How to Do Payroll for Your Small Business [The Ultimate Guide]

Has your business grown to the point that it’s time to hire help? On one hand, that’s great news. But, on the other hand, payroll for small business owners adds another layer of complexity to the act of running your business.

Most small business owners don’t have a background in HR, accounting, or bookkeeping. So how can you set up a payroll system that keeps you on the good side of the IRS without consuming too much of your valuable time?

Having W-2 employees means you’ll have to do payroll. Along with paying their salary, you’ll need to provide worker’s compensation and unemployment insurance. You’ll also be responsible for paying half of their Social Security and Medicare taxes. You’ll need to calculate their income tax withholdings and submit the taxes and file reports to the government on time. You can do all this with either a payroll software or a full-service payroll provider.

Table of Contents

What is Payroll?

The term “payroll” can mean many things. But, in the most general of senses, payroll is the process by which a company calculates and sends pay to its employees.

A company’s payroll system will involve the mechanisms used to track employee hours and time off, the method and timetable by which payments are remitted, and the tools used to calculate an employee’s tax withholding and send to the IRS by the specific deadlines.

Requirements of Payroll

Having W-2 employees means doing payroll. If you have hourly employees, they will submit their hours for each pay period and you are required to pay them upon the schedule you have previously determined–typically weekly, bi-weekly, or semi-monthly.

Calculating payroll means determining the employees gross wages, then withholding income, Social Security, and Medicare taxes.

The taxes that have been withheld then need to be submitted to the government upon a set schedule. For most small business this will be required monthly. However, for large businesses, this can be required as often as weekly.

Quarterly reports are also required. You must file a 941 form each quarter. This form tells the federal government how much payroll you paid as well as how much income tax you withheld and submitted. State filings will also be required, so double-check with your state for their forms and dates.

You will also be required to send annual reports. You will have to process W-2s for your employees and for the government. You also have to send in a 940 form to the federal government for federal unemployment taxes–and you may have to do this more frequently depending on the amount of your payroll during the year.

What is the Cost of Personnel?

The cost of having employees is more than just their wages. You will have additional costs such as extra taxes, insurance, and a payroll service.

Taxes

When you hire someone to work for you 15.3% of their wages are paid towards payroll tax. This is made up of 12.4% to Social Security and 2.9% for Medicare.

Contractors pay this entire amount themselves. But employees only pay half themselves and their employer is required to pay the other half. Therefore, when you pay your employees their wages, your costs are actually 7.65% higher.

For example, if your employee earns $1,000 per week. Your actual cost is $1,076.50 per week.

Insurance

You are required to carry both unemployment insurance and worker’s compensation insurance.

Unemployment insurance is paid to the state and provides benefits to workers who have been laid off. Your rates will be set by your risk level. If you work in an industry that has high layoffs, such as landscaping or other seasonal industries, your rates will be higher than in an industry that doesn’t typically have high layoffs. Your rates will also be determined by how much payroll you are paying. The more payroll you have, the higher your costs.

You can keep your personal rates down as much as possible by avoiding layoffs and fighting illegitimate claims. Sometimes disgruntled employees will try to file for unemployment after they have been fired. Don’t allow this. Everyone who makes a successful claim against your company will increase your rates. If they are not entitled to benefits do your best to keep them off your policy.

Worker’s compensation insurance is paid to an insurance company (or sometimes the state) and covers employees if they are hurt on the job. Again, your rates are set based on your risk level. The more dangerous your industry the higher your rates will be. And just like with unemployment insurance, your personal rates will also be based on the amount of payroll you have.

You can keep your rates down by enforcing the safety precautions required for your type of work. Obviously, you don’t want your employees injured no matter what… but keeping your worker’s comp rates down is an added benefit.

Your employee bears none of these costs. Unemployment and worker’s compensation are both paid 100% by the employer.

Payroll Service

There are a lot of calculations that go into payroll. It’s not simply hourly rate times hours worked. Because of that, you’ll want some kind of payroll service to do this math. Not only will the payroll service calculate the employee’s income tax withholding, it will also calculate their (and your) Social Security and Medicare taxes, as well as the unemployment insurance costs.

If your worker’s compensation policy is with the state it will calculate that as well. If your worker’s compensation policy is with a private company you will likely deal directly with them and this cost will not be calculated through your payroll service.

How Do I Set Up Payroll For the First Time?

There are a few documents that you’ll need to collect before you can kick off your payroll system. You’ll also need to think through your record retention policy and your payment frequency.

What Payroll Documents Do I Need?

Setting up payroll for small business owners requires for them to apply for an Employer Identification Number (EIN) with the IRS. It’s free to obtain an EIN and shouldn’t take you more than 5 minutes. In some states, you may need to apply for a state EIN as well.

If you have an LLC or Corporation then you already have an EIN.

When it comes to your employees, each of them will need to fill out a W-4. This is important because it tells you how much tax you should withhold on your employee’s behalf from each paycheck. Each employee will also need to fill out an I-9 form to verify their identity.

You’ll also need at least your unemployment insurance rates and maybe your worker’s comp rates.

Finally, you’ll need to create a system to track your employee hours. Technically, this could be as simple as a sign-in sheet. A time card system is popular with many small businesses. But if you have a remote workforce, a computer-based or phone-based tracking system may work best.

What Should My Payroll Record Retention Policy Be?

The Fair Labor Standards Act (FLSA) dictates that employers retain several payroll-related documents for at least three years. Those documents are:

Employee’s full name and social security number
Address (including zip code)
Birth date (if younger than 19)
Gender and occupation
Dates of employment
Time and day of week when employee’s workweek begins
Hours worked each day
Total hours worked each workweek
Basis on which employee’s wages are paid
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

For more information about record retention requirements, check out this fact sheet from the Department of Labor.

