If you want your small business to grow, you’re going to need to find employees you can trust to work with you. You can’t carry an expanding business alone! Hiring an employee is an opportunity to expand your team and invite others into your vision.
While hiring employees lets you share the responsibilities of your business, it also means you’re taking on new responsibilities as a manager. One of those responsibilities is paying your employees.
When you’re first starting and running your business alone, you don’t have to worry about paying anyone. Your profits are all your money, and you’re putting all of your money and effort into your business anyway. Employees, however, don’t have access to the profits of the company, and they need to be fairly compensated for their labor with a regular payroll.
What is Payroll?
Payroll refers to the entire process of paying your employees, from determining wages due and processing payments to distribution, recordkeeping, and tax withholding. Payroll includes all the administrative processes involved in paying your employees’ salaries and complying with IRS regulations.
Why is Payroll Important for Small Businesses?
Maintaining your company payroll is important for any small business because your employees need to get paid. If you want your employees to be dedicated and involved team members, you need to treat them fairly, pay them on time, and generally live up to your obligations as an employer.
Having a proven and established payroll process is crucial for making sure you comply with tax withholding requirements as well. If you make a mistake you could be making yourself or your employees vulnerable to unexpected fines and tax problems later on.
How to Set Up Small Business Payroll: Step by Step
The best time to set up your payroll is before you hire any employees. By the time your first staff member comes on board, you want to have your system up and running so that the payroll process will be as smooth and automated as possible.
1. Obtain EIN
The first step is to obtain an employer identification number. Your EIN functions as your company’s federal tax ID, and you’ll need it in order to make tax payments on your employee’s behalf. You can complete your EIN tax ID filing alone or with the help of an accountant.
2. Register EFTPS
The next thing to do is to enroll in the Electronic Federal Tax Payment System. EFTPS will allow you to directly make all your federal tax payments online. You’re going to be paying in regularly for income taxes and employment taxes, so it’s important to enroll promptly.
3. Register as an Employer with Your State
Before you hire any employees, you’ll also need to register with your state as an official employer. Each state may have different requirements and processes to get familiar with.
Some states will have similar online payment systems for handling unemployment tax, state income tax, and other financial obligations. However, states vary in how they handle receiving these payments.
4. Research Labor Laws
Study federal and state labor laws before you advertise your first open position. There are numerous rules governing how you can put an employee to work and how you have to compensate them.
Doing this research in advance will help you avoid problems or penalties later, and it will help you to take better care of your employees. Under what conditions do you have to provide insurance or paid vacation? What are the rules for overtime?
5. Hire Employees
Now that you’ve done all that preparatory work, it’s time to get to work actually hiring a new employee. This means taking the time to advertise open positions, consider applications, interview candidates, and finally offering the job to your chosen candidate.
6. New Hire Paperwork
There are several specific forms for new employees you’ll need to fill out for each person. This paperwork is an essential part of the onboarding process, as it meets your legal obligations and sets you up to handle tax withholding on the employee’s behalf.
Every employee should fill out IRS form W-4, Employee’s Withholding Certificate. With their W-4, the employee is requesting and allowing you to withhold and pay federal income tax on their behalf throughout the year. Each employee’s W-4 tells you how little or how much you should be withholding from their pay for this purpose.
Another important form at this step is I-9, Employment Eligibility Verification. This is a form from the U.S. Citizenship and Immigration Service, and it must be filled out for each employee to ensure that they are legally eligible to work as an employee in the United States.
C State Withholding
Depending on your state, you may need to fill out parallel tax withholding forms for state income taxes. Check with your state Department of Revenue or Department of Labor to find out what your obligations are at this point.
7. Report New Hires
The law requires new hire reporting by employers within a reasonable period after an employee’s first day of work. You must report your hires to your state Department of Labor or whatever agency is designated to receive these reports in your state.
8. Create Payroll Schedule
Before the employee starts working, you need to have a clearly established and consistent pay schedule. Your staff members need to know precisely when they will be paid so that they can plan accordingly. You expect precision and reliability from them, so they should expect the same from you.
Individual states may set specific legal requirements for pay schedule timelines. You can check with the U.S. Department of Labor for individual state payday requirements.
9. Create Payroll Account
You will need to set up a payroll account to organize and distribute the funds needed for payroll. It’s helpful to have a specific account set up for this purpose that only contains money intended for payroll.
This will help you to keep your finances organized and ensure that you have payroll funds set aside in advance. If your payroll gets taken directly out of a more general account, you might find yourself overdrafting or accidentally underpaying employees when payday comes around.
10. Withhold Taxes
As an employer, you are taking on the obligation of making regular income tax payments for your employees (according to their W-4) and paying their Social Security and Medicare taxes.
Instead of forcing employees to measure and submit these tax payments throughout the financial year, you withhold a portion of their income to pay these taxes. You will need to calculate this withholding and report to your employees how much you have withheld every time they are paid.
