Everything You Need To Know About Small Business Payroll
Payroll is a daunting component of any business, and many small business owners admit frustration with managing their payroll documents. But payroll is necessary. Not only is it important that you pay your employees correctly, but making a mistake on payroll is messy, complicated, and could impact taxes. If you’re looking for a quick and easily digestible introduction to payroll, you’ve come to the right place. Let’s delve on in.
Table of Contents
What Is Payroll?
If you have employees, you pay them a wage for their work; that’s just a basic fact of life. Payroll is defined as the regular payment of wages to employees, and it includes withholding the correct amount for taxes, insurance premiums, or retirement plan contributions. Payroll can be complicated and unwieldy with technical minutia, but managing payroll is a legal requirement, so don’t try to skimp on understanding the basics.
In essence, with all payrolls there are dual systems at work — there is the money allotted to employees as wages and there is money that is withheld for payroll taxes. As a small business owner, you are responsible for managing those withholdings. So, when payday rolls around, you give your employees a check that has the appropriate amount withheld for taxes, and when tax time arrives, you provide employees with statements of income (more on this below) and pay the government their share of the booty. That’s payroll, in a nutshell.
The Components Of Payroll
Payroll is broken down into several steps. As the small business owner, you are responsible for providing your employee the correct wages and for withholding state and federal taxes. Your records for payroll need to be clear and accurate, and whether you do these calculations by hand or use payroll software to run the numbers for you, it’s important to understand how payroll works. Anything dealing with money and taxes is fundamentally crucial to your business, and it’s important to your employees, too. A functional payroll sends a message of respect and stability to the people you employ.
Before you set up a payroll system, here are the payroll terms and the concepts you should be familiar with.
What does it mean when someone runs payroll? It can mean running the monthly wage reports for employees, including their withholdings. And it can mean organizing the financial documents related to wage and withholdings for the entire fiscal year, as well. Payroll can also simply mean the amount you pay to employees and the government every year.
Your employees work for you for a certain amount of money, and processing the money you owe them is payroll. In order to set up a payroll system for your business, you will need to acquire some information from your employees. Here’s everything you must have to set up your payroll system:
- Your company’s legal name or DBA (Doing Business As)
- Your Federal employer identification number (EIN)
- State tax withholding ID number
- State unemployment tax ID number (SUI)
- Local tax ID numbers
- Your state unemployment tax rate information
- Details on the pay rate for each employee
- Personal information for all employees, including
- Social security number
- Tax filing status
- Information on deductions and contributions
Once you’ve gathered this information, you can set about calculating the appropriate withholdings and deductions in order to be compliant with the law.
Salary & Wages
Money, money, money, money! Look, wouldn’t it be amazing if each of your employees was independently wealthy and believed in your business enough to work for free? I mean, sure, as a small business you may temporarily use your friends, but if you have someone working for you day after day, then put that person on the payroll. It might feel easier to pay a handful of employees under the table, but it’s both illegal and hurtful to your bottom-line. Here are some salary and wage terms to understand:
Gross Pay/Gross Earnings
Gross pay is the amount of money your employee has earned before any deductions. This includes commission, bonuses, and other payments.
Net pay is the amount of money your employee has earned after deductions and taxes are withdrawn. This can also be called “take-home” pay.
This is the accumulative yearly wage for employees. That salary is then divided up and distributed on a set pay schedule. The payment schedule could be weekly, bi-weekly, or monthly. (A salaried employee has set earnings per month versus an hourly employee.)
This is the amount of money paid per hour to employees who are not receiving a set salary. Freelancers, contractors, and all hourly employees are paid per hour. In a payroll system, the hourly rate is set for employees and is calculated when payroll is run.
If an hourly employee works more than 40 hours a week, any additional hours you approve over that is considered paid overtime. An overtime wage is a set rate and is subject to tax deductions. Overtime calculations can become complicated depending on when payroll is run, so if you have quite a few employees who earn overtime, factor that into your payroll choices.
Someone working for your business on contract has a specific pay schedule related to that contract. As a 1099-employee, a contract is based for a specific amount of time and ends on an agreed-upon date. As an employer, you do not withhold taxes from a contract employee — he/she is responsible for their own withholdings.
This is an amount of money rewarded to an employee for good performance. While it may be a one-time payment in addition to a salary, all bonus money is subject to taxes.
A tip or gratuity is an added amount of money received by employees for a job well done. Some payroll systems allow employees to keep track of their tips, as those wages are taxable income. Having a system to account for tips is important to your business and maintaining compliance.
