My Hideous Tax Reform

(With apologies to economist and author Joel Slemrod, author of the paper, My Beautiful Tax Reform)

As an accountant, I get involved in the practical and tedious task of applying tax laws (and related loopholes) to our clients’ fact situations.  Rarely do accountants get the time to contemplate (or fantasize about) tax reform, nor to consider systems used effectively by other countries.  But, before tax season gets truly underway this year, I have been spending some time educating myself about these matters so that I can combine my practical knowledge with the wisdom of economists and policy analysts around the world.

Professor Slemrod has spent many years evaluating our tax system and expresses the view that a business Value Added Tax (VAT), combined with a highly progressive but simplified individual income tax would deliver the best combination of Fairness and Simplicity (my two objectives for tax reform), and would achieve what he calls “elegance”.  He proposes an individual income tax that would exempt most individuals from filing returns, basically by eliminating all deductions and credits, thus broadening the tax base, and then relying on wage withholding to create the proper and equally applied tax to all labor income.  The VAT tax would apply to ALL business income, and at a flat rate.  Shareholders of corporations would be able to get a credit from the portion of their income already taxed at the corporate level, with the goal being to eliminate all double taxes, and to eliminate all preferential treatment now available through special deductions, credits and business entity selection.

Our current system attempts to tax income (roughly defined as increases in consumption power) by dividing it into 3 pots:  labor income, business income, and income from the employment of capital.  However, there is little consistency in how these different categories actually work.  For example, if I am Mitt Romney and earn my income from “carried interest” I get to pay taxes at a flat capital gains rate of 15%.  If I am Warren Buffet’s secretary, I get to pay taxes at much higher rates, depending on my income and deductions, and I also have to pay social security taxes.  Publicly traded corporations are subject to a double tax whenever they pay dividends to their shareholders, whereas when they pay interest to their bondholders, they are not.  If I lose money on a capital transaction, I can’t deduct the loss unless I have made money on other capital transactions.  If I sell my home at a profit, I can exclude the gain up to $500,000 if I am (legally) married.  If I earn all my income from dividends and capital gains, I might not have to pay ANY taxes.  And, if I am a worker earning a good living, I may be subject to the Alternative Minimum Tax and lose the deductions that my neighbor, who earns less, gets to deduct, thus vastly increasing my marginal tax rate.  These are just a few, selected examples of the way our tax system is both complex and unfair.

Fairness in taxation by definition would have to include progressivity as its underpinning.  In fact, Professor Slemrod rejects consumption taxes outright, as they can never be made progressive enough.  By taxing only consumption, such as through a national sales tax, those who would pay the highest effective rate of tax would be the poor and middle classes, who have to consume certain basic amounts in order to survive.  That would be highly unfair, but would admittedly be a simpler tax to administer than our current income tax.

One reason tax reform is so hideous is that anything that affects the federal system will also affect all the states who are connected to the federal system for purposes of defining and determining taxable income.  Any major reforms at the federal level will require these states to seriously evaluate and reform their own systems of taxation.  Another reason is that by trying to achieve simplicity, one may introduce unfairness, and vice versa.  For example, it might be fairer to measure and subtract inflation before taxing capital gains, but now you have introduced a highly complex calculation into the system.  You can eliminate this problem by using a consumption tax instead of an income tax, but as noted previously, a consumption tax is a regressive tax, and thus, unfair.

In order to restore legitimacy and moral authority to our government and its system of taxation, the current system MUST be reformed, and it must become fairer and simpler, yet still provide adequate funds.  Any steps in those directions are to the good, hideous or not.  President Obama’s recent budget proposals include some movements in the right direction:  indexing and making permanent AMT exemptions,  taxation of carried interest as ordinary income (too bad, Mitt), and simplification of the earned income credit.  However, when you read the summary of the President’s budget (spanning 215 pages) you start to feel pretty queasy.  More and more tax expenditures (credits and deductions) are being proposed in a desperate effort to insert more fairness into the system, but the end result is more, and much more, of the same highly complex and unfair system that we currently have.  Can we give up our favorite deductions and tax credits in exchange for lower and more progressive tax rates?   What might be beautiful is restoring the portion of total income taxes once borne by corporations in 1950 (30% of total revenues) from the shockingly low 7% today, something which could be achieved through a VAT tax.

