Managing payroll is a complex and exacting chore, and it’s important to get it right. Small businesses have many options for payroll processing, including software and online solutions that automate most of the steps and help ensure accuracy. But if you have just a few employees, it’s possible to take a do-it-yourself (DIY) approach—as long as you make sure you understand all the steps, stay up to date with tax and legal requirements and set aside the time to carefully manage the entire process.

Why Should You Handle Payroll Yourself?

Many business owners start out with one or a few employees, and can’t predict how much the business will grow. In those circumstances, it may make sense to process payroll manually, at least in the beginning. It means the business doesn’t need to research payroll solutions or pay for that technology.

But processing payroll manually is time-consuming and it’s hard to avoid mistakes, especially as the company adds employees and its payroll becomes more complex. Failure to pay your employees properly can lead to lost employees and damage your reputation in the industry. What’s more, if payroll is done incorrectly it can subject the business to possible fines. That’s why many small businesses ultimately choose to use payroll software to automate the process and reduce errors.

Common Payroll Challenges for Small Businesses

Manual payroll processing can be surprisingly challenging, especially as the business grows, because wage and tax calculations are complex and there are significant negative consequences if you make mistakes or fail to comply with all regulations.

  • Payroll accuracy. Handling payroll processing yourself increases the chance of human error, which is a major cause of payroll inaccuracies. Errors in calculating wages and taxes can lead to dissatisfied employees and sizable fines from tax authorities for noncompliance.
  • Staying up to date with employment law and tax changes. In general, it’s your responsibility as a business owner to calculate and withhold payroll taxes accurately, pay taxes on time and file the relevant business tax forms. That’s challenging because the rules are continually evolving at the federal, state and local level, and failure to comply with those shifting regulations can again result in penalties.
  • Record keeping. Maintaining accurate records is important not just for business purposes but also for compliance. For example, the Fair Labor Standards Act (FLSA) requires businesses to keep records of employee earnings for at least three years. Many small business owners find that’s not easy when they’re trying to manage a hectic daily operating schedule with limited resources.
  • Misclassifying employees. Many companies have a mixture of full-time employees, part-time workers and contractors. Each category of workers is entitled to different benefits, and misclassifying workers can have serious consequences. For example, if you mistakenly categorize a full-time employee as an ndependent contractor, you can face penalties as well as liability for unpaid taxes and benefits.

Three Steps in The Payroll Process

At a high level, managing payroll can be divided into three stages: Preparation, employee payment and post-payment activities.

  1. Prep. You’ll need to set up payroll before you can start paying employees. This includes determining the pay frequency for hourly and salaried employees and a mechanism for tracking their time. You need to solicit W-4 forms from employees to determine how much tax to withhold from their paychecks, as well as I-9 forms to confirm their eligibility to work in the U.S. Your business will also need an Employer Identification Number (EIN) from the IRS. It’s generally worth establishing a separate payroll bank account to more easily track and manage payroll. Most employers pay by direct deposit, which requires setting up a direct deposit capability with your bank and obtaining your employees’ bank account details, as well as their direct-deposit authorization.
  2. Paying employees. For each payroll run, you calculate every employee’s gross pay, withhold any taxes and other deductions. Then you distribute net pay to employees via direct deposit, check or other methods.
  3. After payment. You need to pay taxes and file the relevant forms by IRS deadlines. You’ll send the IRS the federal taxes you’ve withheld from employee paychecks, plus the employer’s share of Social Security and Medicare taxes, typically every month. You’ll also pay any state and local taxes. At the end of the calendar year, distribute tax forms to employees.

8 Steps to Process Payroll Yourself

Here’s a more detailed look at the steps involved in DIY payroll processing:

