Knowing how to do payroll is essential to the survival of any small business, even those with only a handful of employees. There are several ways to accomplish this task, but the one that’s right for you will depend on several factors. You’ll need to carefully weigh the size of your organization, your budget and how much time you have. A thorough understanding of what goes into payroll is also necessary to make a strategic decision. This guide covers:
- How payroll works
- Setting up payroll
- Do it yourself payroll
- Payroll service providers
- Helpful payroll tools
- Common payroll mistakes
Although there are many steps involved in doing payroll yourself, they are not indicative of the process when working with ADP. We use automation to simplify manual labor and free up your time.
How does payroll work?
Running payroll consists of many calculations. You need to account for wages, hours, benefits, tax deductions and garnishments, as well as comply with federal and state regulations throughout every step. The key to success is to set up a process from the beginning that helps address compliance issues. Otherwise, you could face costly penalties for filing payroll taxes incorrectly or missing a deadline. Bottom line – there’s a lot more to payroll than just cutting a check every few weeks.
How to set up payroll
No matter how you choose to run payroll, the setup is basically the same. To get started, you’ll need to provide federal and local authorities with information about your business and your employees. Creating a payroll schedule and deciding what benefits to offer are also important, as are purchasing workers’ compensation insurance and opening a bank account dedicated to payroll.
Step 1 – Apply for an EIN
In the eyes of the government, individuals are identified by their Social Security Number. The same is true for businesses, except it’s known as an employer identification number (EIN) or federal tax identification number. Your organization will need one in order to file payroll taxes. Obtaining an EIN is free and can easily be done online or via mail using Form SS-4, Application for Employer Identification Number. Once approved, it’s permanent and can’t be cancelled.
Step 2 – Obtain your local or state business ID
States and local governments that assess income tax also require businesses to have an identification number. The manner in which you obtain one varies so check with the appropriate agency in your area for specific details. In general, you should apply for a federal EIN first because some states may use that same number to identify your business.
Additionally, many states require a state unemployment ID number, which must be different from the state income tax number. You will use this number to file state unemployment taxes on behalf of your employees.
And if your business is based out of New Mexico, Washington or Wyoming, you’ll need a separate ID number to apply for workers’ compensation insurance.
Step 3 – Collect employee documents
Once you have your business details squared away, your employees must fill out some paperwork for government agencies. Most of these documents are usually completed on a new hire’s first day on the job:
- Form I-9, Employment Eligibility Verification
In the United States, use Form I-9 to verify the identity and employment authorization of individuals hired for employment.
- Form W-4, Employee’s Withholding Certificate
To determine how much federal income tax to withhold from employee wages, each worker needs to complete a Form W-4. It includes several steps for entering personal information and filing status, multiple jobs or spouses who work, dependents claimed, and other adjustments, if necessary.
- State withholding allowance certificates
In most states, you’re required to withhold state taxes, as well as federal income taxes, from employee wages. Your employees will need to complete a state withholding certificate or the IRS Form W-4 for this purpose. Note that Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming do not impose a state income tax on wages.
In addition to completing government documentation, your employees must supply their home addresses and Social Security numbers so you can prepare and deliver their annual Form W-2, Wage and Tax Statement. And if you offer benefits, you’ll need their selections to make the proper payroll deductions.
Step 4 – Choose pay periods
When it comes to selecting a payroll schedule, you have four common options – weekly, bi-weekly, semi-monthly and monthly. The choice, however, may not be entirely up to you because certain jurisdictions require specific pay frequencies for different types of employees, employers or circumstances.
For example, manufacturing employers or those that are covered by a collective bargaining agreement may mandate a more frequent pay schedule than the general jurisdiction provision. These regulations also typically include requirements for how soon employees must be paid after the end of the pay period.
As you narrow your options, keep in mind that the more often you run payroll, the more you incur accounting and processing fees. Try to strike a balance between cost-effectiveness and convenience, while complying with jurisdiction requirements.
Common in the manufacturing, construction and restaurant industries, weekly pay suits manual labor jobs with low wages. These types of workers need to be paid more often to meet their living situations.
This method of pay may be best for hourly workers because overtime is typically charged by the workweek. Retail employees are sometimes paid in this manner.
Salaried workers often prefer semi-monthly pay due to its consistency and cash flow predictability. Many industries, including financial services and health care, use this pay model.
Since it’s processed less frequently, monthly pay is the least expensive payroll option and is usually reserved for executives with high salaries.
Step 5 – Purchase workers’ compensation insurance
Workers’ compensation is a state-regulated program that pays for medical care, rehabilitation and a portion of lost income for employees who become sick or injured on the job. Additionally, dependents may be entitled to benefits in the event that an employee dies from a work-related injury.
In some areas of the country, you’re required to carry workers’ compensation insurance even if you only have one employee. You can purchase policies through private insurers, the state or both.
