How to Set Up Your Small Business Payroll

A question on the mind of most new small business owners is “How do I begin to set up a payroll system?” Setting up payroll isn’t as simple as deciding on a day to pay your employees. You need to consider tax regulations, methods of record-keeping, time-tracking systems, and more.

This might seem like a daunting task, but we’ve got you covered! Keep reading to learn step-by-step how to set up payroll for your small business.

What Is Payroll?

Payroll is simply the process of paying employees. Employers must handle payroll each pay period so that employees can receive their wages. However, payroll is more than just a paycheck.

There are many moving parts involved in the process:

• Gathering employee hours worked

• Calculating taxes and other deductions

• Distributing wages

• Reporting and remitting taxes and other deductions to the right parties (e.g., IRS)

Key Payroll Terms & Phrases You Should Know

Running Payroll: This is the process of actually calculating and distributing wages and taxes

Employees on Payroll: This is the list of the employees you pay, along with their information. Keep in mind that it does not include independent contractors

Payroll Expense: This is the amount your business spends on employee wages and taxes. You must record the expense in your accounting books

Gross Wages: The total amount you pay an employee before withholding taxes and deductions

Overtime Pay: Overtime pay is time and a half for every hour an employee works beyond 40 in a week. All nonexempt employees receive overtime pay

Pre-Tax Deductions: The amount you withhold from an employee’s wages before calculating and withholding some or all taxes. Examples include health insurance and some retirement plans

Post-Tax Deductions: The amount you withhold from an employee’s wages after calculating and withholding taxes. Examples include garnishments (satisfy a debt or legal obligation (e.g. child support)) and some retirement plans

Net Pay: An employee’s take-home pay / net wages is the total amount after subtracting taxes and other deductions from the employee’s gross wages

Pay Stub: A document that details the employee’s gross wages, taxes, and deductions; employer contributions and taxes; and the employee’s net pay

Payroll Forms: Forms employers must file with tax agencies (e.g., the IRS) that summarize employee pay information, such as wages and taxes. Examples include Form 941 and Form W-2

Pay Frequency: A recurring length of time that determines how often you pay employees. Common pay frequencies include weekly, biweekly, semimonthly, and monthly

Payroll Taxes: The amount you withhold from an employee’s wages and contribute as the employer. Taxes may include federal, state, and local income; Social Security; and Medicare taxes

Payroll Software: A system that automates the payroll process by calculating wages and taxes

Image Source: Canva

Track Time

To run payroll, you need to track your employees’ time. This includes:

• Regular hours worked

• Time off (e.g., paid time off)

• Overtime hours (i.e., time and a half)

Tracking employee hours ensures that you pay your employees the correct amount. Collect timesheets from your employees that detail how many hours they worked during the pay period and whether they took time off.

Calculate Employees’ Gross Wages

It’s possible that you may have salaried employees, hourly employees, or both. Once you know how many hours they worked, you can calculate their gross wages.

To calculate your salaried employees’ gross wages: Divide the number of pay periods in the year by their annual salary (e.g. $50,000 annual and pay them weekly; the employee’s weekly gross wages are $961.54 ($50,000 annual salary / 52 weeks))

Remember to account for any overtime.

To calculate your hourly employees’ gross wages: Multiply their rate of pay by the number of hours worked in the pay period. (eg. $18 per hour and worked 40 hours; you would pay them $720 ($18 per hour X 40 hours).

You might also have additional sources of pay that you must include in payrolls, such as tips, commissions, or bonuses.

Subtract Taxes & Other Deductions

One of the most important (and confusing) parts of payroll is subtracting taxes and other deductions from employees’ gross wages.

For pre-tax deductions: First, determine if an employee has pre-tax deductions. If they do, subtract them from the employee’s gross pay before calculating applicable taxes.

For taxes: Next, it’s time to calculate the employee’s tax withholding. You must deduct the following taxes from an employee’s pay:

• Federal income tax

• Social Security tax

• Medicare tax

• State and local income taxes (if applicable)

• State-specific taxes

Keep in mind that you must also pay employer taxes on your employees’ pay. Employer taxes include Social Security, Medicare, federal unemployment, and state unemployment taxes.

Post-tax deductions: If the employee has any post-tax deductions, withhold them after calculating employee taxes.

Image Source: Canva

Pay Employees

After subtracting taxes and other deductions from the employee’s gross wages, you arrive at the employee’s net or take-home pay. Before you pay your employees, verify that your information and calculations are correct.

Once you’ve approved the payroll, it’s time to pay your employees.

You might pay employees via:

• Direct deposit

• Zelle

• Paychecks

• Mobile wallet

• Pay cards

• Cash

When you pay your employees, you might also provide paper or digital pay stubs. That way, employees can see their payroll information.

File & Deposit Taxes

After paying your employees, you also need to file and deposit taxes with the IRS and, if applicable, your state and local governments.