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Tax Reform: Lies, Damned Lies, and Statistics

There are a number of ideas being parlayed by presidential candidates, policy makers, and politicians regarding how to reform the U.S. tax code.  Unfortunately, none of the ideas mentioned recently are new, nor do they address the fundamental reasons to reform the code, those being:  Fairness and Simplicity, which I am capitalizing here as a way of elevating these concepts above other policy goals (involving unfairness and complexity).

History can be a great teacher.  But, numbers CAN lie, and everyone has an agenda, including me.

But, let’s take a look at history and see if we can put it in today’s context.  First, let’s look at tax rates.  Currently, the top marginal rate is half of what it was in 1975 on incomes over $375,000 – 70% vs. 35%.  All of the other rates are lower as well, but not by nearly as much.  So, the bulk of the benefits of the tax bracket “flattening” has gone to those in the top tax bracket (not surprised, are you?)

Now, what about tax deductions and tax credits?  These are also known as “Tax Expenditures” in the world of tax policy making.  They are special tax breaks designed to benefit only certain taxpayers, such as the oil and gas industry, home owners, or low income workers with families.  Tax Expenditures have risen 43% in the 3 years spanning 2006 to 2009 (think:  George W.), and have risen 78% over the last 30 years.  What this means is that Fairness has gone out the window, replaced by taxation bent on favoring certain taxpayers and disfavoring others.  One taxpayer’s tax on the same income may bear no resemblance to another taxpayer with the same income due to the existence of these special deductions and credits. 

Now let’s look at where the taxes come from today vs. where they came from 60 years ago.  Employment taxes as a share of the total tax burden have risen 400% in the last 6 decades, going from 10% of total revenues in 1950 to a whopping 40% of total revenues today.  Conversely, corporate tax revenues as a percent of total revenues have dropped 428%, going from 30% of total revenues to 7% in 2010.  Meanwhile, total individual taxes (not payroll taxes) as a percent of total tax revenues have remained fairly steady for the last 60 years, at about 42%.  The rest of the tax revenues come from estate, gift, and excise taxes, and these have fluctuated over the years, but overall, contribute a much lower percentage to total revenues than they did in 1950.

It is quite striking to note that despite all the tweaking and complexity of the current tax code, individuals still bear, overall, about the same burden that they did 60 years ago.  The difference is in the mix.  Working people of all income levels now bear a much larger burden of the total budget than they did 60 years ago.  They contribute not only payroll taxes but income taxes as well.  Their total federal effective tax rate can easily exceed 45% if they are self-employed and in the middle class. Wealthy individuals who do not work and derive most of their income from capital gains and dividends enjoy a much lower tax rate. Some of them enjoy a ZERO rate.  And, in 2009, the top 10% of taxpayers, those with adjusted gross income exceeding $112,000 paid an overall average tax rate of just 18%.  It should be noted however, that those with AGI below the median income of $32,000 (the bottom 50%) paid an average rate of only 1.85% (remember this doesn’t include payroll taxes).  It is somewhat shocking to note that the incredibly low AGI number of $32,000 represents ½ of the taxpaying population, and it supports the recent census information indicating that nearly 50% of all Americans are living at or near the poverty level.  The biggest beneficiary of the tax burden shift among taxpayers has been corporations, however.  Maybe now that they are “people” we should tax them as individuals.  That would raise a lot of revenue.

Oddly, tax revenue as a percentage of GDP has remained fairly constant at about 18% for the last 30 years.  So, while tax revenues have been stable despite all the tweaking (an estimated 4,000 changes to the code just last year), the federal deficit has been skyrocketing, and WHO PAYS is really the question to ask yourself.

