Calculating payroll accurately is essential to running a sustainable small business. But you also have to be aware of labor laws and federal and state tax requirements (before you hire your first employee).
It can be complex managing payroll processes because you have to factor in different calculations and deductions. But with the right guidance, advice, and tools, payroll management becomes easier.
Payroll's purpose is to streamline payroll and the calculation of taxes and deductions. So here’s a guide to help you do just that. Continue reading to learn what it takes to build an efficient payroll management system.
The benefit of managing payroll for your small business
If you don't manage your payroll properly, it could lead to issues with the IRS. So to reduce the odds of being audited and owing money to the government, you need a way to manage payroll efficiently.
In doing so, you can yield the following results:
Reduced costly errors: Something as simple as a missed tax filing can cost you hundreds in penalties. Having an efficient payroll system prevents mistakes that can hurt your bottom line.
Organized financial documents: This is critical, especially when the IRS requests specific documents from you. Or when you need to address miscalculations in payments to an employee. Having everything organized reduces the stress during these moments.
More time to run the business: Managing finances is one of your roles as a supervisor or manager. But it shouldn't eat up the majority of your time. With organized payroll management, you can spend less time bookkeeping and more time running the business.
What you need to do before you start running payroll
There are several business decisions to make before calculating your employees' payroll.
Here are a few steps to make the decision process easier.
Step 1: Classify your employees and independent contractors
How you classify workers determines how you pay social security, Medicare, and unemployment taxes.
Are you in charge of where, when, and how the work is done? If the answer is yes, the worker is likely an employee.
Do you have power over the financial aspect of the work? For instance, do you reimburse expenses? Do you make available work-related devices, like laptops? If yes, then the worker is possibly an employee.
Is your relationship with the worker ongoing, or is the worker employed with you for a defined project without anticipating continued employment? Do you provide employee benefits, like health insurance, to the worker? If you provide benefits and the relationship is ongoing, the worker is likely an employee.
Step 2: Determine the length of each pay period
When deciding on pay periods for your employees, remember that the fewer pay periods you offer, the less complicated your payroll will be. However, you should contact your State Department of Labor because some regulate employee pay schedules.
Step 3: Identify your payment methods
The payment method you use will depend on the type of industry your small business operates in. How you choose to pay your employees also depends on the number of employees, your accounting method, and your available technology.
Here are some of the most frequently used payment methods:
Check: Checks are cost-effective for small businesses because they don't cost much and can be traced.
Cash: Small businesses can pay cash to contractors and temporary workers who handle odd jobs in cash.
Pay cards: These cards function like debit cards, and your employees can use them in ATMs.
Direct deposit: This is a popular way to pay small business employees because it allows direct payment into bank accounts on a specific date. Direct deposits provide an efficient method of processing payment. It also gives employees the added reassurance that their pay will be available on a scheduled date.
Step 4: Find a tool for employee time tracking
Tracking the hours worked by your employees is essential to your payroll system. Inaccurately tracking hours could result in either loss of profit or reduced employee confidence. An efficient time tracking system enables you to schedule working hours, record hours worked, and avoid pay-related issues.
The ideal time tracking system will have features such as:
Step 5: Calculate payroll-related taxes
It's your responsibility to deduct the correct amount and type of taxes from your employees' pay. You must also pay the taxes to the relevant state or federal agencies. There are many different types of taxes that small businesses are liable to pay, including:
Federal tax
Local and state taxes
Medicare and social security tax
State unemployment tax
Worker compensation insurance
Tax forms
It's a legal requirement for small businesses to file tax forms on time. Your tax form filing dates could be monthly, quarterly, or yearly, depending on the size of your business.
The following are tax forms that you might be required to file:
Form 1099 Form 941– employer's quarterly federal tax return.
Form 944 – employer's annual federal tax return.
Form 940 – employer's annual federal unemployment tax return.
