Accrued Payroll at Year End: December Wages Paid in January

Which year do wages for late December, paid in January, belong to?

Payroll tax law counts wages in the year they are paid. Cash books and a cash-basis return do the same. Accrual books, and an accrual-basis return, count them in the year the work was done. For December work paid in January, the two answers differ.

The Form 941 instructions say to report payroll tax by the date wages were paid, not the date liabilities were accrued or deposits made. Publication 15 says deposit rules follow the date wages are paid, not when tax liabilities accrue for accounting purposes. The Form W-2 instructions give the example: work from December 13 to 26, paid January 1, goes on the next year's Form W-2.

For Social Security, Medicare and income tax withholding, wages are paid when paid or made available to the employee to draw on without restriction, even if the check is cashed later (26 CFR 31.3121(a)-2; 26 CFR 31.3402(a)-1(b)). That is the pay date.

The return generally follows the method regularly used in the books, and a difference needs records that support it (26 CFR 1.446-1(a)(1), (a)(4); accrual books and a cash-basis tax return). A cash return is also closed to some businesses, such as a C corporation above the gross receipts limit; that guide says who. The deduction follows the method on the return.

In a simple case, a cash-basis business books January payroll in January with no year-end entry, and an accrual-basis business posts one December 31 entry and reverses it on January 1. A case is not simple when an owner or relative is on payroll, when the books are accrual and the return is cash, when a January payroll was posted in full on top of a December accrual, or when vacation pay or a year-end bonus is involved. Each is covered below.

Gather before you post anything:

• The last December and first January payroll registers, with each pay period's start, end and pay dates.
• The accounting method shown on last year's return.
• The December 31 entries from last year, so you can spot a duplicate.
• A list of owners and relatives on payroll, with their ownership stakes.
• The vacation and bonus policies, with any balances owed.

On cash books, when do I record payroll?

A cash-basis business records payroll on the pay date. A pay period of December 15 to 28 paid on January 3 is January expense, even though the work was in December.

On a cash-basis return, deductions are taken for the year paid (Publication 538; 26 CFR 1.461-1(a)(1)).

The employer's share of payroll tax is a tax, and a cash-method return deducts it in the year it is paid (26 CFR 1.461-1(a)(1)). Payroll software usually books employer tax on the pay date. For a payroll paid in the last days of December but deposited in January, the cash-basis deduction for that employer tax generally falls in the year of the deposit, so the return may differ slightly from the books.

A lender or investor who wants December to carry December's labor cost wants accrual figures. The next section shows the entry; accrual books and a cash-basis tax return covers pairing them with a cash return.

On accrual books, how do I record unpaid December wages and clear them in January?

Record the December wages as an expense and a liability on December 31. In January, clear the liability instead of booking the expense again. An accrual method matches expenses to the year they are incurred (Publication 538).

1. Find the December share of the first January payroll. For hourly staff, use the hours worked through December 31. For salaried staff, use the workdays in December divided by the workdays in the pay period, times gross pay.
2. Add the employer's payroll tax on those wages. Employer Social Security is 6.2% and Medicare is 1.45% of wages (Publication 15). Add federal and state unemployment tax at your rates.
3. Post a December 31 entry. Debit wages expense and payroll tax expense. Credit accrued wages and accrued payroll taxes, which are liabilities.
4. Prevent the January duplicate. The usual way: reverse the December 31 entry on January 1, then let the January payroll post to expense as it normally does. The other way: post the December share of the January run against the accrued accounts and only the rest to expense.
5. Check the result. After the January pay date, accrued wages and accrued payroll taxes for that run should be zero.

Social Security tax and federal unemployment tax stop at yearly wage bases (shown for this page's tax year: $184,500 and $7,000; the Social Security base is set again each year, and the FUTA base is fixed in 26 U.S.C. 3306(b)(1)), and wages count in the year they are paid (Publication 15). December wages paid in January therefore start against the new year's bases, even for an employee who already passed them in the work year. Use the new year's published bases, and your state's unemployment wage base, which can differ, to figure the accrued tax.

Which payroll costs do I accrue, and which are not mine?

Accrue what you owe for December work, including your own payroll taxes. Never treat the employee's withholding as your cost.

On an accrual return, wages follow the work period, but the employer's payroll tax follows the payment: the deduction for a tax waits until the tax is paid (26 CFR 1.461-4(g)(6)). An exception covers regular, repeated costs that are owed in a known amount at year end and paid by 8½ months after the close of the year (or the date a timely return, including extensions, is filed, if earlier) (Publication 538; 26 CFR 1.461-5). The IRS has ruled that an accrual employer using the exception may deduct its Social Security, Medicare and federal unemployment tax in the work year on year-end wages accrued that year and paid the next (Revenue Ruling 2007-12, which amplifies Revenue Ruling 96-51). The exception is a method of accounting. A business can adopt it for the first year it incurs that type of cost, and one already deducting payroll tax when paid needs IRS consent to change (26 CFR 1.461-5(d)(1); switching from cash to accrual accounting shows how a method change is filed).

