Payroll Liabilities: Basics, Examples, and How to Calculate

Labor is often one of the most significant expenses for companies across America. Roughly 99.9% of U.S. businesses are classified as small businesses, employing almost half of Americans working in the private sector.

Given the significant contribution of payroll costs to a business budget, managing the payroll operation effectively is an important business process.

Before you can achieve a smooth-running payroll process, though, it’s important to understand payroll liabilities and how they can affect your business, employees, and contractors. Here, you’ll find information on:

• What are payroll liabilities?
• Types of payroll liabilities
• How to calculate payroll liabilities
• Reporting and remitting payroll liabilities
• Common payroll liability issues

What are payroll liabilities?

Payroll liabilities refer to the various costs an employer owes or manages while paying employee wages. As an employer, you might owe these liabilities to several entities, including different tax agencies, insurance companies, and employees.

These expenses cover employee benefits, taxes, and deductions and must be paid in a timely manner. Failure to accurately report and remit payroll taxes and other liabilities can result in significant penalties and legal issues.

As a business owner, you have the obligation of understanding all aspects of payroll liabilities so you can properly make the required payroll payments. As an employee, understanding what happens between your gross wages and net pay can help you better manage your personal budget and other financial considerations.

Types of payroll liabilities

While employee compensation is what people generally think of when describing payroll,  your company incurs additional liabilities such as taxes and garnishments in compliance with federal, state, and local laws.

We cover the different types of payroll liabilities.

Employee compensation

In the category of employee compensation, gross pay refers to the total amount paid to employees for work completed. This amount is calculated for the pay period based on hours worked or agreed salary. The gross number includes the amounts later withheld and paid to different entities.

Some companies include contractor payments under the compensation umbrella to easily track total labor costs. However, payroll technically refers to payment processing only for W-2 employees. Contractor payments would generally be considered in the accounts payable category.

Why is this difference significant? Businesses typically don’t withhold or remit liabilities on behalf of freelancers. Contractors also don’t receive benefits. This is why businesses must classify workers correctly.

If you fail to do so, your workers might file Form SS-8 with the Internal Revenue Service (IRS) to prompt an investigation and status determination. A successful bid for employee status can trigger back pay and back taxes.

Federal payroll taxes

Employee wages trigger payroll tax expenses paid to the IRS. They fall into four main categories.

Social Security

This is one part of taxes created by the Federal Insurance Contributions Act (FICA). The Social Security Administration (SSA) breaks this 12.4% tax liability into halves between employers and employees.

Companies withhold 6.2% from employee paychecks and remit tax payments to the IRS on their behalf. Employers must also remit a matching 6.2% of employee wages at their own expense. For 2023, Social Security withholding has a taxable wages cap of $160,200.

Contractors who receive 1099s must pay the full 12.4% independently. They typically pay this on net earnings rather than gross revenue.

Medicare

Medicare is the second half of FICA taxes. Your payroll team must withhold and remit 1.45% from employee pay. Employers must also pay a matching 1.45% at their own expense. Employers withhold an Additional Medicare Tax of 0.9% after the $200,000 threshold. There is no matching employer contribution for Additional Medicare Tax.

Self-employed workers must pay Medicare taxes independently. This tax also applies to net earnings rather than gross revenue.

Federal income tax

As an employer, you must withhold and remit federal income taxes for your employees. Exact figures depend on the information your employees declare using Form W-4, such as their filing status and annual income. Employees can update their withholdings at any time during the year.

However, your company won’t withhold or remit income taxes for freelance workers. These professionals must calculate and pay federal income tax independently, often with quarterly estimated tax payments.

Federal unemployment tax

FUTA taxes (Federal Unemployment Tax Act) are a company expense without employee withholdings. Employers that must pay FUTA remit 6% of the first $7,000 paid to each employee annually. However, you can receive credits for FUTA rate reductions of up to 5.4% if you pay state unemployment taxes.

You won’t withhold or remit FUTA taxes on compensation paid to independent contractors. This is another reason correct classification is so important. Self-employed workers typically don’t pay FUTA taxes because they don’t meet the requirements set by the IRS’s general test.