We are very far away from Simplicity and Fairness.  The recent proposals to lower rates and take away some deductions (charitable contributions and home mortgage interest) would further skew the Fairness meter, being another boon for the super wealthy.  However, taking away deductions does move us toward Simplicity.

In my next post, I’ll take on what I would do to bring about tax reform.  In the meantime, although I might be using statistics for my “damned lies,” every fact in this blog post was taken from one of three sources:  the Congressional Budget Office, the Joint Committee on Taxation, and the Internal Revenue Service.

The Coming 1099/IRS Matching Nightmare

2011 heralds the beginning of several new 1099 requirements, including the new Form 1099-K, new Form 1099-B, and new requirements for 1099-MISC. 

New IRS Form 1099-K requires 3^rd party settlors of merchant credit card and other payment transactions, such as Paypal, to report those payments to all payees who receive at least $20,000 per year in payments and who have more than 200 transactions per year.  The new form requires reporting the totals by month, so that fiscal year filers can still be subject to IRS matching.  It doesn’t matter who the payee is:  a person, a corporation, an LLC, a trust, or a partnership—all of these entities will begin receiving these new forms in early 2012 for amounts paid to them in 2011. 

The amounts reported on these forms MUST MATCH the amounts reported on the entity’s tax returns.  A new line for reporting these totals has been inserted in all relevant IRS schedules and forms.  If the amounts do not match, the payee will receive an IRS notice assessing tax on unreported income.  Which, of course, was the whole purpose of this new requirement – to tap into the underground economy, and very specifically, Ebay and other on-line sellers who have long been suspected of not properly reporting their income to IRS.

Related to this new requirement is a change to the rules for reporting payments to service providers using IRS Form 1099-MISC.  Beginning in 2011, payers must EXCLUDE any credit card or Paypal-type payments made to vendors when reporting their 1099 totals for 2011.  This is because the vendor will theoretically already be receiving a 1099-K which includes all credit card and other 3^rd party payments.  IRS has modified its instructions for Form 1099-MISC to reflect this new requirement, but it is highly likely that many 1099 issuers will not bother to read this year’s instructions.  That is why we expect the coming 2012 1099 season to result in many, many unmatched 1099s, and thus many IRS notices to taxpayers.  More work for us accountants, yes?

In addition to these two new requirements, another new 1099 form will be required for 2011 – new IRS Form 1099-B.  The 1099-B has historically been used to report gross proceeds from sales of securities.  Now, the new Form 1099-B will also potentially include cost basis information, separate reporting for “covered securities”, “non-covered securities”, wash sale reporting, short sales, and a number of other items.  It will mean that instead of receiving one 1099-B from your broker, investors will receive multiple 1099-Bs which must be analyzed and reconciled to year-end reports, and then must flow to new Schedule D – consisting now of potentially 6 new types of transactions, separately reported on new Form 8949:  short term sales of securities with cost basis reported, short term sales of securities without cost basis reported, all other short-term securities transactions; and the same break-downs for long-term sales of securities.  In addition, for EACH transaction, taxpayers must indicate one of 21 NEW CODES to tell IRS more information about the transactions.

IRS will then attempt to match the totals reported on the new Schedule D and Form 8949 to the filed 1099-B.  Because these requirements are both new and highly complex, we anticipate many, many matching errors and plenty of IRS notices to deal with.  In addition, investors can anticipate that their tax return preparation fees will increase substantially this year.  Essentially, all broker transactions will be analyzed and reported in 6 separate ways, instead of one, and investors who have multiple brokerage accounts will want to consider whether now is the time to consolidate their accounts.  CPA firms are going to be very busy.  Meanwhile, are you having nightmares yet?

Update (2/24/12):  IRS has now announced that they will NOT attempt to match any 1099-K payments for 2011, 2012, nor into the future.  Here is the quote from their website: “IRS announced in October that separate reporting of these transactions for other business receipts or income payments is not required for 2011. Taxpayers should follow the form instructions for reporting their gross receipts or sales. Report items that qualify as a trade or business expense on the appropriate line item of Schedules C, E and F. There will be no reconciliation required on the 2012 Form 1099-K, nor do we intend to require reconcilation in future years. [Added 2/10/12]“ .

