For many small businesses, payroll expenses are one of the biggest costs of doing business. Paying employees can also be a time-consuming job—and it’s critical that it’s done right. Even if you have relatively few employees, it can be challenging to keep up with evolving tax and wage laws, maintain all required records and pay everyone accurately and on time. Penalties for non-compliance are severe and errors can also negatively impact employee trust and morale. Payroll solutions can greatly reduce the complexity and risks, but you still need to understand what’s involved in the payroll process.
- Payroll is one of the top two or three recurring costs for most small businesses.
- Payroll is one of the most important points of engagement between employer and employee. The way you handle payroll can significantly impact employee trust and morale.
- Payroll is complex. Tax withholding and other deductions may differ for each employee. Tax and wage laws change frequently.
- If payroll isn’t handled correctly, businesses can face hefty non-compliance penalties.
- Payroll software and services can help businesses efficiently run payroll, stay up to date with federal, state and local payroll regulations, correctly withhold and pay taxes, and handle employee benefits.
What is Payroll?
Payroll generally refers to the process of paying employees, although the term is also sometimes used to mean the company’s list of employees or the total cost of staff wages.
From an employee’s perspective, payroll might seem deceptively straightforward. An employee puts in a week’s work and receives their net pay on their scheduled payday, with taxes and benefit contributions already deducted.
But a lot goes on behind the scenes to make sure every employee is paid accurately and on time. Wages, tax liabilities and other deductions may be different for each employee. Businesses must pay close attention to complex federal, state and local payroll tax payment and reporting obligations. Businesses must always make sure they have enough cash available to pay on time, which means they need to pull in enough revenue to consistently cover payroll expenses.
How Does Payroll Work?
Here’s a general overview of how payroll works:
For each pay period the business calculates employees’ paychecks based on their salary or hourly wage and hours worked, minus their required tax obligations and any other relevant deductions, like health insurance or retirement plan contributions. Employees may elect to have additional taxes withheld (W-4 form). These additional allowances also need to be factored into the gross-to-net calculation.
Based on these calculations, the company then delivers net pay to all employees on payday, either electronically or via check. The business also pays the employees’ and its own share of payroll taxes to the IRS and appropriate local authorities and updates its general ledger to reflect what’s been paid. The company must also maintain records in compliance with IRS and U.S. Department of Labor rules, and report taxes in accordance with IRS schedules—plus any necessary state and local tax reporting and record-keeping requirements.
Businesses can choose to run payroll manually in-house, outsource the labor to a dedicated payroll company or accountant, or use a software payroll solution.
Who Is on Payroll?
Generally speaking, the term payroll only applies to workers who are considered employees under the Fair Labor Standards Act (FLSA); it doesn’t include independent contractors. Businesses are required to withhold, pay and report payroll taxes for employees, but not for contractors.
Many payroll solutions can be used to pay contractors as well as employees; however, contractors and other “non-employees” are typically paid through accounts payable—no payroll taxes are withheld. Contractors receive a Form 1099 at the end of the calendar year and must pay their own payroll taxes.
What’s the difference between an employee and an independent contractor? Independent contractors, known in some industries as freelancers, may do work for a business, but they aren’t technically considered employees by IRS standards. They receive different income tax forms from the business (a 1099-MISC instead of a W-2), and they’re not eligible for benefits that employees can get, such as state and federal unemployment and disability insurance. Independent contractors must pay their own payroll taxes when tax season comes around; the business is not legally obligated to withhold, deposit and pay their payroll taxes. Therefore, independent contractors generally receive their total gross pay with no withholdings or deductions.
What if I’m my only employee? If you’re the only employee of your small business, the way your business is classified will determine how you’re paid. If your business is set up as an S or C corporation, you’re legally required to receive wages like any employee (i.e., income taxes are withheld from your paychecks and the business covers its share of payroll taxes).
If your business is set up as a sole proprietorship or partnership, you typically do not qualify as an employee and instead receive pay through owner’s draws taken directly from your company’s revenue and profits. You are personally responsible for paying all relevant taxes.
Does My Small Business Need Payroll?
If you have employees, your business needs to run payroll. Whether you decide to do it manually, outsource or use a payroll software solution, every business with employees needs an organized way to track employee hours, pay workers, manage payroll taxes and keep records.
But given payroll’s complexities, simply knowing you need to run payroll is not enough. You need to understand payroll to keep employees happy, optimize business finances and comply with regulations. Failing to do your due diligence can lead to issues with your employees, the IRS and the U.S. Department of Labor.
