Payroll for small businesses

Effectively administering payroll can be the difference between retaining and losing key employees. Just a few payroll errors would lead 49 percent of employees to start job hunting. Plus, errors can be costly: about 28 percent of small and mid-sized businesses have gotten a notice or been audited by the IRS, thanks to payroll mistakes.

As you focus on this crucial part of running a business, here are a few basics to help get payroll right.

Get set up right

Getting your legal and procedural payroll ducks in a row is the first step toward creating an effective payroll process. In order to successfully complete your set up, you must do the following:

  1. Get an EIN from the Federal government

An EIN is your Employer Identification Number, and this is the number the IRS uses to identify your business for tax purposes. Thankfully, getting one is relatively simple (and much less painful than filing taxes can be!). You can apply for free on the IRS’s website here.

  1. Check your local regulations

You may be required to register with your city and state for tax purposes as well. Regulations vary, so be sure to look into the requirements for your specific location.

  1. Collect employee documentation

To run payroll properly and stay compliant, employers are required to collect the following forms from new hires:

  • I-9 Employment Eligibility Verification Form – This document proves an employee’s legal status allowing them to work in the US.
  • W-4 Withholding Allowance Certification – This is required to accurately calculate your employees’ Federal Income Tax (FIT) withholdings. Don’t forget, there’s a new W-4 form for 2020 that’s a little different from what you and your employees are used to.
  • State Withholding Forms – If you live in a state that has a State Income Tax (SIT), you will likely need your employee to fill out a state withholding form so you can calculate SIT withholdings.
  1. Choose a pay schedule

Your payment schedule is the “when” of your payroll. It determines how often your employees or contractors will be paid and the length of your pay periods. There are several options available:

  • Weekly – Employees are paid once a week for work completed during each pay period. This makes each pay period one week long, and it means employees will receive payment 52 times per year. (And you have to prepare payment that many times as well.) This is the most popular option for businesses with hourly employees.
  • Bi-Weekly – Employees are paid every two weeks on the same day, so there are 26 paydays each year, which makes it easy to get a payroll routine down. This is one of the most common payment schedules, especially if you have mostly salaried employees. The downside is that you’ll occasionally have three payrolls in a month, which can make managing cash flow a little tougher.
  • Semi-Monthly – Under this pay schedule, employees receive checks twice a month, on the same two dates every month (the first and the 15th, for example). It results in 24 payments per year, which makes your business cash flow a little more consistent than bi-weekly payrolls, but it’s a little harder for you to have a payroll routine because pay runs will fall on different days of the week.
  • Monthly – While less common, this schedule is sometimes used for highly paid individuals. Each payee under this structure receives payment once per month, ultimately receiving 12 paychecks per year. Some states have rules against paying staffers monthly, so be sure to check what your state allows before committing to an infrequent pay period.

There are pros and cons to each pay schedule, so it’s crucial to consider the unique needs of your business, along with your payroll capabilities, and applicable Department of Labor regulations when choosing yours.

Time for payroll: Gross vs. net pay

With your paperwork in order and your pay period determined, the next stage in the payroll process is determining your employees’ gross and net pay — two very important numbers:

  • Gross pay is the amount an employee is owed for his or her work during the pay period.
    • For an hourly employee, it’s calculated by multiplying their hourly rate by the number of hours they worked.
      • Hourly rate x hours worked = gross pay
    • For a salaried employee, the calculation begins with the total amount they are paid per year, divided by the total number of pay periods in the year.
      • Total salary / total pay periods per year = gross pay
  • Net pay is the amount the employee will receive in their paycheck.
    • This calculation begins with the employee’s gross pay, then subtracts out applicable withholdings and deductions.
      • Gross pay – withholdings and deductions = net pay

Deductions and withholdings

Deductions and withholdings are what get you from gross pay to net pay. They come in several forms:

  • Federal taxes – You must withhold federal income taxes, along with Social Security and Medicare deductions from each paycheck
  • State taxes – If your employees live in a state with state income taxes, you will need to withhold those as well. In addition to income taxes, some states have other taxes (like disability taxes in California) that employers are responsible for withholding. Check with your state to find out exactly what you need to withhold.
  • Employee-specific deductions – Often employees will choose to deduct health insurance payments, retirement plan contributions, or charity donations from their paychecks as well, creating additional deductions and withholdings from their gross pay.
  • Garnishments and levies — It’s also possible that you’ll be required to withhold money your employee owes other people or agencies. For example, wages may be garnished for child support, back taxes, and other obligations.

