How to do Payroll

As a small business owner, one of the most important tasks you will have to complete each month (and perhaps more frequently) is payroll. Whether you’re paying just yourself, one employee, or multiple workers, knowing how to process payroll is a duty that you cannot afford to ignore. 

In an effort to save money, some small business owners opt to handle payroll on their own (often with the help of payroll processing software). Others prefer to save time and hire an outside payroll service and perhaps an accountant to manage the task on their behalf. 

The guide below will walk you through how the payroll process works and nine steps you’ll need to take to get started. (Note: This isn’t an exhaustive list of your employer payroll responsibilities with the IRS, your state, and local government. If you’re not a tax law expert, consider consulting with a professional.) You’ll also discover the benefits of hiring professional payroll services to help you decide which approach is right for your business. 

How does payroll work?

Payroll is the compensation a business pays its employees for the work they perform during a set period of time. It’s essentially the transferring of funds from employer to employee. 

At its core, payroll involves many different calculations. You or whoever you delegate to manage payroll for your company may have to calculate hours worked, hourly pay rates, salary earned, overtime pay earned, benefits owed, taxes owed, wage garnishments, and more. 
Perhaps the most important part of calculating payroll is setting up a consistent process that can be duplicated time and time again. Having a process can help you avoid mistakes and potential compliance issues that could lead to missed deadlines, incorrect payroll tax filings, and other potentially costly mistakes.

How to set up payroll.

It’s important to have a reliable payroll process to make sure your business is compliant with all federal, state, and local tax requirements. The nine steps below aren’t meant to be an all-inclusive payroll guide. But they may provide an overview of how to set up basic payroll procedures for your small business. 

Step 1: Acquire an Employer Identification Number.

One of the first steps in your payroll set up plan should be to apply for an employer identification number (EIN) from the IRS. An EIN is a nine-digit identification number, also called a Federal Tax Identification Number, that separates your business from millions of others in the United States.

An EIN is similar to a Social Security number. But its purposes are for business-related uses only. Not only will you need an EIN to file federal payroll taxes, you may also need an EIN to open a business bank account, apply for business financing, and more. 

Applying for an Employer Identification Number from the IRS is free and easy. You can complete the application online via the IRS’ website. 

Step 2: Apply for a state or local business identification numbers.

In addition to the federal government, your business may need to pay payroll taxes to state and local governments, as well. If your state or local government assesses income tax, your business will need to file for separate tax identification numbers on an as-needed basis. 

It’s helpful to apply for your EIN before you request state-specific tax identification numbers. Some states may require your business to disclose its EIN when it applies for a state tax ID, and the same may be true of local governments too. 

Depending on the state, you might also need to apply for a state unemployment identification number. This separate business ID may be necessary when you pay state unemployment taxes for your employees. 

Step 3: Collect documents from employees and independent contractors.

Once your business’ tax identification numbers are in order, you can collect tax information from your employees. In general, most forms are completed on the first day of employment (or before an independent contractor’s first assignment). 

Below are several common documents you may need employees or freelancers to complete. 

• Form I-9: An Employment Eligibility Verification Form from the U.S. Citizenship and Immigration Services, or Form I-9, verifies identity and employment eligibility to work in the United States. Employers in the U.S. must complete this form for every individual they hire—both citizens and noncitizens alike. 
• Form W-9: A Request for Taxpayer Identification Number and Certification Form from the IRS, or Form W-9, can be used to confirm the identity of an independent contractor for tax-reporting purposes. 
• Form W-4: An Employee’s Withholding Certificate, or Form W-4, allows your employees to answer questions (e.g., filing status, number of dependents, etc.) that determine how much federal income tax you need to withhold from their wages each payroll period.  
• State withholding forms: Your state may require you to withhold state income taxes from employee wages, as well. If so, employees may need to complete state-specific paperwork, similar to the IRS Form W-4, to determine the amount you should withhold each pay period. 

Step 4: Choose a payroll schedule.

After you collect employee tax documents, it’s time to determine pay frequency. Businesses typically follow one of four payroll schedules:

• Weekly
• Bi-weekly (i.e., every other week)
• Semi-monthly (i.e., twice a month on fixed dates such as the 1st and 15th)
• Monthly

Once you choose a payroll schedule, it’s best to stick with it. So, it’s important to weigh the benefits and drawbacks of each option before you decide which payroll schedule makes the most sense for your small business. 

For example, weekly payroll tends to be the most expensive and time-consuming option for employers, but the most attractive to employees. Monthly payroll can be the most affordable and easiest to process for employers, but might be a turn-off when you’re trying to attract new team members or retain quality talent over the long term.

Step 5: Calculate gross pay.

Another important step in the payroll process is calculating gross pay for each employee. For hourly employees, this task begins with tallying up the number of hours an employee worked during the pay period. Next, you multiply the number of hours by the worker’s pay rate to determine their gross pay. 

Here’s an example: 

• 40 hours X $20/hour = $800 gross pay

Of course, the process may be more complicated if there are multiple pay rates involved. This situation might occur if an employee earned overtime pay or a higher pay rate for working on the weekend or a holiday than they earned on other days. 