Payroll for Small Businesses Explained
Small business payroll is about much more than delivering paychecks to employees on time—although that’s vital. Payroll is also about protecting employees, keeping them happy, complying with payroll tax requirements, managing cash flow and optimizing business performance:
- Protecting employees: Employees on payroll are generally eligible for benefits such as unemployment compensation. Other employee benefits that are directly tied to payroll include health insurance and retirement plan contributions. Small businesses that can afford to offer such benefits may enjoy competitive advantages when it comes to hiring and retaining employees.
- Keeping employees engaged: When employees are confident that their pay is regular and accurate, it can boost morale, engagement and trust in their employer. In contrast, payroll errors like late or incorrect paychecks can quickly drain and cause tension. One survey found that 49% of American workers will start looking for a new job after only two paycheck problems.
- Complying with payroll tax requirements and labor laws: Businesses need to stay abreast of complex tax and labor regulations that operate at the federal, state and local level. These regulations are subject to constant change. In 2020, for example, many tax payment requirements were temporarily eased due to the COVID-19 pandemic. Compliance can be even more complicated if employees live in one jurisdiction but work in another, as is often the case for businesses located near state borders or that hire remote workers.
- Managing cash flow and liquidity: Payroll is the biggest recurring expense for many small businesses. Careful financial management is required to ensure the company has adequate cash flow and liquidity to manage its obligations—particularly since payroll costs can be higher than many small businesses initially realize. Employer contributions such as taxes, benefits and payroll service fees typically add 15%-20% to the total cost of employee salaries. Payroll is also highly time-sensitive; the business must have enough cash on hand to completely cover payroll.
- Optimizing business performance: Managing payroll efficiently requires that companies strike a balance between having enough employees to get the job done without hiring more workers than necessary. At the same time, the company may need to maintain enough cash on hand to bring in additional workers if they’re needed at short notice to meet demand or cover for sick employees. Many businesses that work on customer projects also need a clear view of payroll expenses in order to analyze costs and profitability.
How to Set Up Payroll for a Small Business
Setting up payroll for a small business may not be very complicated—but you need to know your exact payroll requirements. The process can be broken down into seven key steps:
Apply for a federal Employer Identification Number (EIN). Also known as a business tax ID, your EIN is the unique number the IRS assigns to your business. You can apply for an EIN online through the IRS website, by mail or by fax. Some states and localities have additional employer tax registration requirements—such as a state tax ID—so be sure to check with the appropriate state and local government agencies.
Understand your business’s financials. Start by setting up the appropriate structure for tracking payroll expenses in your general ledger. Calculate your payroll costs in dollars and as a percentage of revenue. Though payroll costs vary depending on the industry and the business, it’s generally a good rule of thumb to keep costs similar to those of successful competitors.
Do your regulatory due diligence. To mitigate payroll tax penalties and other non-compliance risks, you need to know the ins and outs of taxes and labor laws. Laws are subject to frequent change and payroll taxes can differ for individual employees, especially if they live in different states or jurisdictions.
Classify your employees. Will you be hiring full-time employees or independent contractors? Will employees be salaried or hourly? Will you also have seasonal employees or interns? What is each employee’s pay rate and tax status? The answers to these questions will help determine your obligations under tax and labor law. If employees are misclassified, you could face hefty fines and tarnish trust with your workers. For example, treating contractors as employees and controlling when and how they work, rather than just the outcome of their work, can be considered a form of wage theft. Be sure each employee fills out necessary new hire documentation and relevant tax forms, like IRS forms I-9 and W-4.
Determine pay period. Will you run payroll weekly, bi-weekly, monthly or semi-monthly? Running payroll less often means less paperwork and possibly also lower processing costs, but employees may like being paid more frequently and some states have minimum frequency requirements. Check with your state’s labor department to make sure your chosen pay period meets regulations. Bi-weekly is the most common, followed by weekly. Only about 5% of Americans get paid monthly. Once you have set a pay schedule that works for your business and employees, it’s a good idea to distribute a payroll calendar and an explanation of how payroll works so all employees have a clear understanding.
Establish time off policies and benefits eligibility. Will you offer paid time off and paid sick leave? If so, how many days or hours will employees receive? Will hours accrue and carry over into the next year if unused? If your company plans to offer benefits, when will employees become eligible, and what impact will benefits have on your payroll expenses and calculations? Be sure to clearly explain the policies and benefits to all employees.
