Payroll is an essential component of every business, large and small. Once you have made the decision to hire your first employee or employees, it is inevitable that you must know how to do payroll properly. However, the truth of the matter is, payroll processing is not as straightforward as you may wish it is. It comes with multiple components such as tax calculations and deductions. Proper processing of the payroll requires a sound understanding of all applicable Federal and State tax laws. All these can make your head spin while shifting your focus from what really matters – growing your business.
To get the burden off your shoulders, we have put together the following guide to help you understand how to do payroll and identify an intuitive payroll system for your small business. The guide comes with payroll’s best practices that will help any small or medium business make important decisions in critical areas like choosing the right payroll processing method, timekeeping system, payment method, and understanding and filing payroll tax forms among other features.
Important Components of the Payroll System
Ideally, a complete payroll system comes with three key components: Paying the workforce, preparing and paying payroll-related taxes, and filing tax reforms.
Paying the Workforce
Paying your staff the right amount, on schedule, and in the right way, is key to employee satisfaction and productivity. Whether you pay your staff on a weekly, bi-weekly, or monthly basis, this component includes everything from tracking work hours to processing withholding taxes and issuing paychecks or making direct payments to your employee’s bank accounts.
Processing and Paying Payroll Related Taxes
Upon deducting withholding taxes from your staff’s salaries, it is important that you submit those taxes to the relevant authorities, the Federal and State governments in this case. Depending on the state where your business is established, the following withholding taxes may apply:
- Federal Tax
- State & Local Tax
- Social Security and Medicare Taxes
- Additional Medicare Tax
- Federal Unemployment (FUTA) Tax
- State Unemployment (SUTA) Tax
- Self-Employment Tax
- Worker Compensation Insurance
Generally, the three important tax deductions are Federal Income Tax, Social Security, and Medicare taxes.
Filing Tax Forms
Filing tax forms is no doubt a tiresome and time-consuming task for every business owner. However, as an employer, you are required by law to file the tax forms on time. Subject to your business’ size and flexibility, you may file taxes on a monthly, quarterly, or annual basis. Some of the tax forms you will be required to file as an employer include the following:
- Form 944, Employer’s ANNUAL Federal Tax Return
- Form 941, Employer’s Quarterly Federal Tax Return
- Form 940, Employer’s Annual Federal Unemployment Tax Return
- Providing Form W-2s to Employees and Form 1099s to Contractors
- Annual Return of Withheld Federal Income Tax (Form 945)
Understanding Payroll Methods
Accurate and timely processing of the payroll is one of the most important prerequisites for running a successful business. Since the IRS has lots of guidelines and regulations when it comes to withholding and filing taxes, it is important that you invest in the best available payroll method that suits your business needs while ensuring that you comply with the IRS guidelines. Additionally, you need to keep employee satisfaction in mind because employee performance and productivity are a direct function of prompt and accurate payment.
1. Manual (DIY Method)
Most small business owners, especially those with a handful of employees, prefer to do payroll manually. To effectively do this, you need to build a spreadsheet for tracking hours worked by each employee, calculating taxes, and processing paychecks. In addition, you will have to manually calculate and file payroll taxes.
Manual payroll processing is best suited for small businesses with one or two employees and a limited. If you are a finance-savvy employer with up-to-date information on tax deductions and reforms, you can very well opt for manual payroll processing.
The manual payroll method is cost-effective. If you want to have complete control of your employee’s earnings and tax filings, then manual payroll processing is a good fit for your business.
Clearly, the manual payroll method is a tedious and time-consuming option with potential chances for errors and mistakes that can end up costing your business in the form of IRS penalties.
An accountant can be of great help to your business if you want to do in-house payroll processing. You can engage a part-time or full-time accountant depending on the size of your business and the number of staff. You can even hire an accountant on a contract basis. This option is ideal for small businesses with a large number of employees.
Saves time and energy while allowing you to focus on growing your business. Besides, accountants have adequate knowledge of processing and filing taxes on your behalf hence, there is a limited chance of costly errors.
It can be quite costly, especially for a small business that is keen on minimizing expenditure. Additionally, this option gives you minimal control over your financials.
3. Payroll Software
The purpose of payroll software is to simplify and automate the process of paying your workforce. This involves computing and deducting employee benefits, preparing payslips, computing and filing employee taxes, and complying with regulatory requirements among other functions. The right payroll software can help you set up your business and employee information on the fly. This way, you can enter your employees’ information like pay period, pay frequency, the number of hours worked and the pay date, the system will perform all the tax calculations in a jiffy. Depending on your budget and business needs, investing in the right desktop payroll processing application can save you time, money, and effort.
