If you have a small business—or are looking to start one—chances are you already know that you’ll have to handle payroll for your employees. But managing payroll can be more complicated than many people expect. To help get you started, we’ve answered 15 of the most frequently asked small business payroll questions.
What Are Payroll Taxes?
Payroll taxes, also known as employment taxes, are taxes that must be paid by employers and employees. They are usually calculated as a percentage of employee wages. Payroll taxes include:
- Federal and state income taxes, which are deducted from employee earnings and regularly paid to the IRS and state tax agencies by the employer.
- Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare. Employers and employees share the FICA tax obligation, each contributing 50% of the total tax rate.
- Federal Unemployment Tax Act (FUTA) taxes, which fund unemployment insurance and are paid by employers only. Some states have tax credits that lower an employer’s FUTA tax obligation.
- Any other relevant state or local tax, such as disability insurance, worker’s compensation or payroll taxes imposed by your local jurisdiction.
What Information Do I Need for the IRS to Begin my Business Payroll?
Before you can start running payroll, you’ll have to do some administrative work to establish your business as a tax-paying entity with the IRS, and you’ll have to collect some tax forms from your employees. Planning ahead can help prevent payroll pains. Here’s how to get started:
- Choose a business structure. You’ll have to select a business structure if you haven’t already done so. Business structures include sole proprietorships, corporations and LLCs—all of which have different legal and tax considerations.
- Apply for an EIN. Your small business must apply for an employer identification number (EIN). You’ll need to indicate your business structure on the EIN application. The IRS will use your EIN to identify your business on different tax documents, similar to an individual’s Social Security number. You can get an EIN by applying online, by mail or by fax.
- Choose a tax year. Your taxable income is calculated based on your tax year, which is a 12-month period that you choose for accounting and tax purposes. Businesses can opt to use either the calendar year or a fiscal year that doesn’t end on Dec. 31. You’ll establish your tax year with the IRS when you file your first business income tax return.
- Gather employee information. Employees will have to fill out IRS forms I-9 and W-4 to establish employment eligibility and appropriate income tax withholding, respectively.
Do I Need a Business Bank Account?
If you’re going to be receiving and spending money as a business, you should generally open a business bank account. In addition to providing a central location for withdrawing and depositing business payments, they also make it easier to keep company funds separate from personal funds. You’ll need an EIN to open a business bank account.
Can a Small Business Do Their Own Payroll?
Yes, you can manage your small business’s payroll using spreadsheets or online calculators. But the more employees you have, the harder it will be to keep track of employee hours, pay employees, manage payroll taxes and keep records—especially because each employee may have a unique combination of wages, benefits, tax withholding requirements and other deductions. You’ll also need a deep understanding of all federal, state and local labor laws and payroll tax obligations.
Given the complexity, it generally only makes sense to run payroll manually if your business has a few employees with a simple tax and benefits structure. Even for those businesses, a payroll software solution can automate complex, time-consuming chores like calculating paychecks. Consider integrating your payroll and accounting software to stay compliant with regulations and connect two of your businesses most important resources, people and money.
Should I Hire a Payroll Service or Try Software/Automation?
Before choosing to hire an outsourced payroll service, use an automated payroll software solution or run payroll manually, consider the costs of small business payroll options, as well as the time involved and resources you can dedicate.
An outsourced payroll service should handle every aspect of payroll. It calculates wages and withholdings, distributes paychecks and takes responsibility for compliance with all tax and labor laws—so your business shouldn’t be held liable for any payroll errors. It’s the least time-consuming way to run payroll, but it also tends to be more expensive.
Payroll software solutions automate many aspects of payroll, such as all payroll calculations, while giving your business more control over the process. Some payroll software solutions also automatically file taxes and pay employees via direct deposit or other methods. You may still want to have a payroll expert on your team to ensure that data is entered accurately, and the process runs smoothly. Since your business still has control over the payroll process, you’re liable for following all tax laws and labor regulations. However, a good payroll software solution should stay up to date with changing tax and labor requirements on a federal, state and local level. Payroll software can help you overcome some of the common payroll challenges for small businesses.
Manually running payroll is the most time-consuming way to run payroll because you’ll have to calculate all taxes and deductions, keep up with benefits and employee time off, track hours, send out paystubs, and handle all yearly and quarterly tax reporting obligations. It can be the cheapest option, but it’s important to note that payroll mistakes can upset employees and also expose your business to financial penalties from the IRS or U.S. Department of Labor.
How Often Should I Run my Payroll?
Payroll frequency primarily depends on two things: state laws and your business’s needs. Most businesses run payroll bi-weekly, but weekly, monthly and semi-monthly are other common pay periods.