 

When Pigs Fly: Waiting for Real Tax Reform

We all know that it is not fiscally possible to cut the national deficit/debt without raising someone’s tax bill.  I’ll include corporations in my definition of someone, since they are now “persons” with free speech rights.  The outlandish and bizarre tax code we currently labor under has been tweaked and pummeled into an unrecognizable amalgam of convoluted provisions, some of them well-meaning, but most not thoroughly or even barely understood by experts, much less by taxpayers.

The growing and shameful income and tax inequality in this country is now finally a topic of conversation among policy makers, thanks to the emerging “Occupy” movement.  Will this new dialogue impact tax policy?

Before the Occupy movement took hold, the showdown staged by Republican politicians over the debt ceiling sent shock waves and uncertainty throughout the financial markets all over the world.  Their insistence on cutting the debt/deficit without “raising taxes” was a frightening spectacle, and its premise was not only cynical and dishonest, but completely out of touch with reality.  Every single federal budget report by every single expert in the field points to the stark and frightening realities of the budget debt/deficit–we can’t grow out of it, we can’t spend out of it, and we may not even be able to tax our way out of it.  It is that bad.

I have been waiting for decades for real tax reform.  I started my career before the advent of the passive activity rules, which I mark as the beginning of the end for sanity in the world of taxation.  While it was important to curb the tax shelter abuses of the early 1980’s, the complexity of the passive activity loss rules opened the door to the idea that, with enough rules, regulations, court cases, and private letter rulings, tax planning can become a game only for the wealthy.  Any poor schmuck who can’t afford my fees is doomed.

While tax complexity was increasing, the income gap between the super-rich and the rest of the population continued to grow, grow and grow.  Then, during the Bush years, the super-rich finally received their blessings from on high.  Many multi-millionaires now find themselves in the ZERO percent tax bracket.  Also, during this time the Alternative Minimum Tax went out of control and began hitting middle and upper middle income taxpayers.  Yet, a family with the just the right mix of tax goodies will have a tax liability that bears no resemblance to another family with the exact same income.

Some people say that fairness is subjective.  No, it isn’t.  Fairness is something that society can agree on, just as we can agree on what is a crime and what isn’t.  The current tax system is patently unfair.  Hence, it has no moral legitimacy.  When this happens, you get the Occupy movement.  So, tonight I’ll count pigs flying while I dream about real tax reform.  Maybe pigs can fly.

Going Postal: Proving You Filed Your Tax Returns On Time

Recently we were alerted by one of our clients that, after waiting in line at the post office, he was unable to get a date stamp from the postal clerk on the tax returns he was posting for mail.  Another client informed us that after waiting in line at the airport post office to drop off her tax returns in the “big blue bag” she was informed by the postal workers that even though she was dropping the returns off before midnight, they could not guarantee that the returns would be date stamped for that day, because there were so many returns, they weren’t sure if they would “get to them.” 

After much investigation, we learned that different things happen to different people depending on which post office you visit.  The USPS still offers “hand canceling” of mail, but apparently only if they are not busy and/or are in a good mood that day.  By obtaining the hand canceled date stamp on your tax return envelope, you might be able to meet one of the IRS’ criteria for proving timely filing of a tax return:  the postmark date on the envelope (assuming the envelope is saved by IRS).  The only other methods accepted by IRS are certified mail and registered mail, more expensive and more of a hassle for most people, but necessary in some cases.

While the advent of e-filing has eliminated this issue for most taxpayers, there are still occasions when one must file a paper return.  Late filing penalties are not an issue if you are filing an individual return and don’t owe any taxes.  However, if you do owe taxes and the IRS determines that you have filed late, you are on the hook for a minimum 5% penalty for each month the return is late, up to a total of 25%.  In addition, you will incur late payment penalties and interest.  So, proof of timely filing a tax return can be critical if you owe taxes.  And, S corporations and partnerships now have substantial penalties for late filing, depending on the number of K-1′s per return ($195 per month times the number of K-1s, up to 12 months total – ouch!).

