Basically, as an employer you become an arm of the government to help collect taxes. You’re responsible for paying Social Security tax, Medicare tax, federal withholding tax, and state withholding tax for your employees. There could also be local withholding tax for the city in which the business is located or the school district where the employee lives. In addition, you pay the employer’s side of Social Security and Medicare taxes, as well as taxes for the unemployment fund in your state.

This section explains each type of tax and how it’s calculated, then reviews how all this information is put together to calculate an employee’s paycheck. All taxes collected from your employees are deposited in the Accrued Payroll Taxes account in the liability section of the balance sheet. Just as with the Sales Taxes Collected account, the money sits in that account until you need to pay the government entities, which can be monthly or quarterly depending on the tax and the size of your payroll.

The employer’s portion of taxes is posted to the Payroll Taxes expense account on the P&L. Only the employer’s portion of the payroll tax bill is a business expense. The employee portion that was withheld has been expensed as part of gross pay.

The employer and employee share the Social Security tax equally. Both pay 6.2 percent of an employee’s compensation up to $106,800 for 2010 for a total of 12.4 percent. The maximum level of compensation to be taxed is adjusted each year by the federal government to reflect increased salary levels.

The calculation for the Social Security tax is relatively simple. For example, you would calculate the Social Security taxes for an employee who earns $2,000 per month in this way.

If the employee earns over the $106,800 cap in 2010, the employer still calculates the Social Security tax the same way. After the $106,800 cap is reached during the year, no more Social Security taxes are taken out. For example, a person who is earning $213,600 would meet his or her Social Security obligation by the end of June. He or she would see an increase of 6.2 percent in his or her paycheck beginning in July.

Employer and employee also share Medicare taxes equally—both pay 1.45 percent. The key difference between Social Security and Medicare taxes is that there are no income caps, so this percentage is taken out of the entire earnings for the year.

In 2013, employees earning more than $200,000 per individual and $250,000 per couple will have to pay 0.9 percent more in Medicare tax for a total of 2.35 percent. This increase is part of the health care law passed in 2010.

You would calculate the Medicare tax bite for the employee earning $2,000 per month in this way.

Now that you understand the easy calculations of Social Security and Medicare, let’s move on to the complicated world of federal withholding tax. As an employer, you have one of two methods you can use to calculate taxes. One is as a percentage of earnings, and the second is to use the tax tables in Publication 15, “Employer’s Tax Guide.”

First, let’s review tax rates for the year 2010. The following table shows tax rates for single individuals filing in 2010.

For married individuals filing jointly and surviving spouses, the 2010 tax rates are shown in the following table.

In addition to calculating taxes based on an employee’s income and tax rate, an employer must also take into consideration the number of exemptions the employee claims on his or her W-4. So there isn’t a simple formula for calculating federal withholding taxes. Publication 15 does give you a chart that breaks down these percentage calculations by weekly, biweekly, semimonthly, monthly, quarterly, semiannual, and annual payroll periods. You can use a different chart in the publication to adjust an employee’s salary based on the number of withholding allowances. For 2010, here is the adjustment per withholding allowance.

2010 Withholding Allowance Adjustments

In addition to the withholding chart, percentage charts are developed based on single taxpayers or married taxpayers filing jointly for each of the payroll period types. Just as an example, here’s the weekly payroll chart from Publication 15 for a married person filing jointly in 2010.

To practice calculating federal withholding tax, assume that Jack earns $1,300 per week, is married, and has two children. He claims four withholding allowances for himself, his wife, and two children plus an additional three withholding allowances for the itemized deductions he expects to claim, such as home mortgage, property taxes, and charitable deductions.

Here’s how you would calculate his federal withholding taxes.

So the federal tax to be deducted from Jack’s weekly check is $71.35, which totals $3,710.20 for the year.

You can imagine how time-consuming doing this calculation for each employee would be. For this reason most employers use either the tables in Publication 15, use a payroll computer program that is updated each year for current tax rates, or use an outside contractor to handle payroll. Payroll computer programs and outsourcing are covered later in the chapter.

For now, assume you decide to use the tax tables. Using Jack as an example, we’ll show you a small segment of those tax tables for that weekly salary range. (Note: The tax tables in Publication 15 go up to 10 allowances, but we’re just using the segment up to 7 to save space.)

You can see these numbers are different than the calculation we did using the percentage method. Using the $72 from the preceding table rather than the $71.35 we calculated as part of the percentage method would result in an additional $0.65 taken out of the check weekly or $18.20 for the year. Even though $1,300 appears on two lines, the top of the chart says “If wages are at least $1,290 but less than $1,300,” so you would use the higher number on the middle line.