Step-by-Step Guide to Running Payroll for Your Small Business
For small businesses, payroll can seem daunting…but it is doable. Of course, you know that—due to tax obligations and employment law compliance—employers cannot simply hand out cash or write checks on payday. Running payroll is an ongoing process you must manage carefully from the moment your first employee is hired.
Here’s what you need to know about running payroll, including how to set it up from the beginning and what your options are. By the end, you’ll have a better understanding of how to pay your people consistently, compliantly, and correctly.
Three Payroll Options
Before we discuss how to set up and run payroll, it’s important to note that you don’t have to go it alone. All of your payroll processing options fall into three basic strategies: do it yourself, hire an accountant, or use a payroll service provider. Here are the pros and cons of each:
- Option 1: Doing Payroll Yourself:
Many small business owners choose to run payroll themselves. It can actually be simpler for new employers with a small workforce, and it’s obviously the most affordable option. It’s also a great way to stay on top of your organization’s finances in the early stages of growth.
However, the DIY option comes with a higher risk of error and takes considerably more time. Using spreadsheet software like Excel or Google Sheets can make the process more efficient than manually filling out and calculating payroll information, but doing it yourself still requires gathering all the inputs and making sure your calculations are correct. DIY becomes less viable as your business grows in personnel and operations.
- Option 2: Hiring a Payroll Accountant:
Whether outsourced or in-house, hiring an accountant is the most reliable way to run payroll. A dedicated professional can take a hands-on approach to managing your payroll, ensuring accuracy and compliance. They can even serve as a valuable payroll consultant.
Hiring an accountant is also the most expensive option, even if you outsource accounting services. If you hire an in-house accountant, you should consider the cost of recruiting, onboarding, and training as well. They may well be worth the cost, though, considering the convenience and the confidence of handing it off to a professional.
- Option 3: Use a Payroll Service Provider:
Using a payroll service provider is more reliable and convenient than doing it yourself and more affordable than hiring an accountant, especially when integrated with an all-in-one human resources information system (HRIS) like BerniePortal. An HRIS can distribute and collect the necessary tax and benefit forms, track time and attendance, and host tax reporting documentation. Software also automates running payroll—streamlining the process and eliminating most errors—which can make it as easy as pushing a button each pay period.
A payroll service provider may not be as accurate and up-to-date as a hands-on accounting professional. And of course, it costs more than running payroll yourself. Adopting new payroll software may require extensive training and add to the responsibilities of your current staff.
That’s a lot for a small business owner to consider. While there are advantages and disadvantages to all three options, setting up your payroll looks much the same in each scenario. That’s what we’ll cover next.
How to Set Up Payroll in Three Steps
Regardless of which payroll option you choose, you’ll need to follow these three steps first:
- Step 1: Register for an EIN:
Just as the IRS uses Social Security numbers to identify individual taxpayers, organizations must have an employer identification number (EIN) to file their taxes. The application is free and easily accessible on the IRS website.
Depending on your location, you may also be required to register for a separate state or local ID number.
- Step 2: Collect Employee Tax Information:
You’ll need to distribute a copy of Form W-4 to each employee and collect their completed forms before you start paying them. Employees fill out Form W-4 to determine their filing status, number of dependents, and other adjustments. Employers use the form to calculate how much tax to withhold from employee paychecks. You can use an HRIS like BerniePortal to easily distribute and collect W-4s and even remind employees who still need to complete and return the form.
- Step 3: Determine Payroll Schedule:
There are generally four options for choosing a pay schedule: monthly, semimonthly, biweekly, and weekly. Most states have laws regulating pay periods, but it’s likely you have more discretion in determining your pay schedule than you realize. Keep in mind that the Fair Labor and Standards Act (FLSA) requires overtime to be calculated weekly. It’s also important to consider that most insurance premiums are paid monthly.
There are a few other issues to take into consideration when setting up your payroll. For example, workers’ compensation insurance is required in every state but Texas, and you’ll need that information before running payroll. You’ll also need to consider what benefits you’ll offer in order to plan for premium deductions.
Finally, many small businesses find it easier to manage payroll through a bank account separate from their general business account, so you’ll need to have that set up ahead of time, too.
Again, the steps for setting up your payroll are generally the same for everyone—whether you choose to do it yourself, hire an accountant, or use a payroll service provider. But your experience of running payroll will vary depending on which option you choose.
How to Run Payroll in Five Steps
There are basically five steps to running payroll once you have it set up—no matter who you choose to run it or how. Still, many of these steps can be outsourced to an accountant or automated through a payroll service provider. In other words—unless you run payroll yourself—it’s easy to take some of these steps for granted.
So, to make sure the topic is explained as thoroughly as possible, we’ll cover how to run payroll in five steps as if you were taking the DIY approach.