If you are a sales-based company, your employees might earn money off of each sale they make, and this is called a commission. Even if your employees are commission-only, the IRS still considers commissions as supplemental income and it should be taxed at the regular rate.
Earning time-off is an important part of being an employee. Time off can appear in various forms; family and medical leave, paid vacation time, sick leave, and personal time. Your small business needs time-off policies and a way to calculate those hours separately from paid work hours. Your payroll system will also include information about your business’s time-off policies and calculate adjustments to a paycheck for earned time off. An automated payroll system can calculate earned time off for your employees — making it easy to put available vacation hours on pay stubs.
Paid Time Off (PTO)
This is a set amount of hours per year your employee has to take a paid time away from work. Some companies provide a block of hours employees can use toward sick, vacation, or personal days. Under federal law, you are not required to provide paid time off to your employees, but happy and healthy employees are good for business, so offering PTO is often in the best interest of employers (and can be a huge deciding factor for an employee’s job decision).
Set up a policy for paid time off and communicate it clearly to employees. What happens to unused time at the end of the year? Are employees paid a regular or amended rate for paid time off? Once you’ve made these decisions about time off, then you can find a payroll system that automates the process for you.
While Paid Time Off (PTO) and vacation days can be used interchangeably, they are different. Vacation time by definition is time your employees can take and to be totally free from work duties without restrictions. Business policies regarding vacation will vary. Make some choices about your vacation policies: do employees need to declare vacation by a certain time? How many hours of vacation are employees given a year? How are vacation days tracked?
Humans get sick. Humans make little humans who are sometimes sick and can’t go to school or daycare. Illness is a fact of life and business owners need to prepare for the inevitable with a sick day policy. Bonus: encouraging your employees to stay home when they are ill protects your business from sickness spreading! Check with your state to see if there are state-mandated sick leave policies. Note: At the time of this article, 13 states/territories have paid leave laws: Washington, Oregon, California, Arizona, Michigan, Connecticut, Maine, Maryland, Massachusetts, New Jersey, Rhode Island, Vermont, and Washington DC.
In addition to sick leave and vacation leave, you may want to consider offering other leave options to employees. Personal leave is scheduled time for your employees to use for adulting purposes (doctor appointments, car check-ups, parent-teacher conferences, school meetings, emergency plumbing disasters, mental health). Also, developing a plan for family leave/maternity and paternity leave is a must. Brainstorm the ways an employee might need to be absent and have firm policies in place for those occasions.
Employees care about benefits. Second to salary, benefits matter when employees choose where they want to work. Sometimes small business owners think they can’t afford to offer benefits to employees, but they actually can’t afford to risk the loss of employees by not offering benefits. The value far outweighs the potential cost.
So what are benefits? These are the extras a small business provides for their employees — health care, dental care, life insurance, or a retirement plan. As a small business, depending on your size, you might be required to provide some of these benefits to full-time employees, so as always, check the laws in your state. Here are a few benefits that may be legally required:
- Time off to vote or serve in the military
- Worker’s compensation
- Pay state and federal unemployment taxes
- Comply with FMLA (Family Medical Leave Act) laws
You are not legally required to provide a retirement plan for employees; however, should you provide a retirement incentive, there is marked improvement in employee retention and happiness. There are also tax credits and incentives for small business owners who provide retirement benefits. The options for retirement benefits are tiered and varied; for companies with a small number of employees, retirement options like a Simple IRA or a Simple 401K are easy to implement, and many payroll software systems can help with employer contributions and matching.
Do you need to provide health insurance to your employees? Possibly! The current legal requirement is this: If your business is considered an Applicable Large Employer (ALE) with 50 or more full-time employees for more than six months out of the year, then you will need to provide your employees with health insurance as a legal requirement of the Affordable Care Act.
If not, then health care benefits are a choice! (But a good choice! And one that leads to happy employees, higher retention rates, and a thriving and healthy community.) Need to know more about health insurance, even if you are a small business with only one employee? We have you covered. Check out our Ultimate Guide to Small Business Health Insurance or our post on How Health Insurance Works for One Employee.
As a small business, you may offer life insurance to your employees. Group life insurance is an inexpensive and easy way to communicate to your employees that you value them. (Also, did you know that you can even singularly insure a really important employee? Like, if your business won’t function without a particular human being…insure that human! It’s called Key Person Insurance. Check it out.)
Fringe benefits mean any additional supplement to income that you may offer your employees. They include the benefits listed above, but also include many other types of assistance you may want to offer. Some companies provide access to a company car, rewards for healthy living, transportation vouchers, discounts for schooling, employee discounts on merchandise, technology grants, and paid career advancement conferences. Most fringe benefits are tax-free, but it’s important to check with a tax expert.