Get started with a payroll solution. Decide how to manage your payroll system, depending on your business’s needs and capabilities. Options include doing it manually in house, outsourcing to an accountant or payroll service or using payroll software.
Once you’ve laid out your full payroll plan, classified your employees and received an EIN, you’re ready to start running payroll.
3 Ways to Run Payroll
There are three primary ways a small business can run payroll:
Manually in house: This DIY approach usually involves using spreadsheets and online payroll calculators to calculate paychecks and determine tax withholding and other deductions. You’ll have to closely track changes to tax and labor regulations to make sure you calculate employees’ pay correctly and follow all rules. You’ll also need to keep up with paperwork to ensure you’re protected in the event of an audit.
Manually running payroll can be time-consuming, and calculations can quickly get complicated as you add employees and benefits—even two employees with the same salary may have different tax withholding allowances. Manual payroll is best for businesses that have a few employees and simple, straightforward payroll needs. It’s generally not the best long-term solution for businesses that intend to grow and hire more employees.
Outsource: This involves hiring an external payroll company or an accountant to completely handle payroll for your business. Outsourcing usually means a hands-off process after the initial payroll setup, although you may have to provide information such as employee timecards if the payroll company doesn’t offer a way to track hours.
The provider handles all payroll calculations and distributes paychecks. The outsourcing provider is also responsible for compliance with tax and labor laws, so your business is not held liable for penalties if paychecks or tax filings are incorrect.
Payroll software: Payroll software solutions can be understood as the midpoint between in-house and outsourced options. Payroll software typically automates many aspects of payroll, including performing all the calculations, withholding taxes and paying employees. However, compared to outsourcing, payroll software typically gives businesses a greater level of control.
Payroll software solutions also may integrate with other business software, like accounting or HR systems. However, businesses are fully responsible for following applicable tax laws and labor regulations—though a good payroll software solution should stay up to date with the requirements in every jurisdiction.
Small business payroll software features
Payroll software usually offers features such as automated calculation of earnings and deductions, real-time payroll review and editing and multiple payment options including direct deposit or paper checks. Some payroll software also handles payroll tax filings and provides end-of-year tax forms for businesses and their employees. Employees may have access to an online portal or mobile app that lets them check paystubs, benefit information and how much paid time off they’ve accrued, as well as allow them to enter information such as a change of address.
How to choose payroll software
When choosing payroll software, you’ll want to consider a few critical points:
- Will the software integrate with existing business solutions like accounting and HR programs? Can it automatically update your company’s general ledger with payroll expenses, or does it provide only summary information that has to be reentered into the accounting system?
- How much detail and control will you have over payroll? For example, can you view payroll expenses by department?
- If an employee is laid off or terminated before their pay period ends, you’ll have to run payroll off-cycle to pay them immediately. Will the software let you run payroll off of the standard payroll cycle? If so, are off-cycle payroll runs free or will there be a surcharge?
- Does the software have the flexibility to handle state and local taxes if employees reside in different jurisdictions? Does the software company have the resources to keep up with all changes occurring at federal, state and local levels?
- Are there self-service options so that employees can easily access and update information without having to contact a manager or payroll specialist?
- How secure is the system? Payroll data is private and highly sensitive. Protecting employee privacy is essential, and salary information is often a sensitive topic. Software should offer the ability to limit access based on the type of information and the user’s role.
- Is the software easy to use, and how much training and tech support does the supplier provide?
- Does the cost of the payroll software solution match your budget?
Payroll Payment Methods
There are three main ways to pay employees: paychecks, payroll cards and direct deposit.
Traditionally, generating paychecks has been time-consuming, but payroll solutions can now automate the process and let businesses directly print checks themselves.
Payroll cards, a type of debit card, are growing in popularity. Each employee receives a reloadable card. The employee’s pay is deposited into the debit card account each payday. The cards typically work on the main card networks, such as Visa and Mastercard, so employees can use them anywhere those cards are accepted, but they are not linked to checking accounts like a typical debit card.
Direct deposit uses the Automated Clearing House (ACH) payment network to directly deposit funds from your business’s bank account into the employee’s bank account. After the initial setup, direct deposit is a fast and easy way to pay employees and has become the most common payroll payment method.
Direct Deposit for Small Businesses
Any business, small or large, can pay employees via direct deposit—and most do. According to a 2020 survey, nearly 94% of American employees are now paid using this method. It’s fast and convenient, and employees receive pay directly in their bank accounts, without having to deposit or risk losing a check.