State and local payroll taxes

States and municipalities can create and levy additional taxes to meet local needs. We provide some examples of the most common types.

• State unemployment taxes. State Unemployment Tax Act (SUTA) taxes are the state equivalents of FUTA. Some states refer to SUTA as reemployment tax, state unemployment insurance, or employment security tax. Rates differ across states, and employers typically foot the bill. However, some states require tax withholdings from employee paychecks. Examples include Alaska and Pennsylvania.
• State income tax. Most states require workers to pay a separate income tax in addition to the income tax levied by the federal government. But some states have no income tax, including Nevada, New Hampshire, Alaska, Texas, and five others.
• Local income tax. Some cities and counties have additional income taxes on top of state and federal income taxes. One example is the New York City income tax.
• State disability taxes. Some states have separate state disability insurance (SDI) programs for funding leave not triggered by work-related injuries, such as maternity leave. For example, California funds its SDI program through a deduction from employee wages.

Employee benefits

Employees generally have access to a wide range of additional compensation. Some common examples are:

• Health insurance. Employers may pay for partial or total costs. The Bureau of Labor Statistics (BLS) reports that employers pay 80% of insurance premiums in single coverage plans for civilian workers.
• Workers’ compensation. This is mandatory insurance for businesses with employees. It covers medical expenses and lost wages for workers injured on the job. Companies pay premiums for this insurance to the state or private insurers. Texas and Wyoming are the only states that allow companies to opt out of providing workers’ comp benefits.
• Retirement plans. Employers commonly make partial or full matching contributions to nontaxable retirement accounts. Retirement contribution is an example of a voluntary deduction (employee’s choice).
• Paid time off (PTO). You might offer paid time off for several reasons, including vacation, illness, grieving, maternity leave, or education. State laws affect family and medical leave. California, Washington, Colorado, New York, and Oregon are examples of states with paid leave laws.

Wage garnishments

Wage garnishments are deductions from employee wages mandated by a court order. Garnishment orders usually cover debts like child support payments, tax bills, student loans, and alimony. Several states limit how much an employer can take from a worker’s pay for these purposes.

How to calculate payroll liabilities

When you process payroll, you separate liabilities payable from your employees’ net income. You also determine the separate liabilities your organization must pay based on employee wages.

Use these steps to arrive at the correct number and record payroll liabilities.

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1. Gather employee information

Collect all the information you need upfront to avoid payroll processing delays. The completed Form W-4 is the most critical document for calculating payroll expenses.

You must also verify names, addresses, job titles, hourly rates, wages, garnishments, and voluntary deductions like retirement plans.

2. Calculate gross wages

Calculating gross wages is the easiest step. If you have salaried employees, break down the annual salary by the pay period. For example, an employee earning $120,000 annually has a gross monthly salary of $10,000.

Workers who receive hourly or piece-rate pay need more complex calculations. For example, Samuel has an hourly rate of $30 and works 78 hours during his two-week pay period. His gross wages are $2,340 ($30 x 78 hours).

Confirming overtime hours, bonuses, commissions, and other forms of compensation also happens in this step.

3. Identify payroll deductions

Some deductions affect employees’ taxable income, so address this before considering withholding amounts. For example, let’s say Samuel contributes $200 a pay period to his 401(k) traditional IRA plan. His taxable wages for income tax drop to $2,140 ($2,340 in gross wages, minus $200 in retirement contributions) for his biweekly paycheck.

You must also note taxable deductions and treat them accordingly when calculating withholding taxes. Examples include union dues, life insurance premiums, and spousal support.

4. Calculate withholding amounts

Review federal, state, and local tax laws to determine liability. Payroll software can help automate this process after you’ve confirmed hours, additional compensation, and deductions.

For example, Samuel’s employer would withhold $145.08 ($2,340 gross wages times 6.2%) for Social Security. While his retirement contributions are exempt from income tax, he must still pay Social Security on his gross wages.