Tax Deductions & Withholdings
The most important thing, equal to paying your employees, is paying the government. Managing federal and state tax withholdings is a crucial component of payroll. It is your responsibility as the small business owner and employer to understand the tax law and the federal tax rates (you, or a software program, or a hired accountant). Your employees, when hired, will fill out and send the proper forms to the Internal Revenue Service (IRS), and that paperwork along with current tax rates will tell you how much to withhold for payroll taxes.
We know it’s a lot to take in, but before you start hyperventilating, we’ve broken down the tax withholding basics below.
Federal Income Tax Withholding
This is the amount of money withheld from an employee’s paycheck each month that goes to pay federal income taxes. The federal rate for income tax withholdings changes depending on your income level and your employee’s allowance preferences (as reflected on their W-4s).
State Income Tax Withholding
This is the amount of money withheld from an employee’s paycheck each month that goes to pay state income taxes. As an employer, you are required to calculate how much to take for state and all local taxes.
The social security tax is a federal income tax that affects all employees, no matter what. The tax rate for social security depends upon a formula that takes inflation into account. In 2019, the current rate is 12.4 percent which accounts for a 6.2 percent employee and 6.2 percent employer contribution. (Unless you make over $200,000 a year, then you gotta pony-up an extra .9 percent.) Combined with Medicare, this is what is referred to as Federal Insurance Contributions Act (FICA) Taxes. And FICA taxes are also called payroll taxes.
Along with social security, Medicare is considered a FICA Tax which is considered the cost to the government for employment. The current Medicare rate is at 1.45 percent for all employees, and there is no cap. You will collect this money as part of the paycheck withholdings and send it along to the IRS throughout the year.
Payroll Tax Forms
You cannot create a payroll system without having the right tax documents from each employee. (Cue Roz’s constant battle-cry for paperwork in Pixar’s Monster’s Inc.). Our current digital landscape allows for the ease of sending and receiving tax forms via the internet, so we can cut down on the “paper” part of all this paperwork.
Filing payroll? Here are the forms required by law that you/and or your employees must fill out:
- W-2: Every employer is required to send this document to each employee and the IRS. This form is a statement of all wages earned and all taxes withheld during the previous year.
- W-4: This form is filled out by employees and communicates how much tax they’d like withheld from their paychecks. You will need to know their withholding allowances in order to correctly run payroll and take out the right amount of money.
- 1099: This form is for people who worked under contract or freelancing for your business and do not earn a regular salary. This form is for tracking miscellaneous income, or extra income, a person may earn. Money sent to a 1099 employee does not have taxes withheld, which means the burden of paying taxes moves away from you as the temporary employer.
- Schedule C: If you are an independent contractor or a sole proprietor of a business, you will need to fill out a Schedule C profit/loss report and file it with the IRS. A profit-loss statement is also called an income statement and its purpose is to help calculate your self-employment tax. Under the new tax laws, you will file a Schedule C form with your 1040 form.
- 1-9: This form is required to verify the identity and employment availability of your employees. When you hire someone and onboard them to your business, every single new hire needs to fill out this form. After your employee fills out the first part, you as the business owner need to fill out the second part. Since this is used to establish identity, your employees will need to send you formal identification: a current US passport, a green card or alien registration card, birth certificate, social security card, among others.
- 940: When you run payroll, you will pull out and withhold certain taxes to send to the federal government. One of those taxes is the Federal Unemployment Tax. That money is used to compensate workers who are unemployed and are qualified to receive assistance. You will need to fill out a 940 form every year to declare your payroll: how much your employees earned and how much money you pulled for your unemployment taxes.
- 941: This important payroll tax form tells the federal government how much you paid your employees and how much money you withheld to pay for income taxes, social security taxes, and Medicare taxes. You will file the form and then send the IRS the money you withheld from employees when you ran payroll.
- 944: If you are a big company running payroll, you will pay your payroll taxes every quarter, and this form doesn’t apply to you. However, if you are a very small business and your total withholdings for payroll taxes are less than $1000, then you can file a 944 form once a year.
The phrase processing payroll means several things. We’ve already discussed the biggest decisions regarding setting up payroll. To process payroll means all of these things:
- Determining your employee’s wages and salaries
- Determining an employee pay schedule
- Calculating payroll taxes
- Withholding payroll taxes from employee paychecks
- Delivering paychecks with the proper withholdings
- Submitting taxes to the government
- Dispensing paperwork to employees via W-2 or 1099s.
Payroll is not a single step, but a collection of steps that lead to paid employees and a paid government — keeping the people you employ happy and the tax gods happy. Here are the factors to consider in order to set up and process payroll:
Who Is On Payroll?
