistakes can affect employee paychecks and become larger problems when they continue across several pay periods. Reviewing payroll procedures before a tax notice arrives is usually easier than correcting months of inaccurate payroll.

Disclaimer

This article is intended for general informational purposes only and does not constitute legal, tax, payroll, or accounting advice. Payroll rules and tax rates may change, and the correct treatment depends on each business and employee’s circumstances. Employers should consult qualified professionals regarding their individual situation.