What Payroll Frequency Should I Choose?

How often will you pay your employees? Paying them weekly ensures that you won’t run into any compliance issues, but it’s also the most labor-intensive. If you’d like to pay less often than each week, check with your State Department of Labor to find your state’s minimum payment frequencies.

If you’re allowed to choose semi-monthly or bi-weekly pay schedules, either option will cause you less headache than a weekly payment frequency. But they each have a few pros and cons, as outlined below.

Weekly

With a weekly payroll schedule, your employees are paid on the same day every week. A typical schedule will go like this: they submit their hours at the end of the day on Friday for hours worked that week. Then you’ll have a few days to process payroll and they will receive their check on the following Friday.

This payment schedule is typical for lower-paid workers.

The benefit of this schedule is that employees get paid more frequently. This can make it easier for them to manage their cash flow.

The downside is that you will have to process payroll every week, no matter what. Even if you are on vacation or are sick, you’ll still have this responsibility or your employees will not get paid.

Semi-monthly

With a semi-monthly pay schedule, you pay employees on the same two calendar days of every month–for example the 1st and the 15th. For payroll for small business owners, a semi-monthly schedule can make it easier to plan your other expenses around your payroll dates.

This schedule works best for employees who are paid salary, rather than hourly.

However, there are downsides to a semi-monthly payroll schedule. The first problem is that paychecks won’t be exactly the same. The number of days and hours worked during the first pay period may be slightly higher or lower than the second.

The second downside to a semi-monthly schedule is that payday will fall on different days throughout the week each month. One payday could be Tuesday, the next Friday, and the next Monday. From the employer side, this can make it difficult to schedule a consistent time to process payroll. And from the employee side, if payday happens to fall on a weekend or holiday, it can cause a delay in payment.

Bi-weekly

With a bi-weekly payroll structure, employees are simply paid every two weeks. For the employer, this helps you set up recurring payroll processes. And, for the employee, they can count on having a paycheck hit their bank account every other Thursday, Friday, or whatever day you set.

The only disadvantage to bi-weekly payroll is that there are some months where you’ll need to make three payments to your employees instead of two. And, from an accounting perspective, this will cause your payroll expenses to be higher that month than others.

Difference Between Employees and Contracted Workers

Since we’re talking about payroll for small business owners, it’s important to consider whether or not you even need to set up payroll. If you only work with freelance contractors, then you don’t. How do you know whether the people who work for you are employees are contractors? According to the IRS, it’s all about the degree of independence the worker has.

Does the worker set their own hours and do they provide their own tools and supplies? If so, they may be considered an independent contractor. Also, independent contractors tend to be more project-based. If you’re having someone do a myriad of tasks for you every day, there’s a good chance, the IRS may consider them an employee.

To learn more about the factors that determine W-4 employee or W-9 contractor status, read the IRS guidelines.

Do You Have W-4 Employees?

If so, keep reading this guide to payroll for small business owners. You will need to set up a payroll system and be sure to follow all the IRS guidelines for pay frequency, record retention, and tax withholding.

Do You Have W-9 Contracted Workers?

You don’t need to do payroll if you only have W-9 contracted workers. Instead, you pay them by whatever means and frequency you both agree upon. And you don’t need to worry about tax withholding. You will, however, need the contractor to fill out their W-9. And if you pay any contractors more than $600 during the year, you’ll need to send them a 1099-MISC at the end of the year.

How Should I Handle My Small Business Payroll?

There are two main ways to handle your small business payroll: a service, or software. The main difference between the two services is that a service will remit the taxes and submit the forms to the government on the correct schedule.

Here are the pros and cons of each.

Should I Do Payroll With a Service?

While this is the more expensive option of the two, the great part about this option is that your payroll headache drops to zero. You’ll provide employee information, such as wages and W-4 information, and pay schedule and the service provider will take it from there.

You will still have to go into the service each pay period and “process” payroll. But this is often a few clicks and shouldn’t take more than a few minutes. For hourly employees, you will have to input their hours for each pay period.

From there, the service provider ensures that payroll is processed on time and all tax submissions and reports are sent on the correct schedules. They will also take care of any IRS issues that may arise as well.

They often have systems in place to keep track of things like time tracking, the accrual and use of vacation time, 401(k) contributions, and more.

If you have 10 or more employees, hiring a payroll service could be a good move. But if you have a smaller business, a full-service payroll provider may be a little more than you need.

Should I Do Payroll With Software?

Payroll software will do the payroll calculations for you. It will calculate the correct withholdings from each employee’s check and keep track of how much you owe the government. You are responsible for actually sending in the tax withholdings and submitting the correct forms on time.

When you use a payroll software, you will need to cut your own checks. Or, with some payroll software providers like Square Payroll, you can even set up Direct Deposit.

What Are My Small Business Payroll Software Options?

Whether you have done payroll before or not, you want to pick software with the tools and resources to pay your team with confidence, which will make your life as a small business owner easier!

A quick Google search will surface dozens of capable payroll software companies. Some of the popular options include Square, QuickBooks, Gusto, Wave Payroll, SurePayroll, and Patriot Software Payroll.

Each has its own set of features, but only Square allows you to get started for $5 if you just have a couple of contractors. Square is also the only software that provides a complete ecosystem of tools to help you manage your business.

Plus, if you already use Square for your payment processing, then it’s easy to take advantage of their payroll service.

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The Bottom Line

Payroll for small business owners may seem frightening at first. But with the proper tools, you can get a reliable payroll system up and running in no time. For more ideas and tips for organizing your small business finances, be sure to read the Key Financial Pillars of Building a Start-Up.

How to Do Payroll for Your Small Business [The Ultimate Guide]