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How to Pay Employees in a Small Business

How to Pay Employees in a Small Business
Lauren Ward

Lauren Ward

Updated February 7, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
If you’re starting a small business, you may be interested in bringing on employees to help take your company to the next level. Whether that means one or two freelancers or a large full-time staff, it will be your job as an employer to determine how much, as well as how, your employees will be paid. While the process of setting up payroll for a small business may sound tricky, it’s actually not as complicated as many entrepreneurs think. Below we walk you through the process of paying your employees, from collecting forms to taking out taxes to issuing paychecks.

Types of Payment for Employees in a Small Business

In order to pay your employees, you’ll need to first determine how much you want to pay them. If your business doesn’t currently have a lot of cash on hand, keep in mind that you can often use a small business loan for paying employeesOnce you’ve decided on the amount, the next step is to determine a payment structure that makes sense for your business. Here are some options to consider.   

1. Hourly Wages

Hourly wages are based on an hourly rate and an employee’s pay will depend on how much time they work during a pay period. You must pay employees the federal or state minimum wage, whichever is higher. Typically, hourly workers qualify for overtime pay.Compensating employees by the hour can be a good choice for a part-time employee or someone who doesn’t work a consistent schedule. It can also be a smart move if you’re just getting your business up and running and you’re not sure how much help you will need. 

2. Fixed Annual Salary

Salaried employees are paid a fixed amount each year. Each payday they receive the same amount, and that amount is calculated by dividing their annual salary by the number of pay periods. Offering a fixed annual salary can help you attract (and retain) employees since it means a reliable, predictable paycheck. Another benefit is that you are generally not required to pay salaried employees overtime. 

3. Commission

With commission payment, how much you pay an employee is based on the completion of work. It can be given in addition to a base salary or instead of a salary. Commission-based compensation can be ideal for sales roles, since it helps incentivize employees to meet specific goals. 

4. Bonuses

A bonus is extra money awarded to an employee for whatever reason the employer decides. Some employers give bonuses at certain times of year (such as the end of the year), while others offer bonuses for meeting certain performance goals (e.g., securing 10 new clients).If you plan to offer bonuses, it can be a good idea to tell your employees ahead of time so you put an extra spark in their step. Before making any announcements, however, you may want to speak to your bookkeeper to ensure you have enough working capital to issue bonuses when you plan to.

5. Stock Options

If you can’t offer large salaries to employees, you may still be able to attract the best and brightest by offering equity in your small business. This can also act as a great motivator, since employees with stock options know that if they work hard, they could be substantially compensated in due time. However, offering shares in your startup typically only makes sense only if there is a realistic pathway to cashing out. That means your company is (or will be) backed by outside investors and is likely to go public or be bought by another company. 

6. Insurance

If you’re unable to pay your employee’s top notch salaries, you may want to entice them by offering them help with paying for healthcare. You can do this in one of two ways: by offering a tax-free reimbursement or issuing a tax stipend.With a tax-free reimbursement, you give your employees a fixed amount of money each month to reimburse themselves for paying for health insurance or medical expenses they have incurred. Once they have incurred an expense, they are given the money.With a tax stipend, you give employees additional money each month regardless of whether they choose to purchase health insurance. At the end of the year, this money counts as income and must be reported on tax returns. 

Paying Employees in a Small Business: 7 Steps 

In order to start paying your employees, you’ll need to set up a small business payroll. You may decide to do payroll yourself or simplify the process by hiring a bookkeeper or purchasing payroll software. Below, we outline what’s involved in the payroll process so you can determine the best payroll system for your small business.

1. Have Employees Complete the Relevant Tax Forms

All current and new employees must complete and turn in the following tax forms so you can correctly calculate payroll:
  • USCIS 1-9 form This is used to verify work eligibility.
  • IRS W-4 form This tells you each employee’s filing status so you can withhold the correct amount of federal tax from their pay.
  • State and local forms for withholding This includes any relevant local forms required by your county, city, or state.

2. Calculate Pre-Tax Wages

To calculate pre-tax wages, you need to first determine how often you will pay your employees, such as weekly, bi-weekly, semi-monthly, or monthly. You can then figure out your employees’ gross pay for the pay period:
  • For hourly employees, take the amount of hours they worked and multiply that number by their hourly rate. 
  • For employees on commission, first calculate their hourly rate or salaried base pay, then add any commission they received during the pay period. 
  • For salaried employees, divide their annual salary by the amount of pay periods they receive in a single year. 

3. Determine How Much to Withhold for Taxes

The paperwork you received in step one will help you determine how much of each employee’s earnings you need to withhold for all of the following:
  • Federal income taxes
  • State income taxes
  • Local taxes
  • FICA (which consists of Social Security taxes and Medicare taxes, often referred to as payroll taxes)
  • Deductions for benefits (such as health insurance, retirement savings, and flexible spending)

4. Calculate the Net Pay

To calculate net pay, you take an employee's gross pay and subtract all withholdings. The difference is net pay. For example, if an employee makes a gross pay of $3,000 in a pay period, but has $500 in withholdings, they would receive a net pay of $2,500.

5. Pay Your Employees

Two popular ways to pay employees are issuing physical checks and doing direct deposits. Direct deposit requires the employee to grant you permission to run a direct deposit, but eliminates the hassle of printing checks. If both are too time consuming, many payroll services will do either for employers on their behalf.When paying employees, keep in mind that if you received funds from the Paycheck Protection Program (PPP) (which ended on May 31, 2021), you can use the loan money towards payroll to help qualify for forgiveness. It’s crucial to follow the forgiveness rules, otherwise you may have to repay the PPP loan funds.

6. Submit a Tax Filing

It’s your responsibility to pay taxes on behalf of any employees for whom you’ve withheld income tax. Taxes must be filed and paid to: 
  • The IRS
  • Your state’s tax collection department
  • Your local government
Additionally, employers must pay two additional types of taxes:
  • FICA tax: This is split between the employer and employee. The employer covers a 1.45% Medicare tax and 6.2% Social Security tax. 
  • FUTA tax: You must also pay 6% for unemployment insurance for each employee. Check to see if your state offers a credit, often up to 5.4%.
Keep in mind that taxes you are responsible for paying for your employees are typically a deductible business expense

7. Contribute to Employee Benefits Programs

Some of the money you withhold might be for employee benefits. This might include contributions towards:
  • Health insurance
  • Health savings accounts
  • Retirement
  • Commuter benefits
  • Flexible spending accounts
If you offer any employee benefits, you must make the appropriate payment on behalf of your employees into the relevant accounts each pay period. Recommended: Applying for a Small Business Loan in 6 Steps  

The Takeaway

There’s more to compensating the people who work for you than periodically writing each of them a check. You’ll need to put a payment system in place.The first step to setting up payroll for your small business is to determine a payment structure, such as hourly, fixed annual salary, or commission, plus decide if you’ll offer any extras, such as stock options or bonuses. To pay your employees, you’ll need to collect the relevant tax forms from each new hire, calculate how much to withhold for taxes and employee benefits, issue payment (via check or direct deposit), and pay taxes on their behalf.Once your payroll system is in place, you may want to look for other ways to improve and expand your company. Lantern by SoFi makes comparing different small business loans easy — all you have to do is fill out one simple application.
Photo credit: iStock/aldomurillo
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. SOLC112253

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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