In addition, you need proof of timely filing if you are close to the end of a statute of limitations period, as in the case of filing amended tax returns.  In this case, we always recommend using certified or registered mail as there could be significant tax or refund issues that necessitate proof of timely filing.  Also, if you file your returns more than 2 years after they are due, but are expecting refunds, you will forfeit those refunds, so any late filed returns within the 2 year statute should be sent certified or registered to prove that you have the right to receive your refunds.

So, if you don’t live near a rural post office, with happy-go-lucky postal employees, you should plan on using certified or registered mail for any documents where proof of the mailing date is critical.

The Postman Cometh: Responding to IRS Notices

The IRS sends out millions of taxpayer notices each year.  However, IRS notices are sent ONLY via the U.S. Postal Service, never by email or any other means of communication.  So if you receive an email purportedly from the IRS, it is bogus. (You can forward these bogus emails to your state’s attorney general for fraud investigation.  Don’t open them!)

There are more than one hundred different kinds of notices that IRS can send out.  The most important thing to do when you get an IRS notice is to IMMEDIATELY open it, read it, and then take action.  Often, you will only have 30 days to respond.

These notices can be audit notifications, requests for payment, or any one of the following more common kinds of notifications, as indicated in the upper right hand corner of the notice:

CP 102: A math error was found on certain forms (such as Forms 941, 942, 943, 944 or 945 returns) that you filed, and the IRS believes you owe more tax.

CP 138: The tax you overpaid on one tax return was applied to another return where you owed tax.

CP 165: Your check for your FTD or estimated taxes was returned. This notice asks for the payment, plus a bad check penalty of two percent (the minimum penalty is $15).

CP 205: You used the wrong taxpayer identification number on your FTD coupon.

CP 2000: Issued for verification for unreported income, payments, or credits.  These are generated when IRS computers cannot match information from 1099s, 1098s, etc. to information on your tax return.

CP 2100: To notify the payer/filer of incorrect information, and to remind them of their obligation to solicit the correct information, so they can file correctly in the future. The notice also reminds them of their responsibility to backup withhold if the information is not provided.

CP 2501: A discrepancy was found between what you reported as your income, credit or deduction and what IRS records show.

We tell our clients to forward all IRS notices to us upon receipt.  We prefer to prepare the response, and we have one CPA in our firm who is our designated “notice responder”.  In our own experience, about 80% of the notices our clients receive are incorrect.  So, definitely do not panic if the IRS says you owe them gazillions of dollars. 

Most of the notices we receive are the CP-2000 (1099 matching) notices and the CP 2400 (incorrect estimated tax payments listed on the return).  These notices are easily resolved with proper correspondence, via regular mail, of course.

What’s the Best Accounting Software?

I hear this question a lot, but it’s kind of like asking:  what’s the best car?  The answer:  it depends on your needs.  So, the first step in evaluating accounting software is to evaluate your needs.  In the old days we called this a “Needs Assessment” and even small companies used to hire CPA firms like ours to perform these needs assessments when they were considering implementing new accounting software systems or upgrading their old software systems.

Today, business owners and non-profit organizations often don’t bother to “waste” time assessing their needs.  We don’t have time for that, do we?  Instead, we prefer to go directly to a solution, not knowing whether that solution has much to do with our needs.  Basic software is so cheap now that we don’t care whether it will work well or not.

Businesses have learned to tolerate inefficiencies in the accounting function because they have allocated so few resources to it that they can afford ignore it.  But they often don’t consider the actual costs of using/misusing accounting software.  These costs are hidden in the extra fees you pay at year-end to have your CPA firm unravel the mess you have created in your accounting software (probably using QuickBooks), and in the sometimes critical mistakes you make managing your business because you are relying on inaccurate and misstated financial information.

