How to Set Up Payroll for Your Small Business

If you’re just starting a business and expecting to hire employees, you’ll soon tackle the challenge of payroll. Managing payroll is often complicated, and gaining a thorough understanding of key processes before you begin can be a game-changer. 

If you’re processing payroll in your state and want to stay abreast of federal regulations, choose your state from the list below. You will find which payroll taxes and laws your business is required to follow.

This guide lays out the steps to take to ensure successful payroll processing. 

1. Get an EIN

Your Employer Identification Number, or EIN, is like a Social Security number for your company, enabling the IRS to identify your business. It’s also known as a Federal Tax Identification Number (FTIN), or sometimes for corporations just Tax Identification Number (TIN). 

An EIN is used to identify US businesses and the taxpayers required to file the relevant tax returns. The EIN also contains information about the state in which the company is registered. 

Employers use their EIN to file taxes, so in order to process payroll and ensure the proper withholdings and tax payments, you’ll need to get an EIN. The application is free and can be found on the IRS website. 

The application is form SS-4, and it can be printed out and mailed to the IRS or submitted electronically. Once your information on the application has been validated, your EIN is assigned immediately. The EIN will never expire and is never duplicated, even if you go out of business.

You’ll also need to register for state withholdings, for state income taxes and unemployment insurance taxes. 

State income tax withholding registration is generally done through your state’s Department of Taxation, while the Department of Labor often handles unemployment insurance taxes. However, each state is different, so you’ll need to check with your state government.

Your municipality may also require tax registrations, so check with your local government as well.

2. Employee Tax Information

You’ll need to collect several forms from your employees, starting with a W-4 and an I-9 for all W-2 employees. Your state will also have a specific form for employees to fill out to enable state tax withholding.  

Your employees may also need to register with your city and municipality, so again, be sure to check with your local governments. 

These forms are necessary to withhold taxes from payroll checks and must be kept on file. They are not submitted to the IRS or the state. You’ll also need these forms to issue W-2s or, in the case of independent contractors, 1099s. 

To pay your employees via direct deposit, you’ll need to collect their bank information, including account and routing number, bank address, and phone number. You’ll also need an Automated Clearing House (ACH) account with your bank in order to make direct deposits. 

An ACH account allows you to transfer payroll funds to your employees’ accounts.

3. Establish Your Payroll Schedule

Every state has requirements regarding how often you’re required to pay your employees, which is often bi-weekly. You’ll need to check your state’s requirements. 

You can choose to pay your employees more often than required, such as weekly, as long as you meet state requirements. 

4. Calculate Gross Pay

If you have salaried employees, gross pay is simply their contracted fixed pay amount, such as $4,000 per month. For hourly employees, calculating gross pay is easy. 

First, review their timesheets to make sure they have accurately tracked their hours. Then simply multiply their hours for that week, or month, by their hourly rate. 

For example, if Jane works 40 hours in a week at $15 per hour, her gross pay (40 x 15) is $600. 

Keep in mind that state overtime law dictates requirements for paying overtime. If you fail to pay your employees the correct overtime rate, your business could face serious fines and other penalties. 

To calculate overtime pay, take the number of hours worked over the state limit and multiply it by their hourly overtime pay rate, which is usually 1.5 times their regular rate. Be sure to carefully review your state’s overtime rules.

For example, if Jane worked 10 overtime hours at $22.50 ($15 x 1.5), she would be owed (10 x 22.5) $225. Adding in her normal hours from above, Jane’s total gross pay for that week would be $600 + $225 = $825.

These calculations can be easily done in a spreadsheet, which should then be kept in your records in case any pay disputes arise. 

5. Determine Withholdings, Deductions, and Allowances

Exemptions are the same as allowances — both refer to money taken out of an employee’s paycheck. Allowances are specified on the employee’s W-4. 

Payroll deductions, which are specified by the employee on their tax returns, are amounts that can be deducted from taxable income. When determining withholding amounts, refer to your employees’ tax forms and be sure they filled them out correctly. 

Deductions can include the following:

• Federal taxes
• Social Security
• State taxes
• Local taxes
• Medicare
• 401(k) contributions
• Workers’ compensation contribution
• Unemployment withholding
• Other benefits, such as company-subsidized health insurance

Jane, for instance, might pay $130 in federal taxes, $15 in social security, and $40 in state taxes, in addition to $30 in 401(k). Thus, her total withholdings would be $215. Again, it’s a good idea to use a spreadsheet to record the totals for each employee.