To pay employees via direct deposit, you’ll first have to set up direct deposit either with the bank that holds your business bank account or through a payroll service. Once you’ve completed the initial setup, you’ll need each employee’s bank account number and routing number. From that point, each time you run payroll your bank will send a batch of direct deposits via the ACH network to your employees’ bank accounts. It generally takes one to two days to debit your account, credit the employees’ accounts and clear the funds for use by employees.
Still, direct deposit is not without its disadvantages. For example, businesses must be extra careful of employee privacy when storing sensitive banking data, and there is no way to stop payment on a direct deposit if payroll was calculated incorrectly. It’s also time sensitive. Be sure to check your bank’s direct deposit origination deadline to make sure employee pay will be cleared on time. Further, all employee payments will be withdrawn from your bank account simultaneously so it’s crucial to have enough funds in your account in order to make payroll.
What is Included in a Paycheck?
Though there’s no federal requirement, most state labor laws require that businesses provide a way for employees to see their paycheck statements, also known as pay stubs, with every paycheck—even if they’re paid via direct deposit or with a payroll card. Pay stubs are issued on each payday and include the following information:
- General information such as the employee’s name, the date, pay period and hours worked.
- Taxes deducted from an employee’s pay. Taxes are typically broken down into federal, state and local taxes, plus Social Security and Medicare.
- Additional deductions subtracted from the employee’s paycheck for purposes such as retirement plan contributions, health insurance benefits or wage garnishments.
- Earnings including base wage, any overtime and additional income like tips, commissions or bonuses. Pay stubs show both gross pay (total earnings before any deductions) and net pay (also known as take-home pay). Earnings are typically shown for the current pay period and for the year to date.
5 Steps to Small Business Payroll
Once your small business payroll solution is set up and ready to go, there are five steps to running each payroll batch:
Track employee hours. You can do this manually by entering data, by using a timeclock or punch machine or with time and attendance software. Some payroll software solutions include time-tracking software.
Run the numbers. Calculate employees’ gross pay based on their salary or hours worked, plus any additional income like tips or commissions. Subtract all relevant taxes and other deductions.
Pay employees. Distribute paychecks, reload pay cards or transfer funds through direct deposit. Provide pay stubs. Record the payments to each employee, the total payroll amount and other information for bookkeeping and tax purposes.
Pay payroll taxes and other expenses. Deposit taxes and file tax forms with government agencies in accordance with their required schedules. You’ll pay both the employees’ share of payroll taxes, which was withheld from their paychecks, and the employer’s share. Payroll taxes must be paid electronically, usually through Electronic Federal Tax Payment System (EFTPS). You’ll also pay the firms that provide employee benefits, such as health insurance providers, and any fees due to payroll outsourcing companies or payroll software vendors.
Keep thorough records. Under the FLSA you’re required to keep accurate records of payroll payments for three years. It doesn’t matter how you keep those payroll records. What matters is that you do keep them in a safe and accessible location that can be made available to the U.S. Department of Labor within 72 hours of a request.
What Payroll Reporting and Tax Responsibilities Do Employers Have?
Managing payroll taxes, also known as employment taxes, is one of the most complicated aspects of payroll. There are several reasons for this:
- There are federal, state and local payroll taxes to worry about, some which are paid only by employees, others paid only by employers and others paid by both. These include federal income taxes, Federal Insurance Contributions Act (FICA) taxes which fund Social Security and Medicare, Federal Unemployment Tax Act (FUTA) taxes which fund unemployment compensation benefits and state and local taxes such as state income and disability taxes.
- Tax laws are subject to change and non-compliance penalties can be severe.
- Employees may be taxed differently depending on their personal finance situations and where they live.
- Employers must provide proper end-of-year tax forms and paperwork to employees, as well as maintain required records for each relevant government agency.
- Because some payroll taxes are paid by employers they increase the total cost of payroll for a business.
Given the complexities, it’s critical that businesses have a clear understanding of their payroll reporting and tax responsibilities to prevent IRS penalties and other potential issues—especially if they plan to manage payroll manually in house.
The charts below provide a breakdown of a small business’s payroll tax and reporting obligations. The IRS’s Publication 15 also explains how to manage federal payroll tax responsibilities.
5 Steps to Calculate Payroll Taxes
Calculating payroll taxes can be complicated. A Deloitte survey found that 35% of businesses say their greatest challenge is managing tax withholding calculations for regular or supplemental pay. Payroll outsourcing companies and payroll software solutions generally automate withholding for you. But if you plan to do it yourself, you need to know how to correctly calculate payroll taxes. Here’s how.
