The term payroll can be used to describe both:
- The total amount of money that a business pays to its employees
- The process through which businesses determine and process employee payments
Handling payroll can be quite complicated for small businesses, but it does have to be. In this guide, we break down how payroll works for small businesses, what type of payroll systems you can implement, and why handling payroll efficiently is important.
What Is a Payroll System?
A payroll system is used to manage everything that has to do with payroll (e.g., paying employees, filing Social Security and Medicare taxes, etc.). This means that it can help track:
- The total number of hours worked by employees
- The net pay of each employee
- The amount needed to be withheld for each employee’s taxes
- How payments will be distributed
A payroll system ensures that your employees will get paid correctly, consistently, and on time.
Most importantly, implementing a payroll system can ensure that you consistently comply with the IRS’s requirements when it comes to depositing and reporting your payroll taxes.
Many employees choose to outsource this area of their business, but this is not necessary. Generally, payroll systems can be handled in the following ways:
Hiring an Accountant
Hiring a specialized accountant to handle your payroll is often a strong, albeit expensive, choice. An accountant will be able to handle your business’s payroll and tax needs with accuracy and ensure that you do not fall behind on any legal obligation that relates to your employees.
Setting Up In-House Payroll
You may want to set up your own internal process through which you handle your payroll. These are often handled manually at every pay period (e.g., by appointing yourself or a specified employee to run payroll) and so require high organizational skills.
This can be a favorable option if you are a very small business with a tight budget, but it is not recommended as it is not scalable. It will also mean that you will have to allocate time and resources toward handling your payroll, which will inevitably divert your attention from other business matters.
Working With a Payroll Service
A payroll service is a third-party company that specializes in setting up and managing other businesses' payrolls. These generally charge a flat fee per month, which can be relatively affordable.
Similarly, you may choose to work with a payroll software service. This can allow you to automate your payroll process almost entirely and minimize the chances of human error.
Note: Ultimately, the type of payroll system that you implement in your business is up to you, as it will depend on your preferred management style, budget, and expertise. You will need to “weigh out” the benefits of each one and decide what works best for you.
How to Do Payroll for Small Business
Preparing to handle your payroll is crucial. This is because it ensures that you will have the required:
- Employee forms and information
- Payroll schedule
- Payroll system
When preparing to do your payroll, you should generally follow these steps:
Know Your Payroll System
Will you be handling your payroll manually? Hire a specialized accountant? Or perhaps work with a third-party software provider? Either way, you will need to know this before you start your payroll.
This can preemptively save you stress and time and ensure that you organize all of your required data and filings correctly straight from the get-go.
Collect Forms From Employees
In order to start doing your payroll, you will need to ensure you have access to the following employee forms:
- IRS Form W-4: This is referred to as a “withholding certificate” by the IRS, meaning it is used to explain what percentage of a person’s salary is to be withheld by an employer for income and payroll taxes.
- State Form W-4: For states that do not have designated Form W-4s, the standard one is used instead.
- Form I-9: This is used to certify that all of your employees have the right to work within the US. You will need to obtain one from every person you employ.
- Direct Deposit Authorization Form: If you plan to pay your employees through a direct deposit (e.g., instead of by signing a check, etc.), you will need to obtain a direct deposit authorization form from them. This acts as legal proof that the persons working for you have consented to that form of payment.
Obviously, this list is not exhaustive. Depending on your business, there may be other forms that you may have to collect (e.g., benefits enrollment, emergency contacts, etc.).
Determine Your Payroll Schedule
You will need to decide how often you will pay your employees. It is important that you determine this preemptively, as your state may have specific requirements that you will need to follow in order to avoid penalties such as back taxes and fines.
Simply put, as long as you comply with your state’s minimum requirements, your schedule is entirely up to you.
In order to pay your employees, you will need to calculate how much they are owed.
Calculating Gross Pay
Your employees’ gross pay is the amount that they are entitled to before anything is withheld for payroll taxes, pre-tax deductions, or post-tax deductions.
If your employees are on a salary, you will simply need to divide their annual salary by the number of pay periods that you have. For example, if an employee is on a salary of $90,000 per annum, their gross pay on a monthly pay period would be $7,500.
For employees on an hourly rate, simply multiply their rate by the number of hours worked. Keep in mind that workers whose annual income is less than $35,568 are legally required to be paid an overtime rate for hours that exceed 40 a week. You will need to factor this into your calculations.
Calculating Withholding Taxes
If you are working with an accountant or with payroll software, this part will be handled automatically for you.
If not, you will need to calculate how much you will need to withhold from your employees’ salaries for payroll taxes using the IRS Tax Withholding Estimator.
Keep in mind that for all payroll taxes besides income taxes you will need to contribute an equivalent portion yourself.
This means that you generally withhold:
- Local, state, and federal income taxes: This is a progressive tax, and so will depend on your employees’ total earnings
- Social Security taxes: The rate for this is 6.2% of an employee’s wage. You will need to contribute an additional 6.2% independently.
- Medicare taxes: The Medicare tax rate is 1.45%. Employers need to contribute an additional 1.45% independently.