Payroll processing software is ideal for small businesses looking to speed up their payroll process and wants absolute control over their business financials.
The right software takes away the pain and worries that come with payroll processing. You can process payroll at the click of a button. It provides accurate wage and tax calculations because the software is regularly updated with the latest tax tables.
Generally, most payroll software comes at a one-time low price and comes with enhanced data security. It gives you complete control over your payroll process, saves time, and lets you focus your energy on growing your business.
Like with any application, good payroll software comes with a learning curve, and it is important that you train your employees on how to handle the software correctly.
4. Payroll Services (Outsourcing)
Outsourcing your payroll services frees up valuable internal resources to focus on your business while your payroll is processed efficiently offshore through real-time and remote processing. It is more like having a virtual accountant whose specific responsibility is taking care of your payroll task. Most importantly, your payroll will be in safe hands. All you have to do is submit a timesheet of your workforce to the payroll service provider and they will calculate and pay your staff. Additionally, they will prepare, fill and file your staff’s tax forms to the relevant tax authorities. This provides much-needed relief and time to focus on growing your business. Outsourced payroll services are ideal for small businesses with large workforces.
Outsourcing your payroll, as already mentioned, saves you time so you can focus on important aspects of your business. Knowledge of tax regulations also means that your payroll processor will be efficient and accurate, eliminating the possibility of errors and delayed payments, which may attract penalties from the IRS.
Communication between the employer and the payroll service provider is critical to avoid errors and wrongful payments. Additionally, it is important that the payroll service provider is up-to-date with federal and state tax laws.
Types of Payment Methods
Payment methods vary depending on the business type, industry, accounting method, technological enhancement, and the number of employees. Following are some of the common payment methods:
A business may opt to pay a contractor or a temporary worker handling odd jobs through cash.
Checks are popular with small businesses because they are cost-effective and traceable. Most payrolls print MICR-encoded checks on blank check papers.
3. ACH Direct Deposit
Small businesses, especially in the technological or professional industries, prefer ACH direct payment methods because this lets them directly pay their employees on a scheduled date. It is a very efficient way of paying your employees.
4. Pay Cards
A pay card is another great option when paying your staff. It works like a debit card and can be used at ATMs.
Tracking Employee’s Hours
Every business wants to know how to keep track of employee hours without falling off the cliff. However, keeping track of your workforce’s hours is a crucial part of your payroll and if overlooked, may result in a loss of productivity to the business. Regardless of the nature or size of your business, it is important that you put in place an effective time-tracking system. This way, you can keep a record of hours worked and compensate your employees appropriately. A good time-tracking system also goes a long way in eliminating pay-related conflicts, especially if the staff are paid on a per-hour basis. Here are some of the approaches you can use to track work hours in your organization.
- Manually using a standard time sheet or spreadsheet
- Time tracking software
- Biometric system
- Employee badge swipe
Following the Department of Labor Laws
According to the Fair Labor Standards Act of 1938, “In some industries, particularly where time clocks are used, there has been the practice for many years of recording the employee’s starting and stopping time to the nearest five minutes, or to the nearest one-tenth or quarter of an hour. Presumably, these arrangements average out so that all of the time actually worked by the employee is properly counted and the employee is fully compensated for all the time actually worked.”
In other words, every employer is required by the FLSA to keep overtime pay, minimum wage, recordkeeping, and youth employment standards affecting his workforce. According to TimePays, some of the common wage and hour mistakes are:
- Failure to pay employees on the day of termination
- Inadequate (or non-existent) i-9 documentation
- Unfamiliarity with rules as to on-call pay
- Failure to pay for certain travel time
- Improper use of “comp time”
- Unlawful deductions from employee paychecks
- Docking pay of salaried employees
- Improper designation of “exempt” employees
- Incorrect calculation of overtime pay
- Inadequate record keeping
Understanding Overtime Pay
When it comes to overtime, the law requires that employees who work more than 40 hours per week be compensated for extra hours of work. Some states, like California, have daily overtime pay that requires employers to compensate their employees on a daily basis when they work for more than eight hours. That said, some employees are exempted from overtime pay. Consult your regional DOL office for more information.
