Step-by-Step Guide to Payroll for Small Businesses

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Calculating payroll correctly can be a challenge, especially when you are a small business owner. Your expertise lies in entrepreneurship — not necessarily in keeping track of the various labor and tax laws that apply to each of your employees. Whether you have a single worker or a large staff, setting up an accurate, reliable payroll system will prevent serious issues for your employees and your business.

Key Takeaways

  • The first step in setting up payroll for your small business is to obtain an employer identification number from the IRS.
  • Know the difference between employee's and independent contractors.
  • New employees should fill out a W-4 and I-9.
  • Select a payroll process that complies with state and federal laws, and choose a payroll platform that best fits your budget and business needs.
  • Payroll mistakes can be costly, so take the time to understand the process and talk with your state's Department of Labor to clear up any questions.

Apply for an Employer Identification Number (EIN)

Your (employer identification number) EIN is a unique number assigned specifically to your business for Internal Revenue Service (IRS) purposes. This number identifies your business when reporting information about your employees to federal and state government agencies. Examples of this information include total income and taxes paid on their behalf.

Apply for your EIN through the IRS directly. The most convenient way to complete this transaction is through an online application. However, applications are also accepted by fax and mail.

Check State and Local Regulations for Additional EIN Requirements

Though many states and localities accept your federal EIN for identification, some do require separate numbers for tax purposes. Examples include New York, Massachusetts, and South Carolina. You can determine your city and/or state regulations by visiting the appropriate state’s small business website.

Understand the Difference Between Independent Contractor and Employee

Whether you employ independent contractors or employees significantly impacts how income, Medicare, Social Security, and unemployment taxes are paid, so it is critical to understand the distinction between the two.

The basic test boils down to the following three main questions:

  • Does the employer control when, where and how the work is completed? If so, the worker is probably an employee.
  • Does the employer control the financial aspects of the work? For example, are expenses reimbursed? If so, the worker is probably an employee.
  • Is the relationship ongoing, or is the worker employed for a specific project with no expectation of continued employment? If the relationship is ongoing and if benefits are offered, the worker is probably an employee.

Obtain Required Employee Forms

Once your own documents are in order, you are ready to hire your employees. Be sure to gather tax and payroll information within the first few days of employment to ensure they receive their first paycheck in a timely manner. You may wish to encourage employee use of direct deposit for faster payments.

Each employee must complete IRS Form W-4, which allows you to calculate the correct tax withholding. Employees must also complete an I-9 form to verify they are legally permitted to work in the United States.

Choose Your Pay Period

The fewer pay periods you have, the easier it is to complete your payroll. However, some states require that employees are paid according to a certain schedule, for example, weekly or bi-weekly. Contact your state's Department of Labor to determine whether your proposed pay period complies with state regulations.

Create Payroll-Related Processes

Before you are able to issue accurate paychecks, you will need a method of tracking employee hours. There are many tools available for your payroll system, from basic sign-in sheets to platforms that track employee activity on phones or computers. It is also important to set up policies for paid time off if you plan to offer it, overtime pay, and any other benefits.

On the other side, you must have a process in place to ensure that deductions for benefits, taxes, and similar expenses are paid to the appropriate vendors and agencies on behalf of your employees.

Select a Payroll Platform

If you plan to handle payroll in-house, be sure that you or your bookkeeper is comfortable with the nuances of this task. There are several high-quality payroll platforms available to make things easier. However, most small businesses prefer outsourced controller services, as these professionals have the knowledge and experience to produce payroll accurately and on time.

Produce Your Payroll

Once you or your controller has entered employees’ personal information into your payroll system, you are ready to produce your first payroll run. Using the timekeeping tools you have in place for hourly (non-exempt) workers, enter or report the number of hours for each. Salaried (exempt) workers do not have to report their hours. They are paid the same amount each week.

If you are doing job costing in your accounting, you will still want salaried employees to track their hours. It will not factor into their weekly pay but you will want to be able to accurately allocate time to jobs to understand costs. Consider using a time tracking program that syncs with your general ledger accounting software to produce these reports. Many will have a sync with your payroll as well so you can use them for salaried and hourly employees alike.

Retain Required Records

Certain payroll-related records must be retained for IRS purposes. As a general rule, you must retain all records for individuals who are actively employed, regardless of the length of their tenure. Many records must be retained for a certain period after employment is terminated. For example, you should retain payroll records for six years. Specific instructions are available through the IRS.

Calculate and Pay Federal and State Payroll Taxes

Finally, you as an employer are responsible for making payroll tax payments and producing certain reports. Generally, reports are due either quarterly or annually. Utilize resources available through the IRS and your state tax office to ensure all taxes and reports are handled appropriately.

Accurate, on-time payroll is one of the most important responsibilities of your business. First, payroll errors are a surefire way to upset employees. Second, tax errors can result in significant fines and penalties. Carefully consider how your payroll will be handled to ensure you avoid the most common pitfalls.

Frequently Asked Questions (FAQs)

How do I run payroll for a small business?

There's no simple answer. To run payroll, you'll need to start with the basics (get an employer identification number), then move on to big decisions like choosing your payroll process and platform. Take your time with each step of the process; mistakes can be costly.

How can I do payroll for free?

To do payroll, you'll need to most likely do it yourself. To pay taxes, you'll use the IRS' electronic federal tax payment system (EFTPS). From there, some of the steps you'll need to take care of include reporting your workers to your state, calculating pay and deductions, and adding up and paying federal taxes.

Article Sources

  1. IRS. "Apply for an Employer Identification Number (EIN) Online."

  2. Tory Burch Foundation. "10 Steps to Setting Up a Payroll System."

  3. IRS. "State and Federal Online Business Registration."

  4. Cole, Fisher, Cole, O'Keefe + Mahoney. "Are Interns Entitled to Workers’ Compensation Benefits?"

  5. State of California Employment Development Department. "Employment Determination Guide."

  6. GCF Global. "Workplace Basics: Completing I-9 and W-4 Forms."

  7. State of Washington Small Business Guidance. "Payroll Your Business."

  8. Chamber of Commerce. "How To Choose the Right Payroll Software for Your Business."