Calculate employee’s gross pay by multiplying their hourly rate times the total hours worked in the pay period. If the employee is salaried, you can find their gross base pay for each pay period by dividing their yearly salary by the number of pay periods in a year. Gross pay is the starting point for most payroll tax calculations. For example: If an employee makes $52,000 a year and gets paid weekly, his or her gross pay for each pay period is $1,000.
Calculate federal income taxes. Each employee may be taxed at a different rate based on their income and withholding allowances. The IRS provides an income tax withholding assistant to help you calculate federal income taxes for each employee.
Calculate FICA taxes. To calculate the Social Security portion of FICA taxes, multiply your employee’s gross pay for the pay period by 6.2%, which is their portion of the Social Security tax liability. Using the same example in step 1, the employee would pay $62 per paycheck for Social Security taxes ($1,000 x .062 = $62). However, the Social Security tax liability is based on the taxable wage base of $137,700, which means that an employee who makes more than that is only taxed for the first $137,000 earned in a year.
For the Medicare portion, multiply the employee’s gross pay by 1.45%, their portion of the Medicare tax liability. Using the same example, the employee’s Medicare tax liability for that pay period is $14.50 ($1,000 x .0145 = $14.50).
Add the two amounts ($62 + $14.50 = $76.50) to get the employee’s total FICA contributions for that pay period.
Remember: FICA taxes are a shared tax liability and employers are required to match their employees’ contributions. Using the same example, your business would also pay $76.50 in FICA taxes for that employee.
Calculate FUTA taxes. FUTA is only paid by the employer. The FUTA tax rate is 6% on the first $7,000 in wages paid to an employee in a calendar year, unless your state receives a tax credit lowering your total FUTA payment. Many states get tax credits that effectively lower their FUTA contribution, so most states pay significantly less than 6% on FUTA taxes. FUTA taxes are not dependent on employee income or gross pay.
Calculate any relevant state or local taxes. State payroll tax laws and tax rates differ from state to state, so be sure to check with all relevant state and local government agencies to correctly determine and calculate necessary taxes.
To calculate your employee’s net pay, you’ll then have to subtract their federal income, FICA and any state and local tax withholdings—plus any other deductions—from gross pay.
Payroll Issues and Challenges for Small Businesses
Many small businesses don’t realize the time, energy and resources required to run payroll accurately. Payroll is so integral to the business that even small mistakes can have major negative effects. Fortunately, most common small and medium-sized business (SMB) payroll challenges and issues can be avoided with foresight:
Underestimating payroll costs. Total payroll costs vary widely but can account for as much as 50%-60% of a business’s total operating costs in some industries. Employer contributions such as FICA taxes, unemployment insurance, benefits and provider fees can add 15%-20% to the total wage bill.
- Solution: Make sure you have an accurate picture of your business’s overall financial health and payroll costs, factoring in all expenses.
Making payroll errors. Running payroll is a critical and time-sensitive task because employees rely on their paychecks. More than a third of employees have been forced to make a late bill payment due to payroll errors. Late and/or erroneous paychecks can undermine employee trust and eventually lead to bigger issues: The U.S. Department of Labor recovered a record $322 million in back wages owed to workers in 2019.
- Solution: Take steps to ensure accuracy. If you’re running payroll manually, you’ll need staff with appropriate payroll expertise. Alternatively, you can outsource payroll to full-service payroll providers.
Overlooking tax liabilities. Tax codes and labor laws are complicated and subject to change. Each company must pay taxes accurately and on time, or it may face penalties or even criminal charges.
- Solution: Dedicated payroll experts or a specific payroll solution can help make sure a business stays up to date with tax liabilities on a federal, state and local level.
Failure to keep records. Businesses are legally required to create clear audit trails with accurate, up-to-date records on their payroll processes. Both the IRS and U.S. Department of Labor have specific requirements, and state labor departments may have additional record-keeping obligations.
- Solution: Do your due diligence. Know which records must stay on file for each government agency and the length of time you’re required to keep them.
Failing to update data. Employee, payroll and tax data must be accurately maintained and updated. Even a seemingly minor change such as a change of address can affect payroll tax calculations if the employee moves to a different tax jurisdiction. In addition, it can be particularly challenging to maintain updated and accurate data if a business has separate accounting, HR and payroll systems.
- Solution: Use a payroll software solution that seamlessly integrates with other business software to make sure records are accurate and up to date at all times.