The Fair Labor Standards Act requires employees on hourly contracts who work in excess of 40 hours per workweek to be remunerated at a minimum of 1.5 times the employee’s regular pay rate for every extra hour worked.
Here’s how the overtime pay calculation works:
If an employee works 50 hours a week at a normal pay rate of $20 per week. Thus, they are to be paid $800 for the 40 hours plus an additional $300 for the additional 10 overtime hours. This brings their income for the given week to $1100.
Understanding Payroll Tax Withholding Laws
Abiding by the IRS is an important responsibility of every employer. The IRS Circular E explains Federal payroll tax withholding and how to comply with the laws.
Mandatory deductions are the key component of any payroll tax. Thus, if you are using in-house payroll software, then it should automate the calculation of the deductions and withholdings from the wages. Let us look at the mandatory deductions in detail.
Federal Income Tax
Every employer is required to withhold Federal income tax from employees’ wages. The amount depends on the employee’s gross income as well as other factors like exemptions, marital status, and the amount of semi-monthly gross income. In some instances, deductions such as Public Employees Retirement Systems (PERS) or TIAA/CREF retirement contributions are also used as determinant factors when setting the employee’s federal income tax.
Both the employer and the employees are required to pay Social Security taxes to fund various social security initiatives. This is a vital component of the Federal Insurance Contributions Act (FICA) tax. As of 2023, the Social Security tax rate for both the employer and employee is 8.7% respectively for a total of 17.4%.
The wage limit as of 2023 is $160,200. If the income is beyond the prescribed wage limit, then the employer is exempted from Social Security taxes and vice-versa.
Medicare is part of the Federal Insurance Contributions Act (FICA) tax. Every employee is required to contribute 1.45% of their income to this fund. The employer is also required the same amount, 1.45% of the employee’s income. The Medicare tax rate is 1.45% on the first $200,000 and 2.35% above $200,000.
Federal Unemployment Tax (FUTA)
Every employer is required by law to report and pay unemployment taxes for their employees on a quarterly basis. This payment should be made using Form 941 Employer’s Quarterly Federal Tax Return. This money goes towards financing state unemployment programs. Every employer who has paid at least $1500 in wages during a calendar quarter is subject to FUTA. That said, employees are exempt from FUTA taxes.
As of 2023, the FUTA tax rate is 6% of the employees’ salaries. It is important to note, however, that the FUTA tax applies to the first $7,000 you pay to each of your workforce during a calendar year. The federal wage base is $7,000 and if your staff’s wages exceed $7,000 then you will cease paying FUTA.
State Unemployment Tax (SUTA)
SUTA varies from state to state. Check with your state’s SUTA tax rate as well as the wage base. That said some states do not require employers to pay SUTA and only require them to pay FUTA.
State Income Tax
Besides the federal income tax, most states collect State Income Tax as well.
Worker Compensation Insurance
Small businesses, especially those in sole proprietorships, partnerships, and limited liability corporations, can make deductions for workers’ compensation insurance from their state and federal taxes. The rules with respect to deductible amounts vary from state to state with some states having exemptions for farm and domestic workforce.
For instance, if you own a business in California with only one employee, then you will be required to have workers’ compensation insurance. States like Florida and Alabama, on the hand, have their minimum employees for WCI at four and five respectively.
Additional mandatory deductions include the following:
Court-ordered garnishments for
- Delinquent child support payments
- Delinquent federal or state taxes
- Delinquent student loans
- Payments to creditors who’ve won court judgments against you.
2. Voluntary Deductions
These may vary from business to business and are usually deducted before mandatory taxes. One of the benefits of outsourcing your organization’s payroll to a full-service payroll company is that they will handle all the voluntary deductions by categorizing them in the right classifications. Some of the voluntary deductions an employer may consider include the following:
Contributions to an IRA, 401k, or another retirement plan
The Individual Retirement Account (IRA) is designed to help employees save for their retirement in a tax-advanced system that utilizes a tax-deferred arrangement. There are three main types of IRAs: Roth, Traditional, and Rollover. 401(k), on the other hand, is an employer-sponsored arrangement that lets employees save money from their paychecks before tax deductions. One of the pros of 401(k) for the employee is that they do not have to pay taxes until they withdraw the money from their account.
Health insurance premiums
An employer may deduct health insurance from an eligible employee’s wage before applying taxes.
These are generally termed unreimbursed employee expenses. Some of these expenses may include employee tools and equipment, travel expenses, a passport for a business trip, uniforms, meals, union dues, and work-related training costs.