Overtime pay — By law, employees who work more than 40 hours per week are entitled to overtime pay
The Fair Labor Standards Act requires you to pay hourly employees who work more than 40 hours per week, a minimum of 1.5 times their regular pay, for every extra hour worked. Different states have unique stipulations for overtime pay. For example, California requires employers to pay their employees daily when they work more than eight hours.
Step 6: Configure your payroll administration
There are various ways to manage your payroll. What you choose depends on the size of your small business, whether you want to do payroll yourself, and the amount of money you want to invest in this process.
When considering how to administer your payroll, try to make it easy to set up and manage. Also, consult the IRS to familiarize yourself with all the requirements for collecting and filing taxes. Keep in mind the importance of payroll legal compliance, staff satisfaction, and business profitability when selecting the method to administer your payroll.
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Below are three common ways used to administer small business payroll:
1. Manual process
If you only have one or two employees, you can choose to do your small business payroll manually. Manual payroll consists of using a spreadsheet, like Excel. This spreadsheet will track your employees' hours, calculate taxes, and process pay. Manual payroll processing is suitable for a small business owner who is confident using spreadsheets and knowledgeable about tax issues.
One benefit of using manual payroll processes is that it’s free. And it provides the small business owner complete control of payroll.
The disadvantage of manually administering your payroll is it takes a lot of time and there is a high likelihood of making mistakes. Errors in payroll can be very costly as you may be fined for filing inaccurate tax information.
2. Accountant
You could opt to hire a professional to administer your small business payroll. Accountants are available for hire on a part-time, full-time, or contract basis. Small businesses with a large number of employees may benefit from the services of a professional accountant.
An advantage of using an accountant to administer your payroll is that you can focus on growing your business while this complicated function is outsourced to a professional. Additionally, accountants are aware of various tax laws and filing requirements, so it is less likely that you will make mistakes in relation to your tax.
A downside to using an accountant for your small business payroll is that it can be expensive. Reputable accountants aren't cheap, so this option may not be the best if you are trying to limit your outgoings. In addition, using an accountant means that you do not retain full control of your business finances.
3. Software
Payroll software automates and simplifies payroll processes. Just enter your employees' information, pay frequency, pay period and the number of hours worked. The payroll software will then automatically work out tax deductions for your employees. Due to its simplicity and cost, this type of payroll administration is becoming increasingly popular.
Selecting the right payroll software can reduce headaches associated with payroll. As the software is regularly updated with tax information, it's easy to deduct the right amount from your employees' pay, every time.
Good payroll software has the functionality to integrate with your staff scheduling solution. Using software to administer your payroll is cost-effective, especially in comparison to using an accountant. One disadvantage of payroll software is that it could be a challenge to get the hang of using it. However, most software providers offer support to help you set up and manage the system.
Step-by-step how to run payroll for your small business
Now that you know what to consider for your small business payroll, here are the steps to take to add a new employee to your payroll:
Step 1: Obtain your employer identification number (EIN)
Getting an EIN is the first step before you hire employees. You obtain this number from the IRS. Use your EIN to report your employees' employment information and taxes to state and federal agencies. Some states require different numbers for tax purposes. You should check with your state or locality to determine their requirements.
Step 2: Request relevant identification
Your employees should provide state or local identification, which you need to fill out the necessary forms.
Step 3: Ask workers to complete the correct forms
You have a good idea of the differences between independent contractors and employees. You need to file W-2 forms for employees and 1099 forms for independent contractors. Your employees must also complete a W-4 form for you to deduct the correct amount of federal taxes.
Step 4: Create a payroll schedule
If your state doesn't have a mandatory payment period, you need to decide on a payroll schedule of weekly, bi-weekly, semi-monthly, or monthly.
Step 5: Communicate payment and compensation terms
It's ideal to communicate the terms of your employees' compensation, which include time tracking, overtime, leave, and deductions. Set the terms clearly so there's no confusion about how pay is calculated, the tax owed, and other aspects that affect the amount of money your employees take home.
Step 6: Run payroll
After you gather relevant employee information and set up your payroll software, you're ready to run your payroll and pay your staff.