You’ve hired an employee. Yay! Now, you need to pay that employee. Your payroll will include any W-2 and 1099 employees you pay regularly. But not everyone who works for your business will need to be processed through a payroll system, so who does get paid via payroll?
Whether or not someone is considered an employee has a lot to do with whether or not you control his/her workload, control his/her paycheck, and control your relationship. (If you have control over another human…you’re the boss!) If you can say yes to any or all of those questions, then that person is your employee and you have legal requirements related to paying that individual. If you’re super confused about whether or not you are someone’s boss, you can fill out an SS-8 form with the IRS and they’ll help you figure out the classification.
A contractor is not an employee. They are a freelancer helping your business for a set time or a set project, and are paid according to their contract. Contract employees are responsible for withholding their own taxes! When you run payroll for contractors, pay them their wage and your part is done. (Easy peasy.)
Now it’s time to make important choices about how often your employees will get paid. Twice a month? Once a month? Once a week? Here are the options, challenges, and benefits of each.
On a weekly payroll schedule, employees would receive a paycheck each week for a total of 52 pay runs per year. Some employees like being paid weekly; it can be good for monthly budgeting. However, running payroll every week can be a time-consuming practice for you or your accountant. Many payroll companies will charge you each time you run payroll, so a weekly payment schedule might seem nice, but it’s expensive and hard on the people in your accounting department (or if you don’t have an accountant: you).
A bi-weekly paycheck would arrive every two weeks, regardless of how that week fell on the calendar. Bi-weekly payroll doesn’t always even out since every month is not exactly four weeks. With bi-weekly payroll, there’s a total of 26 pay runs per year (which means that most months, employees will receive two paychecks per month, but twice a year they will receive an extra check). This means the paychecks may appear to come inconsistently and some people find this harder to rely on.
A semi-monthly paycheck arrives twice a month, usually on a set date (for example: the 1st and the 15th; or the 15th and the end of the month). Unlike bi-weekly payroll, semi-monthly payroll has a total of 24 pay runs, meaning employees will get paid twice a month no matter what. Semi-monthly is the best for employees who earn a salary but is cumbersome for calculating overtime.
On a monthly payroll schedule, employees receive a paycheck once a month. Some employees don’t like the once a month payments, but with only 12 pay runs a year, it is the easiest on the person running payroll. The end of the month corresponds with payments to the IRS, so it can be simple to withhold, collect, and report.
One of the components of payroll is giving each employee a pay stub. This is a formal piece of communication between you and your employee about how much they earned and how much you withheld. Each pay stub also includes all the year-to-date figures. The type of information required on a pay stub varies by state.
Payroll Payment Methods
When the time arrives to give your employees their paycheck, you have several methods to choose from. You may offer payment choices to your workers, or you can choose for them. Here the three most popular options you can use to distribute your payroll:
1. Payroll Checks
You can give your employees a paycheck. Manually filling out handwritten checks might take a long time every payroll period, but there are automated ways to print checks, too. (Some require a special printer, so be sure to talk to some payroll experts about your needs.) A check has several benefits: employees don’t need a bank account and there are low distribution costs.
2. Payroll Card
A payroll card is similar to giving employees a preloaded credit card — actually, that’s exactly what it is. Every pay cycle, you put money on a payroll card and employees can use the payroll card wherever debit/credit is taken, or pull the money out as cash. These payment cards are gaining in popularity. This is another method that doesn’t require a bank account.
3. Direct Deposit
If you don’t want to mess with checks and cards, direct deposit into an employee’s bank account can be the way to go. This is the most common way employers pay their workers, and it’s easy: if you have an automated online payroll system, linking a direct deposit creates a seamless payroll. However, it can be expensive to set up and not all employees may have a bank account.
How To Run Payroll
Alright, now the nitty-gritty part of this process. You know what kind of employees you have, they’ve filled out their paperwork, you’ve decided to pay them bi-weekly (or, you know, whatever), you’ve learned about rates of withholding and benefits, and you know how the employees want to receive their money. Bam! You’re on a roll! But now what? How do all those numbers and choices combine into a seamless process that won’t eat up major hours of your time?
Here are the options you have as an employer for calculating and processing payroll.
Manually Calculate Payroll
Manual payroll might be your only choice, financially or otherwise, and that’s okay. If you have only a handful of employees, it could be more cost-effective to do those calculations by hand. If you have a salaried employee, you’ll take their salary, divide it up among the pay periods, and withhold the necessary taxes. For hourly employees, you will examine their time cards and make the calculations based on their hours and rate of pay.