Here’s an example of what a gross pay calculation might look like for a single employee with multiple pay rates: 

• 40 hours X $20/hour = $800
• 10 hours X $30/hour (overtime pay) = $300
• Total gross pay = $1,100

Tip: Familiarize yourself with federal and state requirements where overtime pay is concerned, including the Fair Labor Standards Act. 

Step 6: Determine deductions for each employee.

Next, you will need to determine the number of deductions to take out of each employee’s gross pay. This process can be complicated and may involve both pre-tax and post-tax deductions. 

Deductions from an employee’s gross pay may occur for numerous reasons, including: 

• Health benefits
• 401(k) contributions
• Group life insurance
• Federal taxes
• Social Security
• State taxes
• Local taxes
• Court-ordered wage garnishments (post-tax)
• Roth IRA retirement contributions (post–tax)
• Union dues (post-tax)
• And more

It’s also important to note that the tax withholdings you deduct may vary for different employees based not only on earnings, but also on how each employee filled out their W-4s and various state and local tax forms. 

It’s critical to get payroll deductions right for each and every employee. As a result, many small business owners choose to outsource the payroll process to a professional. 

Step 7: Calculate net pay and pay your employees.

After you tally up all of an employee’s deductions, you subtract that number from the employee’s gross pay. It will be up to you to hold onto those funds and distribute them to the appropriate parties (the federal government, benefit providers, retirement accounts, etc.). The amount left over after any deductions is the employee’s take-home pay or net pay. 

You can distribute an employee’s net pay in several different ways when their scheduled payday arrives. Some employers opt for direct deposit. Others may prefer to hand out paper checks at the office, and some employers even load pay checks onto prepaid debit cards. 

It’s wise to review both federal and state laws regarding the delivery of employee wages. For example, your state might require you to include a payment statement with each paycheck disbursement that explains wages earned and deductions withheld.

Step 8: Correct any mistakes and keep payroll records.

Be sure to go over your payroll calculations to confirm each employee’s net pay amount is correct. Once you verify that all the employee information you used to calculate payroll figures is accurate, you can re-run the numbers. 

If you come up with the same amount twice, you should be in the clear. However, if you arrive at a different result the second time you run payroll calculations, it’s a signal to go back and check for errors. 

It’s also important to keep detailed records of every payroll transaction your company processes. You’ll want to maintain these files for both compliance and tax purposes. Payroll records could be especially important to have on hand if a disagreement or problem ever arises in the future. 

Step 9: Keep ongoing considerations in mind.

As a small business owner, you will have ongoing responsibilities where your company’s payroll taxes are concerned—typically on a quarterly and annual basis. Remember to file any quarterly and annual reports with the IRS and your state by the deadline. Otherwise, you could face penalties. 

If you hire new employees, this will involve extra tax-related work as well. You will need to report new hires to the IRS and perhaps to your state, as well. Business owners who opt to work with an accounting firm or professional payroll processing company may be able to outsource these tasks. 

How to use professional payroll services.

Processing payroll can be tedious and complicated. So, many small business owners hire a professional payroll service to manage the payroll process on their behalf. 

Using a payroll service is typically more affordable than an in-house payroll solution for smaller businesses, since you’re on the hook only for paying for the services you need rather than having another employee on your payroll. 

As your business grows, however, you might consider bringing in your own payroll professional. An in-house approach to payroll processing can be nice because the person administering your payroll will be intimately familiar with your business—potentially reducing confusion and helping you resolve issues faster if and when they arise. 

If you opt to work with an outside payroll provider, however, there are many options to consider. You could work with a large major payroll company, such as ADP or Intuit. Or perhaps you would prefer a smaller, local solution. Below are pros and cons of each solution.

Major payroll company

One of the biggest advantages to working with a major payroll company is breadth and depth. A larger payroll provider often has more specialized teams to handle the various elements of your payroll, sometimes leading to better efficiency and perhaps more accurate results. 

On the other hand, your business might be a faceless number to some of the nation’s bigger companies. And the customer service at larger payroll companies can sometimes be lacking. A nationwide operation is also less likely to understand the nuances of local tax regulations. 

Local payroll company

As a small business owner, you’re well aware of the benefits a smaller operation can provide its customers. You’ll usually receive more personalized service from a local payroll company. You may get more one-on-one time with your contact at the business and the customer service might also be better when you experience problems. 

Possible drawbacks of working with a local payroll service include a more limited suite of payroll offerings. There’s also the possibility of a less refined payroll process, depending on the company. 

Bottom line

Processing payroll is a complicated and time-consuming process—but it’s one that your business cannot ignore. Every business must follow federal and state regulations where payroll taxes are concerned. So, it’s up to you as a small business owner to figure out the payroll processing approach that works for you. 

If you don’t have experience handling payroll, you may want to outsource the process to someone who does. Of course, it’s important to do your research here as well. It’s wise to compare different services to make sure you find a reputable payroll company that fits your budget and provides the services your business needs, so you’re free to focus on other tasks.