11. Pay Taxes
The next step is to use the withheld wages to pay the relevant taxes to federal and state governments. As the employer, you also pay a portion of their Social Security and Medicare taxes with company money not taken out of their wages.
12. Keep Records
A smooth and reliable payroll process depends on efficient recordkeeping. You need to keep meticulous records of all wages and taxes paid as they are submitted. This allows you to check your work to ensure you’re meeting your obligations and prove to others that you’ve done so.
Good recordkeeping also also allows for an easy filing process when it comes time to file tax returns. Reporting on wages and taxes paid for employees should be as simple as calling up the appropriate file.
Running Payroll Manually
There is a lot of work involved in actually running payroll. Some of this can be automated, and all of it can be passed on to an accountant or outsourced to a firm to streamline the process. Here are the key steps for administering payroll if you’re doing it manually:
1. Calculate Gross Wages
First, you have to add up an employee’s total compensation, or gross wages, for a given period. You might track hours for this or pay a preset salary. Gross wages includes all of that as well as any other benefits, tips, or overtime pay. Your employee will not see all of this money deposited into their account, but they should see this total described on their pay stubs.
2. Calculate Pre-Tax Deductions and Subtract
Once you’ve calculated gross wages, you can remove any benefits or deductions that come out of payroll without being subject to taxation.
If your business provides health insurance or a retirement savings plan, you would deduct any payments for those benefits at this time.
3. Calculate Federal Tax Withholdings and Subtract
Once you’ve taken out any relevant deductions, you can calculate the taxes due on the wages that remain. If you’re doing this manually, you can use IRS publication 15-T and your employee’s W-4 to calculate how much you should withhold for federal income tax purposes.
At this stage you’re also calculating the amount of wages to withhold for the purposes of paying other payroll taxes like FICA and FUTA. The taxes withheld this way account for an employee’s contribution to Medicare, Social Security, federal unemployment benefits and more.
FICA withholding for Social Security should make up 6.2% of wages, while your business will be required to contribute an 6.2% toward FICA after withholding. Withholding to pay into Medicare will be another 1.45% of wages.
4. State Taxes
You may also need to withhold additional wages at this stage to pay various state taxes, including income taxes and unemployment. States withholding requirements vary, and some will require regular paperwork as well.
Many states may have an online paycheck calculator that will help you determine the amount of withholding required.
5. Subtract Mandatory or Voluntary Payroll Deductions
After completing the tax withholding, you’ll make any relevant final post-tax deductions from income. This is where you would subtract wages for legally mandated wage garnishment or post-tax retirement contributions like a Roth IRA.
6. Pay Employees
Having completed all of these above steps, you’ve arrived at the final total for wages you owe directly to your employees. Next, you should provide a transparent report to each employee about where all of their deducted and withheld wages went, and you should punctually distribute the rest of their wages according to the pre-established pay schedule.
After Paying Employees:
Getting employees their hard-earned pay is the most crucial step for the everyday operations of your business. If you don’t meet your obligations to your other team members, how will your team survive? But you’re still not done with the payroll process. Here’s what you have to do next:
Record Payroll Totals
The first thing to do after paying wages is to make sure your financial records fully reflect your payroll expenses. You increase your expenses to pay wages and decrease the money you currently owe by an equivalent amount.
Knowing exactly how much you paid and having careful records of it will help you to file taxes and claim the relevant tax deductions later on. It’s also important to have consistent and accurate data for general financial planning.
Make Payroll Tax Deposits
Now that you’ve withheld the proper amount of wages for tax payments, you need to ensure you make the tax deposits on a reasonable schedule.
Federal tax deposits can be made fully online through your EFTPS account, but the process for depositing state taxes may vary.
Calculate FUTA and FICA Taxes
Then there are the portions of the payroll tax that you are fully responsible for as the employer. This is not taken out of employee wages. You must calculate and pay FUTA, the federal unemployment tax, using form 940.
FICA, the Federal Insurance Contributions Act, includes both Social Security and Medicare contributions. As described above, you will contribute by withholding 6.2% and 1.45% of employee wages for Social Security and Medicare, respectively. Then you must make additional and equivalent payments to cover the half that is the employer’s responsibility.
Payroll Tax Reporting
Having regularly deposited payroll taxes for your employees along with their wages, you then have to report out on those payments. You report these payments to the employees themselves with pay stubs and the annual W-2, but you will also need to report total tax payments to the government.
You’ll use IRS Form 941, Employer’s Quarterly Federal Tax Return, to report each quarter on taxes paid and to ensure you’re paying the employer’s portion of FICA. The FUTA payments you have to make are due quarterly as well, but you’ll only have to report it at the end of the year with IRS Form 940, Employer’s Annual Federal Unemployment Tax Return.
Small Business Payroll Tax
The payroll tax return is a complicated but important document. Here are more details on the separate pieces of the payroll tax you need to be paying:
Pay Federal Payroll Taxes
Federal payroll taxes must be paid at least monthly, if not more frequently. For employees with a total income of $142,800 or less, your payroll taxes paid should total 15.3% of their income. These are the FICA tax contributions to Social Security and Medicare. Half should be paid by withholding, and the other half is your responsibility as an employer.