Manually running payroll is cost-effective for your small business and could be a good choice if you feel comfortable and confident working with numbers, and you only have a handful of employees.
For example, you have an employee named Jim. Jim’s a salaried guy making $50K a year, with no overtime. Jim gets paid every two weeks, so his salary of $50K is divided up across 24 payments. 50,000/24 = $2083.33 is his GROSS pay every two weeks. You will still need to withhold payroll taxes though. You can use the IRS’s tax withholding percentages to help you calculate this.
According to the IRS, for a bi-weekly gross pay of $2,083.33, federal withholdings are $267.00, social security withholdings are $129.17, and medicare is $30.21, which means you’d give your employee a NET amount of $1717.37 on their bi-weekly paycheck.
How did I calculate that? Well, I did spend some time with a calculator and the federal rates we discussed above. Then I checked my numbers against a payroll software program. Was I right? Yup! Did the software calculate it faster and give me more confidence? Well, also, yup. So, if manual calculation doesn’t get you feeling all fun and loose, there’s a software for that.
Business software has come a long way in recent years, and payroll software is no exception. There are tons of online, easy-to-use payroll solutions. The benefits of payroll software include built-in time tracking and payroll calculations, expert help from customer support teams, peace of mind, and saved time.
Merchant Maverick has already reviewed a few payroll software providers, including Gusto and Paychex. These comprehensive payroll reviews cover pricing, features, customer support, user feedback, security, and more so you can make an informed decision about the right payroll software for your business.
The last option is to hire an accountant or a payroll outsourcing company to manage your payroll from start to finish. While a payroll program can do the calculations and manage your tax tables, as the small business owner you might still be the singular responsible person for managing payroll. By outsourcing the entire process, you can rest assured that professionals are handling the numbers, and it doesn’t have to be a monthly or bi-weekly chunk of time.
How To Choose Payroll Software
So, you’ve decided that as much as you enjoyed your high school math classes, you want to trust in computer calculations, and you want to check out available payroll software. There are many options at your fingertips. All those options can also make finding the right payroll software a bit overwhelming. Do you need bells and whistles? How much can you anticipate to pay? What if you make a mistake?
Ask yourself the following questions before you start to look at programs:
- How many workers do I need to run payroll for?
- Do I have mostly salaried employees or contract employees?
- Do I provide a benefits package?
- Do I have a payroll manager who is comfortable with the legal requirements of payroll?
- How much am I willing to pay to outsource the work?
Payroll Software Features
Each software program that helps you with payroll comes equipped with different features. Only you will be able to know what features are needed most for your company. To start, here is a list of all the basic features a good payroll software should have:
- Payroll Processing Abilities: Maybe this should go without saying, but your software needs to calculate and process your payroll, whatever that looks like. Look for integration with timekeeping software, ease of use, etc.
- Tax Calculations: Since this is the trickiest part of payroll, it’s important to have software that you trust to manage and perform automated calculations. There’s less human error and the system will help you file those taxes, too.
- Direct Deposit: Automate everything and make sure when you run payroll that your software has the capabilities to work directly with banks.
- Time & Attendance Tracking: Some payroll software can also be used for timesheets and keeping track of employee hours. If you have many hourly employees, this might be a nice integration tool so you don’t have to import hours from a different program.
Payroll Training & Support
When shopping around for a payroll system that works for you, make sure that it comes with real-person training and help. Should you get stuck, you’ll want to make sure there is someone who understands compliance issues available to help you. If your business doesn’t have an accountant, then purchasing software that comes with human support should be a high priority. Payroll can be complicated, daunting, overwhelming, and there are many opportunities for human error.
But there are also many online support and training opportunities if you want to learn it on your own or pay an employee to become payroll certified.
Cost Of Payroll Software
As with the costs of all things, the monthly number differs depending on need. There are some payroll systems that start as low as $10 a month and no additional fees per employee; however, some programs charge a fee per employee (in the $4-5 range). And some payroll software companies can charge up to $200 a month. With that much of a variance between programs, it’s important to set a budget and decide what features are the most important for your business as you move forward.
Getting Started With Payroll
Paying your employees is not an optional part of running a small business. You need to find a payroll system and a method of running payroll that adds quality to your business, not chaos. Compliance, necessary HR onboarding, and running payroll during tax season are all components of a small business that might make you want to go take a long nap and turn your brain off if you have a tendency to want to sleep for years when life gets overwhelming (…or is that just me?), but in today’s digital world payroll is easier than ever.
Research and understand what you need, know your business, and take the leap into organizing your systems with seamless payroll. The IRS and your employees will thank you.