The challenges you face when first opening a small business often come as a surprise. It’s a learning process, and you grow stronger with every move.
Like Thomas Tunaitis, owner of Agaru Tattoo in Wilmington, Delaware. After years of working as a tattoo artist, he took what he learned under an apprenticeship and opened his own shop. He admits that the shock of unknown challenges is often what sinks most small businesses.
“The number one piece of advice I would give to aspiring business owners would be to formulate as solid of a business plan as you possibly can. Include your expenses, costs, what you feel like your income is going to be – and then subtract 20 percent from what you think you’re going to make and double what your costs are going to be. If it still seems like a good idea, then it’s the way to go,” he calculated.
Arguably one of the toughest parts of running a business is managing the people who are supposed to help you succeed. From finding great employees to training and retaining, then figuring out the basics of payroll, it’s a lot to add to your plate. Payroll is also a huge expense that could cause even more headaches if not done right.
Here we break down the basics of payroll and everything you need to know to succeed in this realm of your business.
What is payroll?
In the most basic sense of the word, payroll is a list of a company’s employees who need to be paid, along with the amount of money the company has agreed to pay them.
The term payroll encompasses a few different parts.
- The calculation and distribution of paychecks to employees on payday.
- The financial records for employee wages, salaries, withholding, deductions, bonuses, paid time off, and other items on paychecks.
- Record of total earnings of all employees in a fiscal year.
Of course, as you’ll continue to read on – there is a lot more that goes in to this critical business function.
Key payroll terms to know.
Before explaining, well, everything about running payroll for small business – here are a few key terms you should just keep in your back pocket for reference. Think of this as a mini-glossary.
- ACH (Automated Clearing House)
- Base pay rate
- Employee’s Withholding Allowance Certificate (W-4)
- General Ledger
- Gross pay
- Income tax
- Net pay
- Social Security (OASDI)
- Take-home pay
- Taxable wage base
- Third party sick pay
Definitions as well as a downloadable PDF of these terms can be found here.
How to set up payroll for your small business.
Let’s start from the very beginning – setting up payroll for your small business. The moment you hire an employee, you have to pay them, right? Well, here are the steps to follow to get everything set up correctly. Please note that many states and localities require special forms, so please be sure to check your location as well.
Identify your company.
Obtain an Employer Identification Number or (EIN). This is often referred to as an Employer Tax ID or as Form SS-4. This number is necessary for reporting taxes to the IRS and information about your employees to state agencies.
Click here to apply for your EIN.
Are local IDs needed as well?
Some states or local governments require you to obtain ID numbers to process taxes.
Correctly classify your employees.
With such diverse employment options for your small business, it’s important that you know the distinction between an independent contractor, freelancer, and an employee. This will directly affect withholding income taxes, withholding and paying Social Security and Medicare taxes as well as unemployment taxes. The IRS breaks down the difference here.
Your employees are required to complete Federal Income Tax Withholding Form W-4 and return it to you so that you can withhold the correct federal income tax from their pay.
The federal Immigration Reform and Control Act (IRCA) requires employers to hire only individuals who may legally work in the United States.
Form I-9 is required for all U.S. employers to verify the employment eligibility and identity of each employee hired to work in the U.S. (including U.S. citizens). Employers must have a record of this for each employee.
Pay period determination.
When are you going to pay your employees? Sometimes, the determination is made by your state’s law.
The IRS requires that you withhold income tax for that time period, even if your employee doesn’t work the full time. But, let’s say you have an employee who only works 10 hours making $9 per hour. Chances are they make so little that no federal income tax would be withheld. They would still be required to have Social Security and Medicare along with any mandatory state or local taxes.
Get organized with compensation terms.
It’s vital that you track employee hours, overtime, paid time off, and other business requirements while complying with the federal Fair Labor Standards Act.
In addition, you must appropriately calculate other deductibles such as health plans or retirement contributions (if you offer those options) and ensure they’re paid properly.
When you get to this step, that means all of your forms and information have been filed in the appropriate spot. Determine if direct deposit is right for your business or if payroll cards or printed checks are the best option for you at that time.
Federal law requires that you keep Forms W-4 on file for all active employees and for four years after an employee is terminated. State laws may require that you keep other records as well. Here is some general information on how long to keep tax records around.
With running payroll also comes reporting payroll taxes. This tax guide from the IRS provides guidance on the federal tax filing requirements.
Wondering how to calculate payroll taxes? Keep reading.
What goes into a paycheck.
If you’re running payroll, that means your employees are getting a paycheck in some form or fashion. If you’ve ever wondered what all goes in (and out) of a paycheck, or you’ve gotten questions from employees, here’s how to make sense of it all.
A statement will have basics such as name, pay date and pay period dates, and the check number. It also includes the net pay – total amount of money earned after taxes – and any applicable deductions for the current pay period. The statement will usually list filing status (single, married, divorced) as well as the number of dependents.
Earnings are listed for the current pay period and the entire year. This includes a breakdown of hours worked for the current pay period.
It also lists current (or gross pay) amount, which is the amount of pre-tax money earned for the current pay period, as well as the year-to-date amount.