Free Small Business Payroll Checklist
Use this checklist to help you set up and run payroll and meet tax and reporting requirements.
Setting up payroll:
- Did you receive your EIN?
- Are all employees classified correctly?
- Do you know federal, state and local labor laws?
- Have employees filled out all necessary tax and hiring paperwork, such as W-2s and I-9s?
- Is all employee information accurate?
- If using direct deposit, do you have accurate records of all employee banking information?
- Are pay periods, time off policies and benefits clearly defined?
- Do you have a way to run payroll that suits your business’s needs, whether it’s in house, with a payroll company or a payroll software solution?
- Do you have a way to track how long each employee worked?
- If not using a payroll software or outsourced solution, do you know how to accurately calculate paychecks and withhold all necessary taxes and deductions?
- Do you need to distribute paystubs to employees on payday?
Tax and reporting obligations:
- Do you know your payroll tax obligations, as well as what you must pay on behalf of your employees?
- Do you know all tax payment and reporting deadlines?
- Do you know all the record-keeping requirements? How will you keep records?
Important Payroll Terms to Know
940: IRS Form 940 is the Employer’s Annual Federal Unemployment (FUTA) Tax Return, used to report an employer’s annual FUTA tax payments to the IRS. Only employers pay FUTA taxes.
941: Employer’s Quarterly Federal Tax Return. Employers must file IRS Form 941 each quarter to pay the employer’s portion of FICA taxes and report the income taxes and FICA taxes withheld from employee paychecks.
945: The employer’s Annual Return of Withheld Federal Income Tax. This IRS form is used to report any nonpayroll income tax withheld, such as income tax withheld from pension distributions or backup withholding.
1040: The U.S. Individual Income Tax Return form. This IRS form is used by taxpayers to file their annual income tax return.
1096: Annual Summary and Transmittal of U.S. Information Returns. One use of this form is for employers to provide the IRS with a summary of all the 1099-MISCs provided to independent contractors. IRS form 1096 is also used to transmit forms 1097, 1098, 3921, 3922, 5498, and W-2G.
1099-MISC: The IRS form used to report annual compensation paid to each non-employee taxpayer, such as freelancers or independent contractors. If you paid a contractor $600 or more during the tax year, you need to issue them a 1099-MISC. At the end of the tax year contractors receive one 1099-MISC form from each business that paid them $600 or more in the year.
8027: Employer’s Annual Information Return of Tip Income and Allocated Tips is used to report all tips received by employers in the tax year.
Accrue: To accumulate or receive. In the context of small business payroll, the term usually refers to earning benefits like paid vacation, sick leave and personal time off.
ACH (Automated Clearing House): A U.S.-based electronic payment network that transmits direct deposit payroll transactions.
Base pay rate: An employee’s salary or hourly pay rate before factoring in any benefits, bonuses, commissions or tips.
Bonus: A sum of money added to regular wages, often given as a reward for exceptional performance.
Commissions: Extra pay earned for completing a specific task, such as selling a certain amount of goods or services. Commissions are paid in addition to an employee’s base pay rate and are usually calculated as a percentage of the price of goods or services sold.
Deductions: The amount of money subtracted from an employee’s gross pay to cover taxes, wage garnishments and benefits like health insurance or retirement plan contributions.
EFTPS: The Electronic Federal Tax Payment System is used by employers to pay federal taxes online.
Employee’s Withholding Allowance Certificate (W-4): The IRS form filled out by employees to determine the number of withholding allowances they will claim. Employers use an employee’s W-4 to withhold the correct amount of federal income tax from each paycheck. Filling out a W-4 is standard new-hire paperwork, but employees may wish to change their W-4 each time their personal or financial situation changes.
Exempt: Generally, refers to employees who are exempt from the Fair Labor Standards Act (FLSA). Typically, exempt employees include executives and some other salaried employees.
Exempt employees are not protected by certain aspects of the FLSA. For example, they are not legally required to receive overtime pay.
FICA Taxes: The Federal Insurance Contributions Act, which mandates payroll taxes to fund Social Security and Medicare. Employers are responsible for paying 50% of each employee’s FICA, which must be remitted with federal income taxes—together known as the federal tax liability—and reported quarterly with the IRS form 941.
FLSA: The Fair Labor Standards Act establishes the minimum wage, overtime pay, recordkeeping and child labor standards in the U.S. Some salaried employees may be exempt from certain provisions of the FLSA, such as overtime pay.