The less often you run payroll, the less paperwork your business will have to deal with, and you may have lower payroll processing costs. But employees may prefer to be paid more frequently, especially if they are paid on an hourly basis and their total pay varies from week to week. In addition, some states have minimum pay frequency requirements.
What Are my Employer Responsibilities?
As an employer, it’s your responsibility to make sure the following payroll tasks are performed, whether you do them manually, use software or hire a payroll service.
- Collect all necessary employee information such as W-4s and I-9s.
- Correctly classify employees (employees versus independent contractors; and hourly versus salaried).
- Determine a pay period that works for your business and employees.
- Establish time off policies and benefits eligibility, if applicable.
- Set up direct deposit or other payment methods for employees.
- Track employee hours.
- Calculate paychecks.
- Withhold taxes and any necessary deductions, including federal income tax, FICA taxes, FUTA taxes, plus any state taxes, worker’s compensation and disability taxes.
- Pay the payroll taxes the business owes and the employees’ share of payroll taxes that you withheld from their paychecks.
- Pay employees.
- Provide pay stubs to employees if required.
- Comply with all payroll reporting requirements on a federal, state and local level.
- Keep accurate records.
- Follow all labor laws.
- Pay other payroll expenses, including benefits providers and payroll software or outsourcing fees.
What Are the Payroll Reporting Requirements?
All businesses must comply with payroll reporting requirements, including IRS or relevant state agency requirements:
- Every quarter, you must report income and payroll taxes withheld from employee paychecks on IRS Form 941.
- Every year, you must report several additional payroll tax obligations using standard forms, such as:
- IRS Form 940 to report annual FUTA tax deposits
- IRS Form 945 to report any non-payroll income tax withheld, like income tax withheld from retirement plan contributions or pensions
- IRS Form W-3 to report a summary of all employee wages and contributions submitted to the Social Security Administration in a given tax year
- You must report all new hires to the appropriate state as soon as the employee is hired.
- You must report all employee W-4 withholding certificates to the IRS as soon as they’re hired or revise their W-4.
- You must provide W-2 end-of-year tax forms to employees by January 31 every year, and 1099-MISCs for independent contractors.
- You must provide pay stubs to employees, if required by the state your business operates in.
- You must comply with any other specific state or federal regulations applicable to your business.
What Happens if I Make a Mistake?
Payroll mistakes can be costly. Employees rely on receiving a timely and accurate paycheck, so payroll errors can irk workers and reduce morale. It’s also not uncommon for businesses to misclassify employees as independent contractors. If that happens, a business may risk being sued or fined and may be liable for additional payroll taxes.
To pay employees accurately without the aid of payroll software or a contracted payroll processing company, you need to keep up with many tax and labor laws, all of which are subject to change. The IRS and state governments impose penalties for tax mistakes, while the U.S. Department of Labor may fine you for payroll mistakes like overtime violations or underpaying employees.
If your business does make a payroll mistake, it’s important to recognize the error, explain it to employees, describe how the business will fix the problem and make sure it doesn’t happen again. If you catch the error before employees are paid, you may be able to cancel the payroll cycle immediately, resolve the error and re-run payroll. Otherwise, take steps to resolve the issue and report any discrepancies to the IRS and any other relevant government agency as necessary to minimize the likelihood of non-compliance penalties.
How Do I Pay Employees Versus Contractors?
A key difference between paying employees versus contractors is the employer’s responsibility for payroll taxes. If you’re paying an employee, your business is responsible for withholding the correct amount of federal, state and local income taxes from each employee paycheck. Withholding is based on an employee’s income and the withholding allowances calculated in his or her W-4 form. You then pay the withheld employee taxes to the IRS and state agencies as necessary. As a business owner, you’re also responsible for withholding any other necessary payroll deductions, such as health care or retirement plan benefits. Employees receive a W-2 at the end of the tax year to help them square away their tax obligations with the IRS.
If you’re paying independent contractors, also known as freelancers, you are not required to withhold or pay taxes on their behalf. Independent contractors receive their full gross pay in each paycheck. They are required to pay their own taxes to the IRS and other agencies, including quarterly estimated taxes. Instead of a W-2, contractors receive a 1099-MISC at the end of the year.
What’s the Difference in Payroll Between Hourly and Salaried Employees?
Hourly employees are paid based on an hourly wage and the number of hours they work during each pay period. Their pay is generally regulated by the Fair Labor Standards Act (FLSA) (for this reason, they are considered “non-exempt” employees). Hourly employees must make at least federal minimum wage and receive overtime pay if they work more than 40 hours in a week. States may have higher minimum wage and overtime payment requirements that supersede these federal requirements.