It’s important to note that the federal government collects Social Security and Medicare taxes from both employees and employers, so you will need to calculate and set aside both your employees’ contribution amount and the amount you owe as the employer. As an employer, you’ll also be on the hook for unemployment taxes.

Paying employees

Once you have completed calculations for gross and net payments to your employees, you’ll be ready to pay your team. Your payments can take multiple forms, depending on your business’s capabilities and your employees’ needs.

  • Checks – While straightforward and simple, cutting physical checks introduces the risk that employees may lose checks, extends the period of time an employee must wait to access the funds, and often is more time consuming to prepare and distribute than alternative methods.
  • Direct Deposit – A simple, reliable, and speedy way to distribute payroll, direct deposits send an electronic deposit directly to employees’ bank accounts, saving you time and saving employees a trip to the bank.
  • Other – Less frequently, businesses may use pay cards or cash, but these methods carry the risk of payments getting lost and an increased documentation requirement to remain above board, so they should be used with caution.

Payroll tax reporting and payment

Once you have calculated your employees’ deductions and set aside the amount owed for taxes, the next step is making your tax payments and filings. All the income tax withholdings described above generally must be submitted on a monthly or semi-weekly basis to the appropriate tax authorities. In addition, most businesses are required to file payroll-related tax forms quarterly and at the end of the year.

It’s worth the time to create a calendar of due dates so you don’t miss any.

Specifically, the IRS requires:

  • Form 940 – Submitted annually, this form documents your federal unemployment (FUTA) tax liability and the amount that you have paid on the liability to date.
  • Form 941 – This is a quarterly report documents your business’s payroll tax liability and what payments you have made to date.

Most states require quarterly reports on unemployment and workers’ compensation tax liabilities. You’ll also need to give each employee a W-2 form at the end of the year so they can file their own taxes, and then use Form W-3 to submit all those W-2s via paper filings to the IRS.

How to manage your payroll

Getting payroll right is central to running your business smoothly, so determining the best approach to taking care of your payroll duties is essential. Each option has pros and cons you will need to weigh:

  • DIY – The lowest-cost option is to handle payroll internally. However, if you or your team are already stretched thin, going this route could end up tying up a lot of time that’s needed elsewhere. While it’s certainly feasible for a small business to calculate payroll internally, there is a steep learning curve and stiff consequences if anything goes wrong. For the average small business owner, doing payroll yourself takes about 18 hours a month.
  • Use payroll software or a service provider – Payroll service providers are there to ensure everything runs smoothly when it comes to processing payroll, automating tax deductions and filings, and handling end-of-year W-2s and 1099s. There are very different levels of service (and cost), so it’s important to get a clear understanding of what you’ll need to do and what your provider will handle, as well as what fees are involved.
  • Hire an outside accountant or bookkeeper – Asking your tax pro to handle your payroll can be a smart investment — and a fantastic resource for your business. They stay on top of rules and regulations and can offer expert opinions when complex issues arise. Using your accountant or bookkeeper for payroll also simplifies bookkeeping and has you organized when tax time rolls around.
  • Hybrid accountant + provider – This is a good option if you like the idea of putting technology to work to process and manage payroll while having expert help at the ready — giving you the best of both worlds. As the business owner, you can be as involved or uninvolved as you want to be.

Now that you know everything that goes into running payroll, you should be able to start assessing your options. To avoid mistakes or paying employees late, it’s important to have a routine you can stick to. So spend some time thinking about the pros and cons of each approach — and how much you can realistically take on — before making your decision.

This article was originally written by OnPay, a payroll company we partner with to help you get more of your to-dos done.

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