FUTA Taxes: Taxes established by the Federal Unemployment Tax Act. FUTA taxes are paid yearly by employers using IRS form 940. FUTA taxes contribute to a fund that provides unemployment compensation to workers who have lost their jobs.
Garnishment: A legal requirement that certain amounts of money—usually wages paid by an employer—are seized to satisfy debt or other necessary obligations like alimony or child support. Employers are responsible for taking garnishments out of paychecks after taxes have been deducted.
General ledger: A bookkeeping system used to track and record all of a business’s financial transactions.
Gross pay: An employee’s total wages and earnings before taxes and other deductions are withheld.
Hourly wages: The rate at which an employer agrees to pay an employee per hour worked, such as $15 an hour.
I-9: Employment eligibility verification form used by the IRS to verify an employee’s identity and validate that he or she is legally eligible to work in the U.S.
Income tax: The primary tax that governments levy on the earnings of businesses and individuals. Employers and employees may have to pay federal, state and local income tax. Employees’ income tax obligations are typically calculated by payroll software or services and withheld from employee’s paychecks.
Independent contractor: Sometimes referred to as a freelancer, an independent contractor is a self-employed person who performs work for a business. When first hired by a company, independent contractors generally file a W-9, and they receive a 1099-MISC summarizing their payments at the end of the tax year. Independent contractors must pay all of their own income taxes, including Social Security and Medicare, and are not eligible for employee benefits such as unemployment compensation.
Net pay: An employee’s take-home pay, or the amount of wages and earnings they receive after all taxes and deductions are subtracted from their gross earnings.
Non-exempt employee: Non-exempt employees are covered by certain regulations FLSA. For example, they must be paid at least the federal minimum wage and they qualify for overtime pay. Non-exempt employees are typically paid an hourly rate instead of a salary.
Overtime: Time worked beyond 40 hours in a workweek. Federal overtime laws state that non-exempt employees must be paid one and one-half times their usual wage for overtime.
Salary: A fixed regular pay amount allotted every pay period, but usually expressed as a total annual sum. For example, if an employee earns a $60,000/year salary and is paid twice a month, the employee would receive a gross pay of $2,500 in each paycheck.
Social Security (OASDI): Social Security tax, also known as the Old Age, Survivors and Disability Insurance tax, is a payroll tax paid by both employees and employers. Employees and employers split the tax payment 50/50, meaning the employer and employee each pay 6.2% of the 12.4% tax rate on up to the taxable wage base, or $137,700 of employee earnings as of 2020.
Take-home pay: Also known as net pay, it’s the amount of wages and earnings an employee receives after all taxes and other deductions are withheld from their gross pay.
Taxable wage base: Also known as the contribution and benefit base, the Social Security taxable wage base is the maximum amount of an employee’s income that can be subject to Social Security taxes in a given year. For 2020, the taxable wage base is $137,700. If an employee makes more than that, the employee and their employer pay FICA tax only on the first $137,700 earned. The taxable wage base increases every year.
Third-party sick pay: An insurance disability benefit set up by participating employers that aims to help pay employees if they lose wages due to illness or non-work-related injury. Third-party sick pay is usually provided by insurance companies and is typically paid only when employees are absent from work.
Tips: Optional or extra payments—whether paid in cash or as non-cash rewards like tickets or event passes—given to an employee by a customer as a reward for service. Tips are usually considered taxable income and are therefore subject to income taxes and FICA taxes.
W-2: The IRS form that employers send to employees at the end of the tax year to report the employee’s annual wages and the total amount of taxes withheld from their pay throughout the year. Taxpayers use the information on their W-2 to file income taxes.
W-3: The Transmittal of Wage and Tax Statements form employers must submit to the Social Security Administration each year. The W-3 provides a quick overview of all employee wages and contributions submitted to the Social Security Administration in a given tax year.
W-9: The IRS form filled out by independent contractors to provide their taxpayer identification number to the company they’ll be doing business with. A W-9 is needed in order for the business to send the independent contractor a 1099-MISC at the end of the tax year.
Withholding: The tax liability held back from employees’ paychecks by the employer and sent directly to tax authorities.
Small Business Payroll FAQs
What are my payroll tax obligations?
All businesses with employees are legally required to withhold payroll taxes from each employee’s paycheck and pay all applicable federal, state and local taxes, including additional tax obligations like the Federal Unemployment Tax Act (FUTA) payments and any applicable disability insurance taxes on time. Missed payments or failure to pay taxes can lead to fines and penalties.
What payroll reports do I need to submit to remain compliant?