Life insurance premiums
An employer can also offer group term life insurance coverage to his employee and deduct this cost before payroll tax deductions.
3. Employer-paid benefits
These involve non-monetary compensation from the employer to his employees. They are given in addition to the employees’ regular salaries and wages. They include the following:
- Sick Days
- Insurance (health, dental, vision, life, & disability)
- Retirement plans
- Profit-sharing plans
Adding a New Employee to Payroll
Hiring a new employee in your organization is always exciting and provides a clear indication that your organization is growing. That said, it is important that the new employee is added to the payroll system. Following is a step-by-step process for adding a new employee to your payroll system:
Get Your Employer Identification Number (EIN)
Before making the decision to hire the employee in the first place, you need to get EIN (also known as Employee Tax ID or SS-4) from the IRS. This is what you will use to report the employee’s taxes and employment information to state and federal agencies. You can obtain the employee’s number from this link:
Obtain State/Local IDs
The employee should provide their state/local ID. This will be used for preparing and filing W-2 and 1099 forms.
Do you Need Employees or Independent Contractors?
Depending on the nature of your business and your labor needs, you will need both for your organization at different points. However, it is important that you have a clear understanding of the difference between an employee and an independent contractor. As far as tax reporting is concerned, you should file W-2 for employees and a 1099 for independent contractors. As far as tax deductions are concerned, you will be required by law to withhold mandatory taxes from employee’s earnings. Independent contractors are responsible for their own taxes.
Make your Employees fill out W-4 Forms
It is the employer’s legal duty to ensure that every new employee fills and returns the Federal Income Tax Withholding Form W-9 before they formally start working. This will be useful when the employer is withholding the federal tax income from the employee’s wages or salaries.
Define Payroll Schedule
Most states have their own pay periods. Click here for more information about State Payday Requirements. Workers in states that do not have any mandatory pay period regulations may earn their dues on a weekly, bi-weekly, semi-monthly, or monthly basis.
Documenting Employee Compensation Terms
As a responsible employer, it is essential that you clearly define the Employee Compensation Terms such as tracking time, paid leaves, overtime, healthcare premiums, taxes, and retirement contributions among other deductions. It is important that you clearly articulate all the applicable terms to your employees so they can have a sound understanding of tax deductions and take-home salary.
Since you have already settled on a preferred payroll and payment method, it is time to run the system and pay your workforce what is due to them.
It is important that you keep a clear record of each of your employees’ names, addresses, Social Security numbers, tax deductions, and paid amounts of W-2 and W-4 Forms. It is a Federal and State requirement that you keep this information for up to three years after the termination of employment.
Reporting your Payroll Taxes
Every employer is required by law to report all payroll taxes to the IRS and other relevant authorities. This can be a very tiresome and time-consuming task. However, if you outsource your payroll processing to a professional organization, then you can sit back and relax knowing that someone knowledgeable is going to handle this task within the stipulated timeline.
Payroll Reporting Requirements and Payments
Stop the press, you are not through yet. Having withheld the taxes from your workers’ earnings, it is time to report and submit the taxes to the relevant authorities as required by law. You are required to submit all the withheld taxes on schedule as determined by the local, state, or federal tax agency. Payroll tax submissions may be done weekly, monthly, or quarterly as applicable. This depends entirely on the amount of tax liability.
Small businesses are required to file the following tax forms:
- Employer’s Quarterly Federal Tax Return – Form 941: Filed quarterly, this form is used for reporting the following:
- Wages and taxes for federal income tax.
- Employee social security and Medicare tax.
- Employer social security and Medicare tax.
- Employer’s Annual Federal Unemployment Tax Return – Form 940: This form is used for reporting wages and taxes to FUTA. It should be deposited quarterly. However, if the amount exceeds $500, then you should file it annually.
- Wage and Tax Statement – Form W-2: This form is meant for reporting individual employee wages and taxes. It should be filed annually. However, you should ensure that one copy is given to employees and another filed with the Social Security Administration (SSA).
- Transmittal of Wage and Tax Statements – Form W-3: This form summarizes all the information reported on Form W-2. It should be reported annually to the SSA along with W-2 Form.
- State Payroll Tax Filings and Payments: Every state has specific rules with respect to state payroll tax filings and payments. That said, most states require employers to report state income tax and state unemployment tax at the same time. Consult your state’s department of revenue for information and the state unemployment tax agency regarding the remittance of withheld income tax and unemployment taxes respectively.
