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Paying your employees accurately and on time is one of the most important aspects of running a successful small business. Unfortunately, it can also be one of the most complicated. That’s because running payroll isn’t just a matter of cutting checks and handing them out to your employees. It typically also involves complying with state and federal labor and tax laws, calculating the right amounts for deductions and withholdings, and filing payroll taxes. If you’re a small business owner and wondering how payroll works for a small business, here’s what you need to know.
What Is Payroll?Payroll is the process of paying your employees. Running payroll generally consists of calculating employee earnings and factoring out federal and state payroll taxes. However, payroll can also refer to a few other things, such as:
From a small business owner’s perspective, payroll is also a business expense, often one of the largest you pay out each month.RECOMMENDED: Small Business Payroll Loans Defined & Explained
- A financial record of a business’s employees
- An annual record of employee wages
- The actual payment and delivery of paychecks to employees
Why You Need a Payroll SystemThe most obvious reason for needing a payroll system is that you need to pay people who work for your company. But payroll systems aren’t just about paying employees. They also track who is working for your company, how long they've worked for you, and how much money you're spending on labor.Having a proper payroll system in place can also prevent problems for your small business. If you enter deductions or file payroll taxes incorrectly, you could run into issues with the IRS, incur fines, and expose your business to severe liability. A reliable payroll system can ensure:
- Timely and accurate payments to your employees
- State and federal regulations are followed
- Payroll taxes get paid on time
- Proper deductions and withholdings occur
Can You Do Payroll Yourself?Yes, you can do payroll yourself. You’re not legally required to hire anyone or use any type of software. If you’re a small business owner who only employs a few people, it may be worth learning how to do payroll on your own. However, it can be time-intensive and entail making numerous calculations. If you’re new to payroll, you will likely have to do extensive research to make sure you are up to date with all labor and tax laws. The upside of doing it yourself is that it’s typically the least costly way to do payroll. Keeping the process in-house can also give you complete oversight and control over the process.RECOMMENDED: 6 Tips for Managing Small Business Finances
Tips for Doing Payroll for Your Small BusinessWhether you choose to do payroll manually with a spreadsheet or by using a payroll software program or outside service, it can be helpful to understand the payroll process. Below, we’ve broken it down into 7 basic steps.
1. Get an Employer Identification Number (EIN)An EIN (also called a Tax ID) is a unique number given to your business for IRS purposes. This number identifies your business when reporting information about your employees to federal and state government agencies. It’s like a social security number, but it’s only used for businesses. If you have employees, you need an EIN. It’s free, and easily obtained through the IRS.
2. Enroll Into the Electronic Federal Tax Payment System (EFTPS)A major part of running payroll involves paying payroll taxes on time. The EFTPS is a free payment system that allows you to pay both your federal payroll and your federal unemployment taxes right from your computer using the EFTPS portal. If you are using a payroll service, you can likely skip this step since they typically will be sending in your tax payments for you.
3. Research Local, State, and Federal Labor Laws and RegulationsMany states and counties have different labor and pay laws. If you’re not using a payroll service, it can be a good idea to learn what these laws are, since they impact the type of information you need to have printed on paystubs, as well as how much and how often you’re required to pay your employees. Sometimes labor laws can be difficult to navigate because you have to comply with all three levels of government at the same time — local, state, and federal. If laws differ, an easy rule to follow is to obey the law that gives the greatest benefit to your employees.For example, a common discrepancy is minimum wage. Currently, the federal minimum wage is only $7.25 an hour. However, many states mandate that employers pay their employees considerably more. California, for example, requires all employees to make at least $14 an hour. If you’re an employer in California, you must obey your state’s laws and ignore federal minimum requirements because the state mandate is higher than the federal mandate. Local, state, and federal labor laws may also impact:
When using payroll software or an outside payroll company, you typically don’t need to have as much in-depth knowledge of pay and tax laws, since they’re usually already applied to the software.
- How you need to calculate overtime
- Paid vacation requirements
- If you’re required to withhold money for state disability insurance
- If you need to withhold local income tax
- Your workers’ compensation insurance requirements
4. Select a Payroll ScheduleAs long as you conform to any minimum state requirements, you can pay your employees as often as you like. No matter what pay interval you choose, you may want to keep in mind that it is going to impact your company’s cash flow, as well as when you are able to pay vendors. The most common payroll schedules are:
5. Request Workers to Complete Their New Hire FormsNew hires need to fill out the proper paperwork as soon as possible because you can't process payroll without the details provided on these forms. Each hire needs to complete and turn in:
Many payroll service providers will gather these forms on the employer’s behalf.