- Step 1: Calculate Hours and Gross Pay:
The FLSA divides workers into two categories based on income and job duties: exempt and non-exempt. Exempt workers are salaried, and generally, you can calculate their gross pay by dividing their yearly salary by the number of pay periods in the year. Non-exempt workers are hourly, and you can calculate their gross pay by multiplying the number of hours they worked in the pay period by their hourly rate. Don’t forget to include any overtime pay at one-and-a-half times each worker’s hourly rate.
You can track worker hours through punch clocks, paper timesheets, or a spreadsheet, but an HRIS like BerniePortal can make time and attendance tracking much more accurate and convenient. It can even factor in paid and unpaid time off.
You’ll also need to calculate stipends, bonuses, and tips for gross pay.
- Step 2: Deduct Benefits and Withhold Taxes:
This is where the real challenge of running payroll comes into play. While the terms are often used interchangeably, deductions and withholdings are not the same thing. Taxes are withheld, and benefits are deducted.
Then, calculate how much federal income tax, Social Security tax, and Medicare tax to withhold from each employee’s paycheck based on how they completed Form W-4. State and local income taxes may also apply. To be clear, these taxes only apply to the amount of gross pay minus pre-tax deductions. The IRS website has a Tax Withholding Estimator that can help you with these calculations.
Finally, subtract the total amount of all post-tax deductions, such as Roth IRA contributions, disability insurance premiums, and union dues. Court-ordered wage garnishments for child support, outstanding tax obligations, and debt repayments are also subtracted after taxes.
An accountant or payroll service provider can significantly reduce errors and hassle for this crucial step.
- Step 3: Pay Employees:
Once you’ve deducted benefits and withheld taxes from gross pay, you’re left with an employee’s net pay—also known as “take-home pay.”
While smaller businesses may prefer to hand out cash or cut paper checks, most find direct deposit more convenient and cost-effective as their organization grows and offer employees that option. Either way, most states require employers to provide employees with documentation—called a pay stub—detailing how their net pay was calculated, including hours, pay rate, deductions, and withholdings.
- Step 4: Pay and File Taxes:
Of course, you still have to pay all of those taxes you withheld from workers’ paychecks. Employers must deposit payroll taxes on a monthly or semi-weekly basis. To determine which deposit schedule your business is required to follow, check out the IRS website.
In addition to payroll tax deposits, employers use Form 941 to pay their share of federal taxes and to report the amount of taxes they withheld from workers’ wages. Form 941 must be filed on a quarterly basis. You can download a fillable PDF copy of Form 941 from the IRS website. The BerniePortal blog also has a step-by-step guide to filling out Form 941.
You are also required to pay unemployment taxes, which may not be withheld from employees’ paychecks. To comply with the Federal Unemployment Tax Act (FUTA), employers must file Form 940 annually. You can download a fillable PDF copy of Form 940 from the IRS website. The BerniePortal blog also has a step-by-step guide to filling out Form 940.
Finally, employers must prepare, furnish, and file Form W-2 for each employee each year. Employees need the W-2 Wage and Tax Statement in order to file their individual tax returns. Again, you can download a PDF copy of Form W-2 from the IRS website. The BerniePortal blog also has a step-by-step guide to filling out Form W-2.
As with calculating withholding taxes, an accountant or payroll service provider can significantly reduce errors and hassle for this crucial step. Noncompliance can be costly.
- Maintain and Retain Records:
Federal law requires employers to maintain accurate and organized payroll records.
For tax purposes, you must retain records for at least four years. According to the IRS, these records should contain the following information:
Your employer identification number.
Amounts and dates of all wage, annuity, and pension payments.
Amounts of tips reported.
The fair market value of in-kind wages paid.
Names, addresses, social security numbers, and occupations of employees and recipients.
Any employee copies of Form W-2 that were returned to you as undeliverable.
Dates of employment.
Periods for which employees and recipients were paid while absent due to sickness or injury and the amount and weekly rate of payments you or third-party payers made to them.
Copies of employees' and recipients' income tax withholding certificates (Forms W-4, W-4P, W-4S, and W-4V).
Dates and amounts of tax deposits you made.
Copies of returns filed.
Records of allocated tips.
Records of fringe benefits provided, including substantiation.
The Department of Labor also requires employers to keep wage records such as time cards, wage rate tables, job evaluations, collective bargaining agreements, work schedules, and records of wage changes for two years.
A robust, all-in-one HRIS like BerniePortal can help you better maintain and retain payroll records to comply with federal and state law.
Even if you’d rather focus on more strategic objectives, payroll is one of the most important functions of your business. After all, you need to pay your people well to help you achieve those objectives, and you need to pay them correctly to protect your bottom line.
You can stay informed, educated, and up-to-date with important HR topics using BerniePortal’s comprehensive resources:
- BerniePortal Blog—a one-stop-shop for HR industry news
- HR Glossary—featuring the most common HR terms, acronyms, and compliance
- HR Guides—essential pillars, covering an extensive list of comprehensive HR topics
- BernieU—free online HR courses, approved for SHRM and HRCI recertification credit
- HR Party of One—our popular YouTube series and podcast, covering emerging HR trends and enduring HR topics
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