How Payroll Processing Works

Payroll is a term you hear a lot. But how payroll processing works is not necessarily something people know unless they are already in the industry.

Payroll is the process used to pay employees accurately and on time. Most of us just think about payroll when we get a paycheck, but getting that paycheck in your hand each payday is the culmination of a complex set of tasks.

Knowing these tasks and understanding how challenging they are to business owners is the key to being able to talk with business owners about how payroll issues they are facing can translate into payroll sales for you.

The challenges these business owners face can be put into three categories: Legal, Employee Morale and Technology:

  • Legal Challenges: Years ago, the IRS and the state Tax Bureaus all decided that when it came to payroll taxes and funding the Unemployment insurance funds, they would use employers to do the “heavy lifting” of tax collecting. To make matters worse for business owners, all of these federal and state laws change almost constantly. If these laws are not followed, a company can incur penalties that can be expensive.

  • Employee Morale ChallengesPayroll checks are one of the most scrutinized products of a company. Clear, concise and accurate explanations of payroll information benefit employees. If employees are not paid on time and accurately, employee turnover almost always follows.
  • Technology Challenges: Many software applications have payroll functions but they might not be properly used and must be consistently updated in order to ensure compliance with government authorities. In addition, the software is generally created with other accounting functions in mind with payroll as only an afterthought.

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And when is all said and done, even though there are official legal penalties and unofficial employee turnover penalties for doing payroll incorrectly, there is no actual reward for doing it right. When was the last time you said to your boss, “Thank you for getting my paycheck correct!”

This literally thankless job fraught with all kinds of potential pitfalls is what business owners face every day. Compounding the issue is the fact that Labor is usually their biggest expense, and thus is uppermost in the business owner’s mind much of the time.

In the next few sections, we will cover the basics of how employees are categorized and how payroll is administered.

How Payroll Works With FLSA Rules: Exempt vs Non-Exempt Employees

FLSA stands for Fair Labor Standards Act. This landmark legislation basically took employees (not including contract workers or people with an equity stake in the company) and put them into two categories: exempt and non-exempt.

The general definition is that nonexempt employees are entitled to overtime pay. Exempt employees are not. Most employees covered by the FLSA are nonexempt.

Some jobs are classified as exempt by definition. For example, "outside sales" employees are exempt ("inside sales" employees are nonexempt).

For most employees, however, whether they are exempt or nonexempt depends on:

  • How much they are paid
  • How they are paid
  • What kind of work they do

In most cases, to be exempt an employee must:

  • Be paid at least $50,440 per year ($970 per week) 
  • Be paid on a salary basis
  • Perform exempt job duties

These requirements are outlined in the FLSA Regulations (covered by the U.S. Department of Labor not the IRS). Most employees must meet all three "tests" to be exempt.

Job duties are exempt if they are “managerial” in manner:

  • Regularly supervises two or more other employees
  • Has management as the primary duty of the position
  • Has some genuine input into the job status of other employees (such as hiring, firing, promotions, or assignments).

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How Payroll Taxes Are Calculated

As an individual, you file your taxes once a year in April. Business owners, on the other hand, must file their taxes four times a year. Eliminating this task is a big deal. Owners must deal with both Federal and State Payroll tax laws. Compiling the information for each of  tax returns is a huge time investment and comes with a lot of liability.

Included in the taxes is also the Unemployment tax. The federal version or FUTA (Federal Unemployment Tax Act) imposes a federal employer tax used to help fund state workforce agencies. Employers report this tax by filing an annual Form 940 with the Internal Revenue Service. In some cases, the employer is required to pay the tax in installments during the tax year.

FUTA covers a federal share of the costs of administering the unemployment insurance (UI) and job service programs in every state. In addition, FUTA pays one-half of the cost of extended unemployment benefits (during periods of high unemployment) and provides for a fund from which states may borrow, if necessary, to pay benefits.

The state version of this or SUI (State Unemployment Insurance) is basically a fund the employers pay into and employees that have been laid off or fired can draw from. As you can imagine, employers with more turnover have more people drawing out of this fund, therefore the rate that they pay in is tied to their turnover rate.

How Payroll “Gross to Net” is Calculated

What is commonly referred to as “take home pay”, is properly known as “net pay”. Getting from “gross pay” (essentially, your pay before any taxes or deductions are taken out) to net pay is what payroll processing is all about.

There are two types of deductions: pre-tax and post-tax. You will rarely hear anyone say “post-tax deductions”; usually they will just say deductions--for the same reason most people will say ‘tie’ instead of ‘necktie’. Saying necktie is almost redundant. However, people do say “pre-tax deductions” when referring to the few deductions that are actually pre-tax.

The two most common pre-tax deductions are 401(k) contributions and Health Insurance premiums. So how does pre-tax versus post-tax work? Let’s say your Gross Pay is exactly $1,000 per month. And you owe 20% in payroll taxes. You would take 20% of $1,000 and subtract $200 for taxes, right? Then you would take the remaining $800 and start deducting from the $800 from there for “post-tax deductions.”

However, 401(k) contributions, or pre-tax deductions, work differently. If you were going to contribute $100 per month to your 401(k), then you would subtract this first. So if Gross were still $1,000 per month, you would subtract the $100 401(k) contribution, leaving you with $900 in “taxable income”. Then you would subtract 20% of $900, then starting deducting from there.   

How Payroll for Accounting Works

Every time a company processes payroll, it should record at least one credit entry and one debit entry for payroll in the accounting system.

One of the most common credit entries in a how a payroll journal entry is recorded is the total tax paid by the employer and employee, any employee withholding and the net value of the direct deposits and live checks.

The biggest debit item in a payroll journal entry is usually the salary and wage expense. This includes all wages, bonuses and vacation payouts paid to employees.

How Payroll Works Conclusion

Payroll is the biggest expense that business owners have. Despite the fact that it is a thankless job, it is a multifaceted process that involves calculating the payroll, calculating and paying the relevant taxes and getting the pay data and money to the employees accurately and on time each and every pay period.

› How Payroll Works