- State tax withholding form
- I-9 Employment Eligibility Verification Form
- Direct deposit authorization form (if you offer this service)
6. Calculate Net: From Gross Pay, Deductions, Allowances, Other WithholdingsNet pay is what each employee is paid at the end of each pay period. Calculating an employee’s net pay involves some complicated calculations, but the overall formula is simple: Net pay equals gross pay minus deductions. Gross Pay: How you calculate your employee’s gross wages will depend on if your employee is an hourly or salaried employee. For hourly employees, you can multiply the total hours they worked in the pay period by their hourly wage. For salaried employees, you can divide their total annual salary by the number of pay periods you have throughout the year; this will give you their gross wage for each pay period.Deductions: Payroll deductions are wages withheld from an employee’s total earnings for the purpose of paying taxes, garnishments, and benefits like health insurance. These withholdings constitute the difference between gross pay and net pay and may include:
The amount you withhold for each employee will depend upon that person's W-4, state and local withholding certificates, benefit selections, and other details. You can calculate these withholdings manually or you can automate the process by using an online payroll calculator or payroll software program.Below is a general step-by-step to help you calculate payroll deductions. If you’re new to running payroll and will be doing it manually, it’s a good idea to consult an accountant the first time you do it to make sure you’re not running afoul of any federal and state tax and employment requirements.
- Federal taxes
- Social Security
- State taxes
- Local taxes
- 401(k) contributions
- Wage garnishments
- Workers' compensation contribution
- Other benefits
- Adjust the employee's gross pay by withholding pre-tax contributions to health insurance, 401(k) retirement plans, and other elected benefits.
- Check the employee’s Form W-4 and the IRS tax tables for the current year to calculate and deduct federal income tax.
- Withhold 7.65% of adjusted gross pay for Medicare tax and Social Security tax, up to the wage limit. (Your business is legally obligated to match this amount.)
- If the employee’s year-to-date income has reached $200,000 or more, deduct 0.9% for Additional Medicare tax.
- In states that charge income tax, withhold this tax according to the instructions found in each state’s employer’s tax guide or code.
- Subtract any garnishments, contributions to Roth IRA retirement plans, as well as other post-tax dues to arrive at the employee's total net pay.
7. Keep Records, Adjust, and Fix MistakesMaintaining honest and organized payroll records is important for any business. This allows you to reference your records if there's ever a discrepancy between an employee's net pay and what they expected to receive. Mistakes happen, but as long as you correct them quickly and honestly, you can generally recover quickly.Having these records on hand can also be key in the event you have to work with the IRS. The IRS requires employers to keep records of employment taxes for at least four years.Recordkeeping is also essential for payroll taxes that you have to pay out on a regular basis. RECOMMENDED: 5 Common New Small Business Mistakes & How to Avoid Them
Alternatives to Running Payroll by YourselfIf the idea of setting up and running your own payroll system feels overwhelming, you may want to consider some alternatives that can make your life a little easier.
Payroll SoftwarePayroll software is often the least costly option outside of doing it yourself. Aside from being a time-saving measure, many of these programs offer automatic updates to tax regulations, reminders, and an additional layer of security.There are numerous payroll software programs on the market. These include:
- Quickbooks Payroll
- Paychex Flex
Payroll Services ProviderIf you are willing to pay a bit more to have the whole payroll process taken off your hands, you may want to look into hiring an outside company that specializes in payroll services. A full-service organization can often handle all payroll processing, direct deposits, printing of checks, tax payments, withholdings, and tax filing.
CPA or BookkeeperAnother option is to hire an individual who is experienced in running payroll to handle the process for you. If you go with a CPA, they may also be able to help you with general small business accounting needs.
The TakeawayRunning payroll for your small business is a cumbersome but necessary task. If you’re willing to put in some time and effort, you can likely do payroll yourself. If you’d rather focus on other aspects of your business, it may be worth it to purchase payroll software or to hire an outside payroll company to handle the whole process. Once your payroll system is in place, you may want to look for other ways to improve and grow your company. Lantern by SoFi makes comparing different small business loans easy — all you have to do is fill out one simple application.
Tax Information: 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.
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About the Author
Lauren WardLauren 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.