How Does Payroll and Taxes Work?

Payroll and taxes are two components vital to any company or business, helping to keep organisations compliant with all the country’s current rules and regulations surrounding the payment of employees. It is therefore important for all companies and businesses to understand what payroll and taxes are, and how they work to ensure this essential compliance and to protect an organisation from the penalties and repercussions that come with non-compliance.

Through this piece we will therefore be exploring what payroll and income tax is, and how they work within an organisation. The definitions of both payroll and income tax are as follows:

  • Payroll – a company’s list of all employees and the total sum of money they will be paid from their work.
  • Income Tax – the tax that employees pay on their income. Often a company will deduct this tax from your income for you through their payroll process.


How Payroll Works

Payroll, as previously mentioned, is a company’s list of employees and the amount they are due to be paid from said company. It is the method organisations use to both organise and pay all of their members of staff. For most businesses and companies throughout the UK, a PAYE system will typically have to be operated as part of the payroll. PAYE can be defined as HMCR’s method of collecting both National Insurance (NI) and Income Tax from employment.

Therefore, when a company pays its employees through its payroll, necessary deductions such as NI and Income Tax are applied through PAYE. These deductions will vary dependent on such factors as amount of earnings, and all go to HM Revenue and Customs (HMRC).

For organisations that run their own payroll, a report of all employees’ payments and the subsequent deductions to this must be submitted to HMRC on the day, or before, every payday. If a new employee joins a business or a current member of staff has a change in circumstances (e.g. reaches the age for state Pension), an organisation must report this to HMRC.

Payments from a business to their employees are not limited to simply their set wages or salary, but can include anything from bonuses, tips, sick pay, maternity and paternity pay, all of which should be kept clearly on the payroll record. Companies will have to send a report to HMRC to claim any and all reductions on what they owe due to reasons such as those listed above.

To make your payroll more efficient in-house, you can look at using flexible payroll softwares or working with professional payroll specialists such as SD Worx.


How Income Tax Works

As previously defined, Income Tax is the tax on an income that employees are required to pay. It is common for an employee’s company to deduct this tax for them. If you are self-employed, such as a freelancer or contract worker, you will need to register yourself as self-employed through the government website and pay this tax yourself. If you are self-employed the first £1,000 of income made is tax-free, and is otherwise known as a ‘trading allowance’.

Tax of this kind is typically paid on the following things:

  • Salary or wages earnt from employment.
  • State benefits.
  • Pensions
  • Profits made of those in self-employment, e.g. services sold.

If the company deducts the Income Tax off earnings for its employees, this will get sent to HMRC along with payment for National Insurance, with the amount for both deductions displayed clearly on the employee’s pay slip.

Knowing how payroll and taxes such as Income Tax works is vital for any company or business, ensuring they are abiding by the current rules and regulations for employee payments and further reducing the risk of penalties and other repercussions that could cause significant damage to an organisation.

For more information, see our top 10 payroll softwares.