Step 7: Update records
It's critical to maintain accurate payroll-related information for every employee, such as tax deductions and social security numbers. You're required by law to keep your employees' payroll records for up to three years after they leave your employment.
Step 8: Report payroll taxes
The law requires you to report all of your payroll taxes to the IRS and other appropriate authorities. Check with your State Department of Labor for local filing dates.
Using software to manage your small business payroll is an efficient and cost-effective solution. Your payroll system is only as accurate as the information you put into it. So integrating your payroll software with an employee scheduling tool is a good idea. This way, you pay your employees for only the hours they work, without having to manually enter their hours.
How to handle payroll taxes
As a small business, it's your responsibility to ensure payroll taxes are taken care of. You can do this yourself, hire an accountant, or outsource it to a bookkeeping firm. What makes this process tedious is that there are multiple taxes employers must manage.
You're required to withhold, deposit, and report from each employees' gross pay. Let's take a closer look.
Federal income tax
All employee wages, and other forms of payment made to an employee, are subject to federal income taxes. This includes tips received at restaurants, commissions earned through sales, bonuses paid, and bonuses.
How much you withhold in federal income tax depends on factors like the employees' salary and personal allowances they claim on Form W-4. The only time an employer doesn't withhold federal taxes is when they're tax-exempt.
Social Security & Medicare
Employers are responsible for paying Social Security and Medicare taxes on behalf of their workers. These two taxes are combined together and added to the total wage before being distributed among the government and the worker.
How to calculate income tax withholdings
Determining how much income tax to withhold from employees' checks isn't difficult when you have the proper documents. You'll need to gather information from W-4 forms, analyze allowances withheld, and use that to calculate what to pay to the IRS.
There's an IRS withholding table available to help with the calculation.
Meanwhile, use the following steps to calculate withholdings for employee income tax.
1. Collect relevant documents
To accurately calculate how much income tax to withhold, you need access to the right documents. This includes W-4 forms for each of your employees, along with the IRS worksheet with the withholding tax tables.
Next, look at their filing status, additional income, number of dependents, and other amounts the employee requested to be withheld.
2. Gather information from payroll
Review payroll period details to determine the frequency of payments. Are they weekly, bi-weekly, monthly? How much does the employee receive per pay period?
You'll need this information to complete the calculations in the next step.
3. Select how you'll calculate income taxes
There are two methods you can use to calculate withholding tax.
The first is the percentage method. It's more complex, but it comes with instructions on the IRS Publication 15-T. You'll find instructions for both manual and automated payroll systems. It provides step-by-step guidance for calculating withholding tax based on employee wages and tax credits.
Alternatively, you can use the wage bracket method, which is easier for most employers. Review the IRS income tax withholding tables to determine your employee's wage range. Then use that to identify how much to withhold. You can find the bales on the IRS Publication 150-T form as well.
Maintain payroll records
The FLSA requires all covered employers to maintain certain types of records regarding wages and hours worked by its employees. The law also sets forth specific timeframes within which these records must be kept. Employers who fail to meet any of these deadlines may face penalties per violation.
In addition to keeping records related to wages and hours worked, employers must retain other documents such as pay stubs, W2 forms, and tax returns. You must also document employee information, such as their name, social security number, total hours worked, pay periods, and hourly pay rates.
Note that state law requirements may differ from federal record-keeping guidelines. This may be the case with the length of time you have to keep the record and the scope of the records you must maintain.
Reconcile payroll
When you reconcile payroll, you compare your payroll register against the amounts you plan to pay them. This ensures everything adds up properly. If there are discrepancies between the two lists, then you'll want to fix them immediately so they won't affect future calculations.
You can either manually check off items from one list to another or automate this process using workforce management software. You'll need to perform payroll reconciliation frequently, including every pay period, or quarterly using Form 941, and annually using Form W-2.
Create a seamless payroll system
Maintaining payroll documents and calculating tax withholding is only as difficult as your payroll system. If you're still using paper trails and manual worksheets, then it's time for an update.
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