Which year do Form 941 deposits, W-2 wages and withholding fall in?

All three follow the pay date, whatever method the books or the return use. Wages paid on January 3 for December work are first-quarter wages on Form 941 and new-year wages on Form W-2.

• Form 941: Monthly schedule depositors enter liability in the month the wages were paid. Semiweekly depositors enter it on the pay date on Schedule B. Neither uses the date it accrued or a deposit was made (Form 941 instructions; Schedule B instructions). Wages paid January through March belong to the first-quarter return.
• Deposits: The deposit clock starts on the pay date. A monthly schedule depositor deposits tax on January paydays by the 15th day of the following month. A semiweekly depositor deposits by the following Wednesday or Friday, depending on the weekday of the payday (Publication 15).
• Form W-2: Entries are based on wages paid during the calendar year (W-2 instructions).
• Withholding: The employee's Social Security and Medicare tax is collected by deducting it from wages as and when paid (26 U.S.C. 3102).

A Form 941 for the fourth quarter will not show wages accrued but unpaid on December 31. Accrued employer tax appears in IRS records only from the January pay date, so tie the accrual to the payroll register, not to the IRS balance.

As an accrual taxpayer, can I deduct December wages paid in January on this year's return?

Generally yes, if the return uses the accrual method and the payee is not a related person. An accrual-basis employer deducts wages when the liability is fixed and economic performance has occurred (you owe the pay and the work is done), and for services that happens as the employee works (Publication 538; 26 CFR 1.461-4(d)(2)). December work is December cost, even when payday is January.

Three things can move the deduction to the year paid:

• The return is on the cash method. Then the deduction is the year paid.
• The payee is an owner or relative who is paid later. The related-person rule covers this (26 U.S.C. 267(a)(2)), explained below.
• Payment is late. Pay for the work year that the employee receives after the 15th day of the 3rd month after the end of the year is presumed to be deferred compensation, and is deducted in the year the employee includes it in income (26 CFR 1.404(b)-1T, Q&A-2; 26 U.S.C. 404(a)(5)). Pay received by that date is not treated as deferred. Vested vacation pay has its own window, below.

If the books are on accrual and the return is on cash, the deduction follows the return. Whether that pairing fits is the question accrual books and a cash-basis tax return answers.

What changes if the payee is an owner or a relative?

An accrual-basis payer cannot deduct pay owed to a related person on the cash method until it is paid and the payee includes it in income (26 U.S.C. 267(a)(2); Publication 538). The relationship is tested on the last day of the payer's tax year. If the owner or relative reports on the cash method, as most individuals do, an accrual-basis payer's deduction for their December wages paid in January falls in the year paid, not the work year. If the payee reports on the accrual method, or is paid by year end, the delay does not apply. Payment within 2½ months after year end does not bring the deduction back to the work year, and neither does ending the relationship after year end (26 CFR 1.267(a)-2T, paragraph (b), Answer 5).

A personal service corporation (defined in section 441(i)(2)) and its employee-owners are always treated as related (26 U.S.C. 267(a)(2)).

The books still accrue the wages in December. Only the deduction waits. Form W-2, withholding and deposits follow the pay date for every employee.

A partner is different. A partner who receives guaranteed payments is not treated as an employee for withholding (26 CFR 1.707-1(c)). The related-person delay does not apply to a partnership's guaranteed payments, to the extent section 707(c) covers them (26 U.S.C. 267(e)(4)). See guaranteed payments versus partner draws.

What about accrued vacation pay and year-end bonuses?

Accrued vacation pay and year-end bonuses each have their own deduction window on an accrual return.

Vacation pay. The books accrue earned vacation the business owes. On the return, vacation pay earned by employees is deductible for the year earned if paid during the year or, if the right to it is vested, within 2½ months after the end of the year. Paid later, it is deducted in the year actually paid (Publication 538).

Year-end bonuses. An accrual-basis employer can deduct a bonus for the work year only if the liability is fixed by year end. The IRS has ruled that a bonus pool whose minimum total is fixed before year end meets that test even if individual amounts are set later (Revenue Ruling 2011-29). In the ruling's program, an employee had to be employed on the pay date, a forfeited bonus went to the other employees, and payment came shortly after year end. The ruling covers only the fact of liability, and only for that kind of program. A bonus the employer can cancel after year end needs a closer look. A bonus paid after the 15th day of the 3rd month after the end of the year is presumed deferred pay and is generally deducted in the year paid.