This section is a bit more in depth, but we’re sticking with the basic information here. The majority of U.S. employees are subject to pay Federal Insurance Contributions Act (FICA) taxes. In addition to federal personal income tax, most employees are also subject to state and local taxes.
What payroll deductions are required by law? Mandatory payroll deductions for taxes include – federal income tax, state taxes, local income tax withholding, FICA that includes social security taxes and Medicare tax withholding.
There are also some voluntary payroll deductions that often are a benefit for the employee. That can include charitable donations, employer-sponsored 401 (k) plans, and insurance.
Each year, the IRS publishes income brackets with tax rates for individuals for federal personal income tax. Find that here.
As for FICA – there are two parts, which total 15.3 percent combined. Employees and employers split the costs and pay 7.65 percent each. However, if self-employed, you’re required to pay the full 15.3 percent on their earnings. More on FICA in the next section.
State and local taxes vary by state but are generally used for education, health care, transportation, and more.
How to calculate payroll taxes.
We’ve heard it all. What payroll taxes do employers pay? How payroll tax is calculated? Where do payroll taxes go? Which payroll taxes are the employee’s responsibility?
In this section, we’ve clarified some of those burning questions about payroll taxes.
What is payroll tax?
If your business has employees, you’re required to withhold payroll taxes from employees’ paychecks and pay any applicable federal, state and local taxes.
Federal taxes include the following:
- Federal Insurance Contributions Act (FICA) - Half is paid by the employer, half is paid by the employee.
- Federal Unemployment Tax Act (FUTA) - Paid for totally by the employer.
- Federal income tax - Paid for by the employee.
On the state level, there’s State Unemployment taxes that are mostly the responsibility of the employer. For some states though, like Pennsylvania and Ohio, State Unemployment Insurance (SUI) taxes are the responsibility of both the employer and employee.
Always check your local regulations as there are certain payroll taxes that are as specific as which municipality or township you operate in.
Which workers are taxable?
Before you even get to all these calculations, you have to determine the amount of taxable workers you employ. That might seem like an obvious step, but it could be easy to overlook the tax responsibilities of an employees versus an independent contractor. Most of the time, employees are subject to payroll taxes while independent contractors are responsible for paying their own taxes. However, some states are now requiring state withholding to be remitted by the employer.
The IRS has a comprehensive guide for determining the difference, but here’s a quick set of questions to ask that can help.
Does the company control or have the right to control what the worker does and how he or she does the job?
Are the business aspects of the job controlled by the payer? (Ex. Are expenses reimbursed?)
Are there written contracts or employee type benefits? (Ex. Vacation pay or insurance). Will the relationship continue and is the work a key aspect of the business?
What are the current tax rates?
In order to calculate your payroll tax, you must know the current rates. Keep in mind that whatever the employee puts on their Form W-4 would impact how much or how little they would be taxed.
Here are some federal numbers:
The Social Security tax rate for employees is 6.2 percent of the employee’s gross pay. (So as the employer, you match what the employee pays meaning your rate would be 12.4 percent).
For state unemployment, it varies widely based off factors of what type of business you are and which state you’re in of course.
- The Social Security taxable wage base is $132,900.
- The Medicare tax rate is 1.45 percent of the employee’s gross pay.
- The FUTA tax rate is 6.0 percent of the first $7,000 you pay in wages to an employee.
The Self-Employment Contributions Act (SECA) tax rate is 15.3 percent. This means if you’re self-employed, you pay both the rates for yourself as the employer and yourself as the employee.
For state specific numbers, check our Quick Wage & Tax Guide. We update this resource every year.
What are taxable wages?
At its most basic level, taxable wages are compensation for services performed. This would include salary, bonuses or gifts. Other forms of compensation that you might provide such as business expense reimbursement do not qualify as taxable wages. In order for the expenses to be nontaxable, they must be necessary, reasonable and business-related, and employees have to verify them through receipts or expense reports.
Withholding – What are the responsibilities for both the employee and employer?
Upon hiring, each employee is required to fill out a Form W-4. Federal and state taxes are calculated based off that form. Your employee will provide their filing status and number of allowances they are qualified to take and that is used to calculate the amount held from gross pay.
Federal withholding on payroll taxes are paid using Forms 940, 941 943 or 944. Form 943 is for agricultural employees, and Form 944 is for small employers whose annual liabilities are $1,000 or less.
FICA is the federal law that requires employers to withhold Social Security and Medicare taxes from employees’ wages. It requires the employer and employee to each pay half of the FICA tax.
FICA taxes are unaffected by the number of withholding exemptions claimed by the employee. To calculate, you multiply an employee’s gross wage payment (keep in mind that if there are any pre-tax benefits, that would reduce the wages) by the applicable tax rate to determine how much to withhold and how much you have to pay as an employer. See next section for more on deductions.
Employee - driven deductions.
Do you offer benefits that are funded through payroll deductions? Some are made on a pre-tax basis, thus reducing the amount of pay that’s subject to tax.
Examples of these types of deductions that need to be factored in are:
- Contributions to certain types of retirement plans.