To calculate federal income tax withholdings, refer to IRS Publication 15. You can find information on withholding state taxes by checking with the relevant department in your state, usually the Department of Taxation.

Be sure to check with your local government about required local withholdings.

6. Calculate Net Pay

To calculate net pay, simply deduct withholdings from the gross pay you previously calculated.

Gross pay – Withholdings = Net pay

So, Jane’s net pay for the week detailed above would be $825 minus $275, which equals $550.

7. Pay Employees

To offer direct deposit, you’ll need to first set up an ACH account with your bank, which will require a business bank account. You can usually set up ACH online following your bank’s instructions. Once your account is set up, just add your employees as payees. 

Then, you’ll process the ACH payments through your bank and provide every employee with a pay stub detailing itemized withholdings. This also applies if you issue paper checks. 

8. Keep Records

It’s important to keep detailed payroll records, which can be used in the event of an error or dispute. You’ll also need these records to calculate your own payroll tax payments. 

If you do your own payroll and tax calculations by hand, you’ll want to keep ledgers of everything you withhold and pay. But keep in mind that most accounting software tools, like QuickBooks and Freshbooks, incorporate payroll accounting capabilities and will do this work for you. 

If you’re just starting your business and planning to do your own accounting and payroll, you may want to consider purchasing some quality accounting software. It will not only save you a great deal of time, but also ensure error-free payroll and tax calculations. 

9. Pay Federal Payroll Taxes

Following IRS guidelines for depositing withheld taxes and paying your payroll taxes is absolutely crucial. Here are the instructions from the IRS website:

Depositing Employment Taxes

In general, you must deposit federal income tax withheld as well as employer and employee social security and Medicare taxes.

There are two deposit schedules, monthly and semi-weekly. Before the beginning of each calendar year, you must determine which of the two deposit schedules you are required to use. To determine your payment schedule, review Publication 15 for Forms 941, 944 and 945. For Form 943, review Publication 51.

Deposits for FUTA Tax (Form 940) are required for the quarter within which the tax due exceeds $500. The tax must be deposited by the end of the month following the end of the quarter.

You must use electronic funds transfer (EFTPS) to make all federal tax deposits. See the Employment Tax Due Dates page for information on when deposits are due. If you fail to make a timely deposit, then you may be subject to a failure-to-deposit penalty of up to 15 percent.

Reporting Employment Taxes

Generally, employers must report wages, tips and other compensation paid to an employee by filing the required form(s) to the IRS. You must also report taxes you deposit by filing Forms 941, 943, 944, 945, and 940 on paper or through e-file.

Federal Income Tax and Social Security and Medicare Tax

In general, employers who withhold federal income tax, social security or Medicare taxes must file Form 941, Employer’s Quarterly Federal Tax Return, each quarter. This includes withholding on sick pay and supplemental unemployment benefits.

File Form 943, Employer’s Annual Federal Tax Return for Agricultural Employees, if you are filing to report agricultural wages.

File Form 944, Employer’s Annual Federal Tax Return, if you have received written notification about the Form 944 program.

File Form 945, Annual Return of Withheld Federal Income Tax, if you are filing to report backup withholding.

Federal Unemployment Tax Act (FUTA)

Only the employer pays FUTA tax and it is not withheld from the employee’s wages. Report your FUTA taxes by filing Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.

10. Pay State Payroll Taxes

You’ll need to check your state’s processes for paying state income tax withholding payments as well as unemployment insurance tax payments.

Again, be sure to check with your local government about local payroll taxes. 

Using a Payroll Service

Processing payroll can be terribly complex, which is why it’s so important to have a strong understanding before you attempt to do it yourself. This also explains why many business owners turn to a payroll service provider. It’s often less expensive than creating a new staff position for managing payroll. 

Payroll and payroll taxes come with countless laws and restrictions, and a payroll service can ensure your business remains in compliance at the federal, state, and local levels. 

You’ll just send over your digital timesheets and relevant information and the service provider will take care of the calculations, payments and taxes, freeing you to focus on growing your business. We highly recommend hiring a payroll service — as a busy entrepreneur, you won’t regret it!