Employers must submit several federal payroll reports periodically in order to remain compliant. These include IRS forms 940, 941, W-2 and W-3. Additional reports may be required depending the nature of the business and its employee classifications. State payroll report requirements may differ depending on state-specific laws, so be sure to check with the appropriate state government organization.
What payroll reports are due annually?
Several payroll reports are due annually:
- Form 940, identifying the amount of FUTA taxes paid throughout the year, due Jan. 31 following the close of the tax year.
- Form W-2, summarizing each employee’s wages and tax withholding for the year. W-2s must be supplied to employees by Jan. 31.
- Form W-3, a summary report of all the W-2 forms issued by the employer for the tax year. W-3s must be submitted to the Social Security Administration by the end of February following the close of the tax year.
- Any additional relevant federal payroll tax reports, if applicable.
- Any relevant annual state payroll reports, if applicable.
What payroll reports are due quarterly?
The main payroll report that must be submitted quarterly is Form 941, which is used to pay an employer’s portion of FICA taxes and to report total federal income and FICA taxes withheld from employee paychecks. Some states may also require businesses to submit additional quarterly payroll tax reports.
What payroll records do I need to create and keep?
Every employer covered by the FLSA must keep particular records for all non-exempt employees, with the following information about each employee:
- Name, social security number, address, birthdate and gender
- Pay rate and how they are paid
- Time and day of week when workweek begins
- Hours worked each day
- Total hours worked each workweek
- Total daily or weekly straight-time earnings
- Total weekly overtime earnings
- All additions to and/or deductions from pay
- Total wages (gross pay and net pay) paid each pay period
- Date of payment and the pay period covered by the payment
The FLSA mandates that these payroll records are kept for at least three years; some other records, such as timecards, must be kept for two years.
In addition, the IRS requires that employers keep employee information such as:
- Employee name, address, social security number and occupation
- Employment date
- Amounts and dates of all earned wages, including any pension or annuity payments
- Amounts of tips reported
- Dates for which employees received sick pay or injury compensation, including the amount and weekly payment rate
- Copies of employee’s income tax withholding certificates (W-4)
- Dates and amounts of tax deposits made
- Amount of additional benefits provided
States may have additional record-keeping requirements.
What payroll records do I need to create and give my employees?
The primary payroll record you need to create and give to each employee is a W-2. This must be provided annually, before Jan. 31. Independent contractors who are paid more than $600 must receive a 1099-MISC.
In addition, some states require that employers provide employees access to pay stubs with each paycheck.
What are payroll deductions?
Payroll deductions are items subtracted from an employee’s gross pay, reducing net pay. Deductions can be mandatory or voluntary. Mandatory deductions include taxes and court-ordered wage garnishments, while voluntary deductions typically include benefits like health insurance, third-party sick pay and retirement plan contributions.
Which deductions are required by law?
The five mandatory payroll deductions are federal income taxes, state income taxes, local taxes, FICA taxes and court-ordered garnishments like child support payments.
How can I estimate payroll costs?
First estimate how much you will be paying employees. One way to get a rough estimate of your total payroll costs is to then add an additional 20% on top to account for payroll taxes, benefits and payroll service fees. Depending on your business and employees, the additional 20% may be on the high side, but it’s generally better to overestimate than underestimate.
What percentage of gross revenue should go to payroll?
It depends. Not all businesses or industries have the same labor requirements. Payroll expenses can account for anywhere from less than 10% of revenue to more than 50%, depending on the industry.
How do payroll companies/outsourced services work?
Outsourced payroll services typically provide a completely hands-off way to handle payroll. The provider performs all payroll calculations and distributes pay. Outsourced services also handle compliance with tax and wage laws, and your business is generally not held liable for penalties if paychecks or tax filings are calculated incorrectly.
How does payroll software work?
Payroll software solutions generally automate aspects of the payroll process, such as payroll calculations and wage payments, to help save businesses time and money. Unlike outsourcing services, payroll software typically gives businesses a greater degree of internal control over the payroll process. Payroll software systems may integrate with other business software like accounting, human resources or time tracking systems.
How do I know which payroll software is right for my business?
The choice of payroll method depends on several factors, including the size of your business, payroll complexity, your budget and your plans for business growth. If you have a small business with a simple payroll, you may choose to manually run payroll, at least to start. If your business is larger with more employees or your payroll situation is more complex, consider using payroll software or an outsourced payroll company. If you have many employees that live in different states, you will need a payroll solution that stays up to date with all federal, state and local tax laws.