- Additional Medicare Tax: Once your employees earn over $200,000 per annum, you will be required to begin withholding an additional 0.9% for the Additional Medicare Tax.
- State unemployment and FUTA taxes: These are not actually withheld from your employees’ salaries and are instead paid solely by you as an employer. The current tax rate for FUTA is 6.0%, although this can be reduced by up to 5.4% if state unemployment taxes have been paid in full.
Keep in mind that:
- FUTA taxes are only applicable for the first $7,000 of an employee’s salary.
- Social Security taxes are only applicable for the first $147,000 of an employee’s salary.
- Additional Medicare Tax’s minimum income threshold depends on filing status (e.g., workers who are married and filing jointly owe the Additional Medicare Tax after $250,000 per annum).
Calculating Net Pay
Now that you know your employees’ gross pay and tax withholdings, you will need to make a few remaining deductions to calculate their net pay (i.e., the amount that they “take home”).
You will want to subtract:
- Pre-tax deductions: These include medical benefits, 401(k) retirement plans, disability insurance, etc.
- Post-tax deductions: These include garnishments, union dues, charitable donations, etc.
Paying Payroll Taxes
After you have paid your employees, you will need to follow a few final steps to stay compliant with the legal requirements of the IRS. These include:
- Depositing your payroll taxes
- Reporting your payroll taxes
- Filing your W-2 and W-3 forms
Depositing Payroll Tax
How often you will need to deposit your payroll taxes will depend on what form you will be using.
Note: Payments will need to be made electronically through the Electronic Federal Tax Payment System (EFTPS).
Reporting Payroll Tax
You will need to use a different form depending on the type of payroll tax that you want to report:
- Social Security and Medicare taxes (Form 941)
- Additional Medicare Tax (Form 941)
- Federal income taxes (Form 941)
- Federal unemployment tax (FUTA) (Form 940)
Depending on the nature of your business and your specific situation, you may have to rely on additional forms:
- Backup withholding (Form 945)
- Workers working in agriculture (Form 943)
- Employers who have been notified about the Form 944 program (Form 944)
You can report your payroll taxes electronically through E-File or by post. The IRS generally recommends that this is done electronically, but if you wish to send them by mail, you should keep in mind that the address you will have to use will depend on both your form and your state:
Filing W-2 and W-3 Forms
If your business pays $600 or more a year in payroll taxes, you will be required to file both a Form W-2 and a Form W-3 with the Social Security Administration (SSA). This needs to be done for every employee that you hire.
Note that unless you plan to file your forms electronically, you will be required to order scannable copies from the IRS. This can be done by calling 1-800-829-3676 or by visiting the IRS’s online ordering page.
All employers with 250 or more W-2 forms are automatically precluded from filing non-electronically unless otherwise told so by the IRS.
More Payroll Resources
- How to Calculate Payroll
- How to Calculate Payroll Taxes
- How to do Payroll for Small Business Yourself
- How to do Payroll in QuickBooks
- What are Payroll Taxes?
- What is Certified Payroll?
- What is Payroll? (A Guide for Small Business Owners)
- Full-Service vs. Self-Service Payroll
- How to Choose the Best Payroll Service for Your Business
- Why Your Business Needs a Payroll Service
- The 6 Best Payroll Services for Small Business in 2023
Frequently Asked Questions
Which states have no income state tax?
As of 2021, seven states have no income tax. These include:
- South Dakota
This means that persons living in these states are only liable for income tax on a federal level.
Do I need to pay Medicare tax if I make $200,000 a year?
Yes, unlike Social Security tax, the Medicare tax rate of 1.45% needs to be paid regardless of how much an individual is earning.
Employers are responsible for contributing a commensurate amount as well, meaning the total Medicare tax that needs to be paid is 2.9% of an individual’s salary.
What’s the difference between Medicare and Additional Medicare Tax?
The Additional Medicare Tax refers to the “additional” Medicare tax that individuals are required to pay after their received wages exceed a certain income threshold in any given year. The rate for this is 0.9%.
Generally, individuals who have received over $200,000 are required to start paying the Additional Medicare Tax, but this can vary depending on a person’s filing status. For example:
- Married filing jointly: $250,000
- Married filing separately: $125,000
- Single: $200,000
- Head of household: $200,000
- Qualifying widow(er) with dependent child: $200,000
See our guide on calculating payroll taxes for more information.
What is certified payroll?
Certified payroll is a weekly payroll report that is filed through Form WH-347. All employers who work on federally funded projects with a value that exceeds $2,000 are required to submit it in order to avoid fines and potential prison time (up to five years).
For more information on certified payroll, see our What Is Certified Payroll guide.
What is the largest payroll tax?
The largest payroll tax — excluding state and federal income taxes, which are contingent on individuals’ earnings — is Social Security tax.
The rate of Social Security tax is currently 6.2%. An additional 6.2% needs to be provided by workers’ employers, making the total amount owed to the IRS 12.4%.
For more information on payroll taxes, see our What Are Payroll Taxes guide.