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What Is Payroll?

Written by:

Edited by:

Reviewed by:
Daniel Eisner and Mark Stewart

Published on September 25, 2022

Updated on November 17, 2022

What Is Payroll?

What Is Payroll?

If you’re starting a business and expecting to hire employees, payroll, or the process of paying your employees, is going to be a critical function. It may sound simple, but it’s actually a complex process, with countless rules and regulations. 

Lucky for you, this guide lays out all the details of the payroll process to ensure you’re able to effectively run your business. 

How Does Payroll Work?

Doing payroll, or running payroll, as some say, requires a number of key steps.

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 first obtain your 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. This is usually done with your state’s tax department. Some states issue a state tax identification number. Your municipality may also require tax registration, so be sure to check with your local government.

2. Employee Tax Information

You’ll need to collect a number of forms from your employees, starting with a W-4 and an I-9 for all employees. 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. Your state and local governments may also require your employees to fill out a state-specific form.

If you plan to pay employees by direct deposit, you’ll need to collect their bank information, including account and routing number, address, and phone number. You’ll also need an Automated Clearing House (ACH) account with your bank, which allows you to transfer payroll funds to your employees’ bank accounts.

accountant using calculator for payroll

3. Establish Your Payroll Schedule

Every state has rules about the length of pay periods, which are either weekly, bi-weekly (every two weeks), semi-monthly (twice a month), or monthly. You can choose to pay your employees more often than advised, 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 $2,000 per week. 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 in your state, the overtime law dictates when and how much you must pay for overtime. If you fail to pay your employees the correct overtime totals, your business could face serious fines and other penalties. You might want to invest in some payroll software or payroll processing tools. 

To calculate overtime pay, take the number of hours over the state requirement and multiply it by your state’s hourly overtime pay rate. 

So if Jane worked 10 overtime hours and the required rate is 1.5 times the hourly rate, at $22.50 ($15 x 1.5), she would be owed (10 x 22.5) $225. Adding in her normal hours, Jane’s total gross pay for that week would be $600 + $225 = $825.

These calculations can be easily done in a spreadsheet. You should keep the spreadsheets for your records in case any pay disputes arise. 

5. Determine Withholdings, Deductions, and Allowances

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

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

Deductions may include:

  • 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, as it makes calculating and remembering much easier.  

  1. 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.

  1. Pay Employees

If you offer direct deposit as an option for employees, you’ll need to first set up an ACH account with your bank, which will require having a business bank account. You can usually set it up online following your bank’s instructions. Once your account is set up, you’ll 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. 

  1. 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 or Freshbooks, incorporate payroll accounting capabilities and will do all 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 ensure error-free payroll and tax calculations. 

  1. 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.

  1. Pay State Payroll Taxes

Be sure to follow your state’s procedures for paying state payroll taxes, and check with your local government to learn the procedures for any local payroll taxes. 

Using a Payroll Service

Processing payroll can be quite complex, so you might want to consider using a payroll service. It’s likely to be less expensive than creating a new staff position for managing payroll. Payroll and payroll taxes come with countless laws, rules and restrictions, and a payroll service can ensure your business remains in compliance at the federal, state and local levels. 

With a payroll service, all you need to do is send your digital timesheets and relevant employee and business information, and all the calculations will be made for you. The service will take care of payments as well as taxes, freeing you up to focus on running, and growing, your business. 

We highly recommend hiring a payroll service for your business — as a busy entrepreneur, you won’t regret it!