These costs are also buried in the extra loan documentation hassles and delays that occur when you try to submit your in-house financial statements to your banker.  You might even be paying a higher interest rate than you should because of these financial inaccuracies.

So, back to the accounting software/car analogy:  think about the software in terms of what you need it for, just as you would weigh whether to buy a convertible or an SUV.  The most critical area to assess is the sales cycle:  if your accounting software doesn’t enhance your sales/revenue function, then it almost doesn’t matter what else it can do well. If you sell inventory, then you need a point of sale system that actually works and that integrates with your accounting software.  If you provide services but need to use job costing, then you need enhanced billing features that allow you to track income and expenses by job, including employee time and expenses.

The next most critical area to assess is how the software will be used and accessed by different users simultaneously, and how or whether the software’s internal controls allow for separation of duties.  If you have an accounting clerk processing purchases and recording invoices, you don’t want that person to have the same access to the entire system that your CFO has.  And, please don’t follow the practice of having one logon name and password and handing that out to everyone who will be using the system!  This happens more often than you can believe, and defeats one of the most stellar internal control applications that software can offer:  determining who did what, and when.

After these two areas have been analyzed, you can move on to other functions, but one decision you will need to make is whether or not to go the “cloud computing” route and purchase an on-line accounting software service.  Cloud versions of traditional accounting software systems have, so far, been stripped down versions of the “real” package, so be very careful when choosing.  On the other hand, some strictly cloud-based software services have been around for years and are worth investigating.   If you do go this route, you’ll be improving your productivity, reducing costs, and making life easier for all the users of the system, including the business owner.  But this is where system security, passwords and log on names must be strictly adhered to, since you are also exposing your business to greater risk.

Once you’ve identified the key features you need, you can get a lot of help using the internet and seeing how other businesses rate their experiences with various software systems.  Ask your CPA firm how they view your accounting system’s needs.  If you do take the time to evaluate your own accounting needs, even if you don’t do a formal needs assessment, you are much more likely to find the best accounting software application(s) for your business or non-profit organization.

The IRS, the AICPA, QuickBooks, and You

Earlier this year the IRS announced that it would begin demanding a business’ QuickBooks data file during all future audits conducted by the agency.  In the past, CPAs and their clients would often export the accounting software’s general ledger and other financial information to Excel, and then provide this information to the IRS during an audit, as a way to limit IRS access to non-accounting information.  IRS was satisfied with this until recently when it began to realize the wealth of information that is contained within a company’s software data file – much of which may be unrelated to the year being audited, but may in fact reveal information that could be useful to IRS in evaluating information reported on tax returns.

The IRS has long regarded electronic records as being suspect:  “Electronic records, are, in general, considered less reliable than their paper counterparts due to the ease with which they can be manipulated” according to the recently updated Internal Revenue Manual.  Bingo.  What is so helpful about having the QuickBooks file to audit is the existence within the file of an “audit trail” – a function which cannot be disabled by the users, and which records every keystroke by date, time, and user name.  By studying this audit trail, IRS can determine whether transactions were altered, deleted, or modified, and how often, by whom, and when.

Many CPAs have expressed concern over this new approach because their clients routinely make errors in QuickBooks which have to be corrected after the fact.  They were worried that IRS would regard these errors and corrections as indicative of deceit or fraud, when in fact they are only indicative of incompetence.

Enter the AICPA.  Earlier this year, the AICPA sent a memo to IRS asking for their clarification on their position regarding providing “an exact copy of the original electronic data file…and not an altered version” to IRS auditors.  The AICPA wanted to know whether such a file could be condensed so as not to provide prior year data, but only the data for the year under audit, and whether CPAs are being exposed to potential malpractice claims by inadvertently turning over unrelated data contained within a client’s QuickBooks file.  Some CPAs have gone ahead and either condensed the QuickBooks file or had a software company perform a “redaction” of the file, to remove prior year information.  Anecdotal evidence indicates that this is okay with the IRS, however, it has yet to officially comment on the AICPA’s questions.