FUTA, the federal unemployment tax, is also paid by the employer. It must be paid quarterly, but only if the taxes due are $500 or more. The FUTA due should be 6% of an employee’s first $7,000 in earnings. You can calculate the exact FUTA due using IRS Form 940.
For every quarter where your FUTA liability totals $500 or more, you must make your unemployment payment through EFTPS by the deadline. The deadline for each quarter is the last day of the next month after the end of each quarter.
- Q1 ends March 31: FUTA due April 30
- Q2 ends June 30: FUTA due July 31
- Q3 ends September 30: FUTA due October 31
- Q4 ends December 31: FUTA due January 31
Pay Local Taxes
On top of your federal tax obligations are any state and local taxes. Make sure you’re as informed as possible about all your tax responsibilities. You will likely have to make regular payments for state unemployment insurance and possibly more.
File Payroll Tax Forms
In order to consistently pay and report these payroll tax payments, you’re going to need to get comfortable with the corresponding paperwork. Here are some of the primary forms you’re going to need to familiarize yourself with.
You will need to fill out a W-2 form for each employee. You use the W-2 to report on all of their wages for the year and all of the taxes you’ve paid on their behalf. Here employees can find their gross wages, their total state and federal tax contributions, and identifying tax information for your business.
The fill-out process for form W-2 should be straightforward if your payroll records are reliable and thorough. Your employees will rely on the W-2 extensively when it comes to filing their own income tax returns.
IRS form 940 is an annual return reporting on your FUTA paid throughout the year. This is a report sent directly to the government so that they can ensure you’ve paid everything you owe.
Preparing your form 940 for unemployment contributions will be simple if you’ve been keeping up with your FUTA payments and maintaining careful payroll records. You’ll need to report all employee wages subject to FUTA and then compare the total tax due with the estimated FUTA you’ve already paid.
Every quarter you must file an informational report on your payroll taxes with form 941. After each quarter ends, you simply need to submit this form, including your total eligible employee wages for the quarter and everything you deducted and paid for FICA payroll taxes.
Make sure to include state taxes in your process. At the very least, you may need to include state income tax considerations in your withholding and W-2 reporting. Some states also require separate paperwork.
Check with your state Department of Revenue or local business authorities to get the most reliable information. If you work with an accountant, they will be able to fill you in on all your state tax obligations as well.
Common Small Business Payroll Challenges
If you can’t tell already, running a small business payroll is not the simplest task. There are a lot of challenges that can make it stressful and difficult for the owner and the employees.
Your records are only as helpful as you make them. Maintaining records of everything related to payroll is a big task, and it’s important for everyone involved. Employee hours have to be recorded. Wages paid out have to be recorded, and every tax payment needs to be recorded.
Keeping all of this straight can be difficult for a business owner without bookkeeping expertise, especially because you only have so much time as an owner to devote to focusing on bookkeeping.
Payroll is Time-Consuming
All of that recordkeeping and administration takes time and effort. Even if you’re already an expert at basic accounting practices, there are a lot of mundane but essential tasks and variables that go into administering payroll.
As your business expands, you’re going to find payroll taking up more and more time and mental energy. And if you insist on handling it on your own, you may spend most of your time on bookkeeping, or you’re going to sacrifice the reliability of your payroll and records.
When you start to slack off, because running payroll and double-checking every number and record simply takes too much time, you’re going to start making errors. The more errors add up, the less useful and accurate your records will be.
You might underpay or overpay your employees, which could endanger your employee relationships or business finances. You might also make dangerous mistakes while paying or reporting various payroll taxes, which could lead to all sorts of legal fines and penalties.
One of the biggest challenges involved in running payroll, especially for new small business owners, is the problem of compliance. There are so many governmental rules and regulations governing payroll, taxes, and employee management at both the federal and state levels.
It takes time and effort to keep your company in line with all of these complications, even if you know the system in and out. If you’re just starting out and still don’t know everything involved in payroll compliance, this becomes an even bigger obstacle.
Use Online Payroll Services
One helpful and cost-effective solution for businesses struggling with payroll is to obtain online payroll services to smooth out the process. By buying software to help facilitate your payroll, you can automate a lot of the time-tracking, recordkeeping, and wage distribution.
An online payroll service or program can help you increase efficiency, decrease human error, and save you time and money on payroll administration.
Work With an Accountant
If you really want to optimize your efficiency and ensure your payroll is reliable and accurate, you can also work with an accountant, either by hiring one or working with an external accounting firm.
An online accounting program will do exactly what you tell it to do. An accountant, however, can look at your payroll and company finances and offer you concrete and creative advice for improving your system and improving your business.
The payroll process is complicated and time-consuming, and the requirements can differ widely across states. Working with an accountant puts an expert on your side to guide you through the process and prepare you for anything unexpected.