  1. Collecting W-4 forms. You’ll need a completed Form W-4 from each new employee in order to determine how much of their gross pay to withhold. Withholding depends on several factors, including whether an employee is married or single and how many dependents they have. W-4s don’t expire, but must be updated if there are changes to an employee’s status, such as getting married, divorced or having a child.
  2. Getting an Employer Identification Number (EIN). The IRS uses EINs to identify businesses, just as it uses social security numbers to identify people. You need an EIN even if you only have one employee, because you can’t pay employee taxes without it. Applying is free and easy—you can do it by phone, mail, fax or online. The IRS prefers online applications and will get you an EIN immediately as long as your application is approved. You just need to tell the IRS which type of business you have—whether it’s a corporation or an LLC, for example—provide a business address and say why you want an EIN.
  3. Choose your payroll schedule. Typical pay frequencies are weekly, every two weeks (biweekly), twice a month (semimonthly) or monthly. Some states only permit certain pay frequencies, so check your state’s requirements before making this choice. Each option has advantages and disadvantages, and you need to balance the benefits for the company against the benefits for employees. Monthly pay periods require the least work for employers and can help improve the business’s cash flow, but they are often not employees’ first choice. Many companies pay salaried employees twice a month and hourly employees weekly.
  4. Determine and withhold income taxes. This is one of the most complex aspects of calculating employees’ pay, and it’s easy to make mistakes. You need to deduct any pre-tax contributions for health insurance (medical, dental and vision) and retirement plans. Then, for each employee, calculate the amount owed in federal and state income tax as well as Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare, along with any local taxes.
  5. Run the numbers. Subtract pre-tax deductions and taxes from gross pay to obtain each employee’s net pay. For salaried employees, gross pay won’t change from paycheck to paycheck unless there are exceptional circumstances such as unpaid leave or variable payments like bonuses and commissions. Gross pay for salary workers is calculated by dividing their annual salary by the number of pay periods per year. For hourly workers, you’ll need to know hours worked at the regular hourly pay rate plus any overtime, and factor in any holiday pay, paid sick leave and vacation days.
  6. Distribute paychecks or direct deposit. Direct deposit is by far the most popular method of paying employees, but many companies give employees other options, such as checks or pay cards, which are specialized reloadable debit cards. With pay cards, you deposit an employee’s pay into an account linked to the card; the employee can then use the card for purchases, like a regular debit card.
  7. Pay taxes. You need to pay the taxes that you’ve withheld from employees’ paychecks, plus the employer’s share of taxes. For example, employers and employees each have to make FICA tax contributions of 7.65% of an employee’s earnings. You also need to pay federal unemployment insurance and any state and local taxes. The timing of these tax payments varies depending on the size of your business and the state in which you operate. Most businesses need to pay federal taxes either monthly or semiweekly. Many states require quarterly payments.
  8. File tax forms. Employers generally need to file some tax forms quarterly and others at the end of the year. For example, you need to report FICA taxes and some other withheld taxes on IRS Form 941 each quarter. At the end of the year, you provide regular employees with W-2 forms summarizing their wages and withheld taxes, and you also need to submit those forms to the IRS. You’re also responsible for submitting Form W-3, a summary form that accompanies the W-2s you send in, as well as Form 940 for federal unemployment tax. There are deadlines for filing each of these forms, with penalties and interest for late payments.
8 Steps to DIY Payroll Processing
1 Verify eligibility Verify new employee identity and employment authorization with the I-9 form.
2 Collect W-4 forms Get a W-4 from each new employee to determine tax withholding.
2 Get an EIN You need an Employer Identification Number from the IRS in order to pay employees.
3 Choose a payroll schedule Options vary by state—common frequencies include weekly, biweekly and semimonthly.
4 Calculate and withhold taxes Calculate employee taxes and other deductions that you’ll withhold from their paychecks.
5 Run the numbers Calculate net pay for each employee by subtracting taxes and other deductions from gross pay.
6 Pay employees Options include direct deposit, check or pay card.
7 Pay taxes Pay the employee’s and employer’s share of federal, state and local taxes
8 File tax forms File quarterly and annual tax forms with federal, state and local authorities. Provide W-2s to employees.

Choosing Payroll Software for a Small Business

As businesses grow, a DIY approaches become less manageable. Payroll software can greatly simplify payroll processing, ensuring accuracy and compliance. Depending on the solution, software may also automate wage and tax payments and tax filings, accounting for tax credits. Here are five things to consider when selecting a payroll solution:

  1. How much can you afford to spend? Look for a system that suits your budget. You need to balance the cost against the benefits, which can include greater accuracy and speed in addition to freeing up staff time for other activities. Many payroll solutions are priced per employee, so the cost is proportional to the size of your business. Some payroll solutions are provided as part of larger business software suites, which can provide additional benefits such as simplified accounting and cost analysis. Be sure you understand which features of a payroll service are included in the base fee, and which cost extra. Also consider potential growth. While migrating from one payroll software to another isn’t too complicated, it is a consideration if you’re expecting rapid growth.
  2. How complicated are your payroll needs? A larger company with different categories of employees in multiple tax jurisdictions will need more sophisticated software than a small firm with salaried employees in a single state. And the less payroll expertise you have in-house, the greater the value of a system that handles every aspect of payroll processing, including automatic payments and tax filings.
  3. Are there solutions tailored to your kind of business? Some solutions are designed to meet the needs of specific types of business, such as law firms or restaurants. If you operate in a market segment that has a lot of small businesses, there’s probably at least one offering designed for a business of your profile, and it’s worth seeing if that solution is a good fit for your company.
  4. What kind of reports do you want to generate? At its best, payroll software can support strategic decisions by allowing you to quickly analyze costs and the impact of potential business decisions. How much can we save by changing our mix of permanent and hourly employees to reduce overtime? How much will personnel costs rise if we open a new office in Boston rather than Chicago? Payroll software that’s part of an integrated suite can also make it easier to perform additional analyses and reporting that combines payroll data with other business information.
  5. How happy are others with software packages you are considering? Reading online customer reviews and case studies can be helpful. But don’t stop there—get in touch with vendors you’re interested in and ask them for reference clients.

Small Business Payroll FAQs

  • Why do I need a payroll system?

    Theoretically, anyone can administer payroll themselves using spreadsheets, but doing so is complicated, time-consuming and requires expertise. If you make mistakes, you can face significant penalties. For most businesses, it makes sense to use a payroll system that automates the process and potentially consult with an accountant well-versed in the latest laws and taxes.
  • What is a payroll calculator?

    A payroll calculator is an online tool that calculates an employee’s net pay and withholdings. You enter data such as pay rate, local tax jurisdiction and any exemptions. Then the calculator runs the numbers.
  • What is a payroll journal entry?

    Accountants and bookkeepers use payroll journal entries to record the compensation paid to employees. These entries can then be incorporated into the company’s general ledger. There are three main types of entry: initial recordation (gross wages earned by employees along with withholdings and any additional taxes), accrued wages (an entry recorded at the close of each accounting period to record any wages owed but not yet paid), and manual payments (these cover occasional manual paychecks generated because of pay adjustments or terminations).

It’s possible to manage payroll yourself, but it’s complicated, labor-intensive and error-prone, especially for any business with more than a handful of employees. Because payroll processing is an administrative cost rather than a revenue-generating activity, most businesses want to minimize the amount of time and money they spend on it. For many small businesses, using payroll software to automate the process is a much better option than trying to handle payroll manually.