So far, the IRS is only training its auditors on the use of QuickBooks and Peachtree during an audit, but it may expand its training to other software packages if it sees a need.  Since QuickBooks has the market share, with a reported 85% of the total, IRS was smart to choose QuickBooks as its first software package to use in its new approach to auditing electronic records.

Now you can count the IRS as yet one more reason not to use QuickBooks.  But, if you are already using QuickBooks or Peachtree and you are about to be audited, but sure to contact your CPA so that they can help you in providing only the information that IRS is entitled to receive during the audit, and nothing more.  And, since QuickBooks is kind enough to provide you with an audit trail, make good use of it by strictly adhering to user log-ins and passwords for each unique user of the system.

How Gross Are Your Gross Wages?

It is amazing just how much difficulty business owners and bookkeepers have in understanding how to post payroll entries.  A common misconception is that somehow a business’ gross wage expense is altered by decisions that the employees make as to how to spend their salaries.  Part of the cause is the way in which businesses must assume responsibility for some of these decisions, such as turning over 401k contributions, Section 125 cafeteria plan deferrals and the like.  Another part of the cause is that accounting software makes bad bookkeepers out of good business owners.

But here is the accounting, legal and tax reality of employee wages:  the salaries recorded on your books must always be the amount which your employee has earned for the period in question.  This must always be the “gross” amount, not reduced by ANY deferrals made by the employee.  What the employee decides to do cannot impact the expense that you as an employer incur when you pay your employees the wages they have earned.

The next challenge is trying to create a journal entry from the payroll reports you receive from the payroll service bureau.   I follow the practice of using a “payroll clearing account” which is an account in your general ledger meant to always end up having a zero balance at month end.  Using a clearing account makes it easier to post payroll entries, especially if you use direct deposit for your employees’ paychecks.  Here is an example of how this works.

A direct deposit comes out of your business checking account to pay your employees, usually accompanied by a report called a “check register” which should be familiar sounding.  The check register shows each direct deposit amount, with a total amount debited from your business account usually a day or two before payday.  Let’s say this amount is $25,000.  Remember, this is your employee’s net pay.  Then, your bank account gets hit for another sum, which includes employer payroll taxes and employee withholdings.  We’ll say this amount is $10,000.  And, you also need to turn over employee retirement plan contributions and Section 125 plan contributions to a 3^rd party administrator, in the amounts of $3,000 and $1,000 respectively.  You will also receive reports that indicate how these amounts have been determined.  Usually, the payroll journal and the cash requirements report are the most helpful in generating the format for the journal entry.

Using a payroll clearing account allows you to post the bank debits in lump sums without needing to know at the time how these amounts are to be spread and “grossed up” to employees’ wages and employer payroll taxes.  Here’s how this looks, using “T-accounts”:

Clearing account                                Cash                 

Dr          |          Cr                                Dr          |    Cr       

25,000                                                                  25,000

10,000                                                                  10,000

As you can see, we’ve just dumped the entries into the clearing account, but now we can reconcile cash easily at month end because the totals entered will match the bank statement.

At month end or before, we need to “clear” the clearing account with a journal entry.  We can look at the payroll journal and find the amounts for gross wages for the month,  and total employer payroll taxes.  Here’s what the entry looks like:

                                    Dr                                    Cr                                       Type of account

Gross wages                $34,000                                                                       expense          

Employer taxes               5,000                                                                      expense

Payroll clearing                                     $35,000                                          clearing          

Retirement plan payable                        3,000                                            liability

Section 125 plan payable                        1,000                                           liability

I realize this seems too easy, but there’s really nothing more complicated to it.  When the checks were written to pay the retirement plan and 125 funds to 3^rd party administrators, you posted those to the same liability accounts noted above.  At the end of the month, those account balances would be zero, since no further funds are owed.  The clearing account is now zero.  And, gross wages are really, really gross.