5. Record liabilities for the company

Then, calculate your employer taxes and other liabilities (e.g., FICA, FUTA, and state-level obligations). For example, let’s say you, as Samual’s employer, pay 100% matching contributions to his 401(k) account. So, you’d also set $200 aside to match his contribution for the pay period.

6. Remit the appropriate payments

After calculating your company’s liabilities, you’ll remit the correct payments to federal, state, and local agencies. You may also need to submit payments to private organizations like unions and insurers.

You may pay taxes directly or use a payroll service provider. Track all incomes and expenses on your balance sheet and report them accurately, regardless of your chosen method.

7. Reclassify payroll liabilities balances into payroll expense accounts

Updating payroll expense accounts ensures your company correctly reflects payroll information on your financial statements. How you manage your accounts will depend on whether you use the cash or accrual accounting method.

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Reporting and remitting payroll liabilities

You’ll want to report and remit taxes to the correct agencies to ensure timely payments and avoid penalties. Tax analysts typically handle this segment of the payroll process.

Report to the IRS

Employers must report all compensation paid to employees. These include wages and tips. Depending on the general schedule, you might deposit employment taxes on a monthly or semiweekly basis. Make sure to use the correct forms to complete the process.

The IRS regularly reviews and updates these files. Ensure you use the one applicable to your year and filing period.

Report to state and local tax authorities

State and local tax agencies set their own regulations, forms, and payment schedules. Review requirements for all the states, counties, and cities where you have employees—not just the locations where you operate.

Remit payroll taxes (and other liabilities)

You must also determine your federal depositing schedules before the start of each calendar year. Use IRS Publication 15 to determine the appropriate payment schedule, such as monthly or semiweekly.

Your payroll team should determine the payment methods accepted in the applicable state and local jurisdictions.

Common payroll liability issues

Managing payroll liabilities can be challenging, and your company must stay vigilant to avoid costly penalties or lawsuits. Three liability issues your company might encounter include:

• Incorrect worker classification. For example, imagine if the IRS reclassifies contractors as employees after a former contractor files an SS-8. What are the consequences? In New Jersey, a company paid $1.3 million in back wages and penalties for misclassifying 20 contract workers.
• Late or missed payments. You should also prioritize promptness and compliance because filing errors and late payments can lead to high penalties. For example, Illinois charges a 10% penalty on the amount due for taxes late by 31 days or more. You may also face underpayment penalties.
• Compliance. Managing payroll laws in various jurisdictions can be challenging. Even within the same state or metropolitan area, laws may differ across county or city lines.

Tips for avoiding common payroll liabilities issues

Implementing a robust payroll system and partnering with a knowledgeable payroll service provider can help alleviate some of the complexities of managing payroll liabilities.

Let’s take a closer look at effective risk management strategies:

• Use payroll software. Investing in quality payroll software can help you manage compliance and accuracy with taxes, wages, benefits, and deductions. An automated system offers more precision than manual processes. It also provides regular reports to ensure balance sheet accuracy. Generally, updates are made available when rules and requirements change.
• Outsource payroll services. Working with a payroll service provider can provide considerable savings, especially if you operate in multiple countries. These providers offer specialized services, advice, and timely tax filings and payments. They can also notify you of changes in compliance requirements or deadlines.
• Hire contract workers. Businesses hiring contractors outsource the responsibility for tax and benefits management to these professionals. However, the IRS warns companies that freelancers must retain control of their work processes to avoid reclassification.

Manage your payroll liabilities with Upwork

Managing payroll is a technical financial management process that is often outside the expertise of most business owners. Hire competent payroll professionals and use trusted software to automate as much of the process as possible.

If you feel overwhelmed by payroll requirements, you’re not alone. Finding those professionals can take time, but we’ve streamlined the process by identifying the best payroll professionals at Upwork.

We also provide in-house services that can meet more complex needs. Whether you need assistance with global teams, worker classifications, or running payroll, Upwork Any Hire has your back.

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This article is intended for educational purposes and should not be viewed as legal or tax advice. Please consult a professional to find the solution that best fits your situation.