- If you’re a nonprofit, your employees may participate in a 403(b) plan.
- A health flexible spending account (FSA) or a health savings account (HSA).
Employer - FUTA
Now FUTA comes into play. This tax is paid by the employer. You are required to pay this tax if either of these apply:
- You pay wages totaling in at least $1,500 per quarter.
- You have at least one employee on any day for 20 weeks in a calendar year (regardless of if these weeks are consecutive).
If you want to read more on payroll taxes, (because, why not?) click here.
What payroll reports are due annually?
What about quarterly?
Once your employees get an accurate paycheck on time, your payroll job is done for that week, right? Nope. You also need to submit certain payroll reports to ensure you’re staying compliant. Luckily, they don’t need to be submitted every week though.
Every quarter you must file Forms 941 to report federal income, Social Security, and Medicare taxes as well as employee wages. This form is typically due the last day of the month following the end of a quarter.
State payroll reports
On a more local level, many of the state payroll reports due are quarterly. These would include reports on state income taxes and state unemployment taxes.
Similar to a Form 941, Forms 944 are used to report federal income, Social Security, and Medicare taxes on an annual basis. The IRS will tell you if you’re qualified to use Forms 944 or if you must use Forms 941.
This payroll report is used to report federal unemployment tax (FUTA).
Forms W-2 and W-3
Form W-2 is what you give to each employee, as well as federal and state governments. This lists out wages and withholdings and a lot more that you can find explained here.
Form W-3 is the transmittal form for Form W-2, which summarizes all of the employees’ Forms W-2 information.
Believe it or not, some states actually require monthly filings. It’s best to check with your state or locality for more information.
What payroll information must be kept?
No one likes clutter, but when it comes to payroll information, you probably want to keep those documents around for a while. The FLSA actually has recordkeeping requirements that say employers must record and maintain specific information to demonstrate compliance with FLSA standards. That includes minimum wage, overtime, equal pay and child labor.
According to the Society for Human Resources Management (SHRM), information must be made available to DOL representatives within 72 hours of a request.
The DOL lists the following as basic records that employers must maintain:
- Employee’s full name and Social Security number.
- Birth date if younger than 19.
- Sex and occupation.
- Time of day a week when employee’s workweek begins.
- Hours worked per day.
- Total hours worked each workweek.
- Basis on which employee’s wages are paid (ex. $9 an hour.)
- Regular hourly pay rate.
- Total daily or weekly straight-time earnings.
- Total overtime earnings for the workweek.
- All additions to or deductions from the employee’s wages.
- Total wages paid each pay period.
- Date of payment and the pay period covered by the payment.
The DOL explains that records that wage computations are based should be retained for two years. Ex. time cards, or work and time schedules.
For more on these requirements, please click here.
What payroll deductions are required by law?
Mandatory payroll deductions for taxes include – federal income tax, state taxes, local income tax withholding, FICA that includes social security taxes and Medicare tax withholding.
There are also some voluntary payroll deductions that often are a benefit for the employee. That can include charitable donations, employer-sponsored 401 (k) plans, and insurance.
How do payroll companies work?
If you’re reading all of this and thinking that you’d rather not have to deal with the compliance aspect of paying your employees, you might consider outsourcing payroll to a trusted provider. But what do payroll companies do?
What is payroll software?
Payroll software is designed to organize everything related to employee payment and filing of employee taxes. Once employee wage information and hours are input into the system, the software will perform calculations that result in gross wages and deduct the necessary withholdings. A basic payroll service will also mail out Forms W-2 and 1099 and handle dealings with the IRS or other government agencies.
Of course, those are just the basics. More comprehensive payroll solutions can cover other business functions such as administering benefit accounts or retirement plans. Many payroll companies will offer you the ability to process payroll online, making it easy to input information on your own, at your own pace.
As far as cost for using a payroll provider, it really depends. Many pricing structures are determined by the number of employees you have, how many pay periods, and how comprehensive the services are.
Before you outsource – consider this.
The truth is, outsourcing payroll functions is one of the smartest decisions you can make as a small business owner. It’s cost-effective, compliant, time-saving, and gives you peace of mind. But before making your decision, here are a few savvy questions to ask a potential provider:
- What does your basic service model include?
- Are there options to upgrade?
- What do you offer that the competitors don’t?
- What information do I need to sign up?
- What is the setup process like and how long until I will be able to run my first payroll?
- With your tax filing service, do you cover the penalties and/or interest charges?
- Do you offer filing assistance for local taxes?
- Do you handle taxes if I have employees in multiple states?
- Can you work with my CPA/accountant?
- How do I know my information is safe?
- What security measures do you take to ensure this?
- Will I work with the same customer service rep every time I need something?
- How often will I see my sales rep?
- Do you stand behind your work?
- What happens if you make a mistake; will you pay the penalties?
- Can you provide a couple of references from other small business owners?
- What’s the average length that clients stay with you?
- Are there any hidden fees that have not been mentioned yet (ex. startup costs)?
- What does your service cost for one year?
- How long are these rates in effect?
- Do you charge if I add more employees to my payroll?
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