Deposit federal income, Social Security, and Medicare taxes with the IRS. You must deposit these taxes monthly or semiweekly, depending on your deposit schedule. To report the taxes, file Form 941, Employer’s Quarterly Federal Tax Return, or Form 944, Employer’s Annual Federal Tax Return.

Deposit the state and local taxes depending on the tax agencies’ rules. The forms you must file to report the taxes vary, too.

Last but not least, remember to deposit and file employer-only taxes, like federal unemployment tax and state unemployment tax.

Keeping Records

The Fair Labor Standards Act (FLSA) and IRS require you to keep detailed records for different lengths of time. The length of time to keep your records depends on the record type.

Timecards and other records on which wage computations are based: At least 2 years

Payroll records: At least 3 years

Employment Taxes: At least 4 years

Image Source: Canva

How To Set Up Payroll

Setting up payroll can be summarized in a few simple steps:

• Understand the State and Federal Employment Laws

• Decide on a Payroll Schedule

• Draft a Payroll Policy

• Apply for Your Employer Identification Number

• Choose a Payroll Administrator for Your Business

• Sort Out the Employee Paperwork

Understand State & Federal Laws

The payroll process begins with understanding various state and local laws that apply to small businesses. Before you set up payroll for your company, you need to get familiar with relevant laws in the U.S. Different federal and state regulations apply in this case, such as the minimum wage laws, employment tax rates and, the Family and Medical Leave Act

An excellent place to start is the U.S Department of Labor website. Here, you can access different resources to help you understand and comply with the federal employment laws.

It’s also important to know the payroll rules regulating local businesses in your state.

Decide On A Payroll Schedule

Payroll Schedule = Pay Frequency

While some small companies pay their employees within a weekly or bi-weekly pay period, others choose to make direct disbursements on a semi-monthly or monthly basis.

To select a schedule, go through the relevant laws—are there any specific regulations dictating how often you can pay your employees? Also, consider business cash flow. If the bulk of cash inflow happens at the end of the month, you should consider fixing a monthly payroll schedule. Make sure to choose a pay schedule that you can easily keep up with.

Image Source: Canva

Draft A Payroll Policy

After deciding on a pay period for your business, you should create a payroll policy or employee handbook.

An employee handbook is a formal document that spells out the different guidelines for managing business payroll, including the payroll schedule, employee benefits, and payroll method; A detailed employee handbook helps companies to process payroll effectively.

Drafting a payroll policy is one of the essential steps in this setup as it helps business owners avoid several liabilities. Payrolls impact employees directly, so they need to have first-hand information about how the business plans to manage the process and if their benefits are affected in any way.

A payroll policy is not a legal agreement between a business and its employees. Ask an employment law expert to review the document before sharing it with your workers.

Apply For EIN

You need an Employer Identification Number (EIN) for processing payrolls. Companies can apply for an EIN on the U.S. International Revenue Service (IRS) website.

Once an EIN is assigned to you, it becomes your employer tax ID, and you can use it when filling out any business tax forms. Even if you are not setting up payroll immediately, you still need to have an Employer ID Number for different transactions.

Depending on the tax laws in your state, you may have to file state income taxes for your employee(s) too. In this case, you need to apply for state withholding and unemployment tax accounts. Some local governments assign separate ID numbers to businesses for payroll tax filing, so find out if these terms apply to you.

Image Source: Canva

Choose A Payroll Administrator

Administering payroll is a lot of work, and many small business owners find it challenging to juggle it with their day-to-day responsibilities. You can assign this task to someone you trust in-house, outsource it to an accounting and bookkeeping service, or use payroll software like Gusto.

Do payroll by hand/in-house: This is the most time-consuming method. It requires that you learn the ins and outs of payroll, calculate taxes and deductions manually, and makes you responsible for filing and depositing taxes. However, this is also the least expensive option.

Outsourcing: Most expensive but least time-consuming option. An outside source will handle the entire process from calculations to wage distribution.

Payroll Software: This is the middle option. It can be inexpensive and easy to use, allowing you to pay for the specific services you want help with.

Sorting Out Paperwork

To complete the payroll setup, employers need to collect some details from new hires and update the payroll information of existing employees. These pieces of information include:

• W-4 Form: How much federal income tax you should deduct from the employee’s paycheck on payday

• I-9 Form: Ensure the employee is legally authorized to work in the United States. Here, your employees need to provide a formal means of identification, and you should keep copies of these documents.

• Social Security Verification: To avoid name and SSN mismatches. The SSN Verification Service is free of charge; employers only have to register to use it.

• Depending on the local laws in your state, you may have to file new hire paperwork with the relevant authorities.

• Independent Contractors: Agreement & W-9

Still Need Help With Your Payroll or Business Finances?

We offer expert assistance for small business owners looking to improve their businesses’ financial systems. Take a look at our services and book a call with us today!