- Form 1099-MISC, Miscellaneous Income: This form is used for reporting the amount to independent contractors that exceed $600 in a year for their services to your business. You are not required to pay anything as independent contractors will pay their own taxes. All you need to do is report these amounts in the 1099 MISC Form.
Most Common Payroll Problems
When it comes to payroll, you MUST never make any mistake in payroll processing because this can attract heavy penalties and fines from relevant government authorities. Common payroll problems include the following:
- Setting up your payroll incorrectly
- Inexperienced payroll processors
- Misclassifying workers
- Doing payroll manually
- Ineffective time records
- Untimely payroll processing
- Miscalculating overtime
- Failure to issue form 1099s
- Failing to timely deposit withheld taxes
- Forgetting to keep records
- Staying compliant with multi-state complications
- Forgetting to record paper checks
- Failing to update your state unemployment insurance (SUI) rate
How Not To Do Payroll
By following the best payroll processing practices, you together with your workers, independent contractors, and government agencies will have peace of mind. The reverse applies. Here are bad payroll practices that can ruin your business and freedom:
- Processing payroll and other administrative work manually. Manual payroll processing can significantly increase the chances of errors and inefficiencies, which can attract heavy penalties and fines from government agencies.
- Overdependence on one person for payroll processing. If the responsible staff is on leave or has left the organization then your organization’s entire payroll system might break down. You will have to make a decision quickly either to hire an experienced accountant or outsource payroll. Whichever you opt for, it will take time and might result in delaying payment to your employees as well as taxes to the authorities.
- Buying expensive software with monthly recurring fees will actually translate into an additional expenditure for your business. In addition, it will put undue pressure on your business financials. Buying one-time low-fee payroll software for your small business may be the best route.
- Spending lots of time and effort in learning and understanding the payroll system and tax regulations could be a great mistake. Delegate these tasks to professionals who know how to do payroll effectively and accurately. Being a small business owner does not mean that you should involve yourself in every aspect of the business. Your primary focus should focus on building and growing your business to the next level rather than indulging in administrative tasks.
- Employee satisfaction is the lifeblood of every successful business. Untimely payment of wages will lead to an increase in attrition rate and a decrease in the morale, productivity, and happiness of the employees.
- Employee payroll data is of great importance because it contains personal as well as financial details. So you cannot compromise the security of this data. You should have adequate security to save confidential data from falling into the hands of hackers. The desktop-based payroll software is the best bet because all the information is saved on your company’s own server.
Payroll Best Practices
Payroll, which is one of the most important components of any small business, can be a great tool for cost-cutting and efficiency if you adopt certain best practices. In the long run, these best practices will yield significant dividends for your business. Some of payroll best practices include:
- Integrating payroll with accounting, time-keeping, and HR systems.
- Customizing the paying methods according to the worker’s types and work.
- Allowing employees to choose their preferred payment method: whether by cash, check, pay card, or direct deposit.
- For businesses with multiple locations, process payroll from the main office so that you can have complete control over the business financials.
- Outsourcing payroll processing to a service provider when it becomes a burden to in-house staff
- Keeping note of important tax deadlines because late deposits can attract IRS penalties and interest charges.
- Proper classification of employees and independent contractors.
- Distributing W-2 forms to employees and 1099 forms to independent contractors accurately and on time.
- Recording and maintaining proper records of confidential payroll data in a secured repository. Making regular backups of your data is the key in case of any data loss.
- If your business has a limited handful of employees, then you need to train more than one person in using the payroll software.
- Properly calculating and reporting overtime pay.
- Double checking entries in the software as well as when filling tax forms to avoid any errors.
- Conducting regular audits to ensure that all the processes are working smoothly. Sometimes, you will be performing the same mistake again and again, which will lead to an unknowing loss of money. For example, if you do not report to your payroll service provider about the employees who have recently resigned, then they will end up paying them a salary. It will be a mistake on your side.
- Gaining a general understanding of how payroll, tax deductions, and tax filing work.
Payroll is undoubtedly one of the most important components of any business. It is imperative that it is set up properly in order to have peace of mind for the rest of the year. A good payroll system will not only save time, money, and effort but also help your business grow exponentially.
If you feel this guide has really helped you in understanding how to do payroll for small business in an effective and convenient manner, please feel to share it with your business partners, colleagues, or staff.
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