A bonus to an owner or relative follows the related-person rule above unless it is paid by year end. The W-2 year, withholding and deposits follow the pay date.

What should the balance sheet show on December 31, and how do I check it?

On accrual books, December 31 shows accrued wages, accrued employer payroll tax and any accrued vacation or bonus as liabilities. It also shows the withholding and tax owed on wages already paid but not yet deposited. Cash books carry no accrued wages or accrued payroll tax, so only the second group appears.

The withheld income tax and the employee's share of Social Security and Medicare are held for the government. A person responsible for paying them over who willfully does not can be personally liable for 100% of the unpaid amount (26 U.S.C. 6672). The IRS generally has 3 years to assess it; see the trust fund recovery penalty.

To check the accrual against the first January payroll register:

1. Take the first January register's gross wages and pay period dates.
2. Work out the December share, by hours or by workdays, and the employer tax on it.
3. Compare that to the December 31 accrual. Explain any gap, such as a raise, overtime or a rounding difference.
4. After the January payroll posts, confirm accrued wages and accrued payroll taxes for that run are zero. A balance left behind means a duplicate or a wrong split.
5. Tie the year: gross wages on the year's registers, plus the year-end wage accrual, minus the prior year-end wage accrual, equals wage expense on accrual books.

If the duplicate sits in a year already closed or filed, settle which method the return used and whether taxable income changes before you post a correcting entry. Payroll liabilities that won't clear covers clearing the account and when a clean-up reaches back into closed years.

Example

These examples are illustrative. All figures are in US dollars.

Cash-basis retailer

A retailer on the cash method has a pay period of December 15 to 28. Gross pay is $10,000, paid January 3. The books show the wages in January. The Form W-2 lists them in the new year, and the deposit clock starts on January 3. The December books show no payroll cost for those two weeks, so December profit looks higher than the month earned and January lower. A lender comparing months sees that swing.

Accrual-basis consulting LLC

A consulting LLC on accrual books has $6,000 of wages for December 22 to 31, paid January 7. No owner or relative is on this payroll. Employer Social Security and Medicare at 7.65% come to $459. Unemployment taxes are left out to keep the figures simple. On wages paid in January they start against the new year's bases, so a real accrual adds them.

On January 7 the payroll posts as usual: wages $6,000 and payroll tax $459 go to expense, and the January 1 reversal cancels them. January expense for the December days is zero, and the accrued accounts are back to zero.

If the LLC's return is on accrual, the $6,000 of wages is a December deduction. The $459 of employer tax is also a December deduction if the LLC has adopted the recurring-item exception for payroll tax, because the tax is paid within the exception's window. Without it, the tax is deducted when paid. On a cash return, both fall in the new year. Either way, Form W-2 and Form 941 show the wages in January.

Accrual-basis S corporation with an owner bonus

An S corporation on the accrual method accrues a $20,000 bonus for its owner in December and pays it on March 10, within 2½ months of year end. The books show the expense in December. The owner is a shareholder who reports on the cash method, so the corporation's deduction waits until the March payment, even though it came within 2½ months. The return for the work year shows no deduction for it, and the next year's return takes the $20,000. The owner's Form W-2 and the withholding follow the March pay date. The books and the return differ by $20,000 at year end, and the reconciliation shows the gap reversing when the bonus is paid. If the corporation used the cash method on its return, the deduction would also fall in March. Different facts change this. A bonus paid by year end avoids the delay. An owner on the accrual method avoids it too, but a bonus paid after March 15 would still be presumed deferred pay (see the late-payment rule above).

Different for you?

• Your books and return use different methods, an owner or relative is on payroll, or January payroll was booked on top of an accrual: which method the return uses, how each owner's stake changes the deduction, and how to correct a year already booked twice all need the books and the filed return side by side. Get bookkeeping help.
• You want to change from cash to accrual, or back: see switching from cash to accrual accounting.
• You are not sure which method suits the business: see cash or accrual for a small business.
• You need the journal entry for a whole payroll run: see payroll journal entries.
• Payroll liability accounts will not clear: see payroll liabilities that won't clear.
• A payroll run had the wrong amount or date: see fixing a payroll mistake.
• You are putting yourself or a first employee on payroll: see setting up payroll. A single-member LLC owner has extra rules in wages from your own single-member LLC.
• Your fiscal year does not end December 31: Form W-2 and Form 941 stay on the calendar year, while your books and return close on your own year end. See fiscal year or calendar year.
• Several years of year-end payroll cutoffs are missing or wrong: see catching up on overdue books and get bookkeeping help.