Salaried employees are paid based on a fixed annual salary. This amount is divided by the number of pay periods in a year to calculate employees’ pay for each period. Some salaried employees, such as executives and employees in certain professional or administrative roles, are exempt from FLSA overtime laws and therefore are not required to receive overtime if they work more than 40 hours in a week. Salaried employees generally receive the same base pay regardless of how many hours they work.
How Does Holiday Pay or Bonus Payroll Work?
Holiday pay is pay provided to employees on holidays, even if they don’t work. For example, some companies may offer employees paid time off for holidays such as Memorial Day, Independence Day and Labor Day. The FLSA does not require businesses to pay employees for any time off, including holidays. It’s up to each business to decide whether to do so.
Some companies might choose to offer employees a higher rate of pay if they work on holidays, but it’s not required by law. In other respects, holiday pay is treated as normal pay and is taxed the same way.
Bonus pay is a form of supplemental wages—pay employees receive on top of their regular wages. Since bonus pay is different from regular wages, it’s taxed differently. There are two ways to calculate payroll taxes on bonus pay: the aggregate method and the percentage method.
- Aggregate: If bonuses are paid alongside regular wages, the bonus pay is added to the employee’s regular wages, which may increase the employee’s tax bracket. Tax withholdings are then calculated based on the temporarily updated tax bracket.
- Percentage: The bonus must be identified as separate from regular wages and is then taxed at a flat rate on the entire amount. As of 2020, the federal tax rate for supplemental pay is 22%. Bonus pay is also subject to FICA taxes and any other relevant taxes.
How Should I Keep up With Employee Benefit Packages in Payroll?
Offering employee benefits can be costly and managing them can take a lot of time and effort. But it’s often worth it because benefits packages can attract better talent and help your business retain employees.
If you plan to offer employee benefits such as health insurance or matching retirement plan contributions, you’ll have to make the associated payroll deductions. Because deductions may differ for each employee, this can get complicated, especially if you’re doing payroll manually. However, if your business uses a payroll software service or outsourcing company, the provider should automatically calculate deductions and contributions for each payroll run, reducing payroll errors and miscalculations. Payroll software solutions may also make it possible to easily integrate benefit information with payroll, accounting and HR business functions so each department has an accurate, up-to-date record of employee benefits.
How Does my Payroll Change When Employees Go on Leave, Like Parental Leave?
When employees take leave, the changes to their pay depend on a number of factors. These include the size of your company, its location, the type of leave and your company’s leave policies. For example, the rules differ depending on whether the employee is taking parental leave, military leave or voluntary leave.
Under the Family and Medical Leave Act (FMLA), employees can take up to 12 weeks of unpaid leave in any 12-month period if they have to attend to family or medical needs. Employees are also allowed to keep work-sponsored health plans, but they must continue to pay their contributions. The FMLA applies to private businesses with at least 50 employees, with some restrictions, and all government agencies and schools.
Some states have their own family leave laws, which may supersede the FMLA requirements. In New York, for example, most private employers with more than one employee are required to have paid family leave insurance in place. As of 2021, employees eligible to receive paid family leave benefits can receive up to 12 weeks of time off while receiving 67% of their average weekly wage.
Employers are legally required to provide time off for employees serving in the military, offer the same or similar job when they return.
Federal law doesn’t require you to pay employees for voluntary leave, such as taking time off work to pursue an educational opportunity, but businesses may create their own voluntary leave policies.
How Do I Know What Tax Exemptions my Business Qualifies For?
In order to be completely exempt from federal income taxes, a business must qualify and register as a not-for-profit organization, which usually means meeting the requirements for charitable organizations defined in section 501(c)(3) of the federal tax code. Such organizations are also eligible for tax deductible charitable gifts and may be exempt from federal employment taxes. In addition to being nonprofit organizations, they must meet other requirements. For example, they:
- Must operate for religious, scientific, educational or other charitable purposes.
- Must not attempt to influence government legislation.
- Must not violate fundamental public policy or practice illegal activities.
Even if your business is not tax-exempt, it may qualify for some common small business tax deductions, including tax deductions for vehicle expenses, salaries and wages, office supplies, employee benefits, furniture and equipment, office supplies, travel expenses, and more. Small business tax deductions are worth researching because they can reduce your yearly tax bill—substantially in some cases.
Managing payroll can be surprisingly complex, even for small businesses with a few employees. It’s critical to understand what’s required for initial setup as well as all employer responsibilities for withholding and paying taxes, classifying workers and paying leave. Consider a payroll processing software so your payroll runs smoothly and accurately to keep your employees happy, give you peace of mind and help your business stay compliant.