Workers’ compensation is not deducted from payroll, but when a claim is made, you must file reports with your state.
Step 6 – Offer optional benefits to employees
Benefits – such as health insurance, dental care, life insurance and retirement plans – can make your business an attractive place to work. Employees typically pay a portion of the cost, which is deducted from their paycheck. How much depends on the types of plans you offer and the level of coverage the individual chooses. Some benefits, such as those offered under a cafeteria plan that meets the specific requirements and regulations of section 125 of the Internal Revenue code, may be offered on a pretax basis. Others, like Roth IRA retirement plans, are deducted on a post-tax basis.
Step 7 – Open a payroll bank account
Many businesses choose to open a bank account separate from their business account just for the purpose of payroll. If you do so, use this account only for paying employees and fulfilling tax obligations. This will allow you to keep more accurate records of your payroll transactions.
How to calculate and do payroll on your own
Many small businesses begin doing payroll on their own and if you only have a handful of employees, this may be a cost-effective option. Whether you can do it correctly, however, will depend on your individual skills and experience. Any miscalculations can result in costly fines that could impact your bottom line. To help avoid this, you’ll need to meticulously maintain all your payroll records, double check your data entry and meet all tax filing deadlines.
Step 1 – Calculate hours worked and gross pay
The first step in processing payroll manually is to calculate the total number of hours each of your employees worked during a given pay period. Paper time sheets, spreadsheets and punch clocks are all ways to track this information. The total hours worked is then multiplied by each worker’s pay rate, or at least the applicable minimum wage, to determine the gross pay.
If your employees are nonexempt, remember to account for any tips they receive and overtime hours. To calculate overtime pay in accordance with the Fair Labor Standard Act (FLSA), multiply each hour worked over 40 in a workweek by no less than one-and-a-half times the employee’s regular rate of pay. Although you can define when your workweeks begin and end, they must consist of seven consecutive 24-hour periods. Also note that certain states have different requirements for when overtime pay is due. For example, some require overtime payment after eight hours of work in a day.
Step 2 – Process payroll deductions
Once you’ve calculated gross pay, begin processing payroll deductions based on the employee information you gathered earlier.
First, make your pre-tax deductions. If you offer your employees qualified health benefits, 401(k) retirement plans or group-term life insurance, this is when you’ll withhold those contributions.
Next, calculate the statutory deductions, including federal and state income tax and Social Security and Medicare tax, also known as Federal Insurance Contribution Act (FICA) taxes. A portion of every employee’s paycheck goes to both FICA taxes (until the Social Security wage base is met), which you must match as the employer. You’re also required to pay federal unemployment tax (FUTA), but this is not deducted from employee wages and is solely your responsibility. Note that certain states and local jurisdictions have additional taxes that must be withheld from employees and/or paid by employers.
Lastly, subtract the post-tax deductions. Employees with court-ordered wage garnishments, Roth IRA retirement plans and union dues are subject to these withholdings.
Step 3 – Calculate net pay and pay employees
When all the pre-tax and post-tax deductions are subtracted from an employee’s gross pay, you’re left with net pay or take home pay. You have several options to distribute net pay, as long as you adhere to the various federal and state laws that govern wage payments.
If you’re using electronic delivery, you should be familiar with the specific requirements for each jurisdiction where you have employees. Most states also require employers to include a pay statement with each payment of wages. State laws vary as to how the pay statement may be delivered to employees.
In addition to compliance, flexibility and cost are top of mind today. Many employers are moving away from traditional checks because paper, materials and postage increase payroll operating expenses. Alternative options, such as direct deposit and paycards, are less expensive, more convenient and can help attract prospective talent to your business.
Step 4 – File tax reports
Deducting taxes from your employees’ pay is only half the battle. You also have to file them with various agencies, including the federal government.
Generally, you can use Form 941, Employer’s Quarterly Federal Tax Return to pay your share of FICA taxes and report the amount of income tax, Social Security tax and Medicare tax you withheld from employee wages.
You may also have to file Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return. Remember that only employers pay FUTA tax, so don’t deduct this from employee wages.
In addition to FUTA, most employers pay state unemployment taxes. These should be filed according to local guidelines.
Step 5 – Document and store payroll records
Aside from getting your payroll calculations correct, the best way to avoid compliance headaches is to take recordkeeping seriously. For each employee, payroll records1 should include:
- Name and occupation
- Social Security number
- Day and time when an employee's workweek began
- Number of hours worked each day and workweek
- The basis on which the employee’s wages were paid
- Regular hourly pay rate
- Total daily or weekly straight-time earnings
- Overtime earnings for each workweek
- Gross wages
- Payroll deductions
- Allowances claimed
- Net wages
- Date of each payment and the pay period that it covered
- Taxes withheld
- Form W-4
Records required for tax purposes must be kept on file for at least four years. All others should be saved in accordance with federal or jurisdiction requirements, whichever is greater. If in doubt, check with the appropriate federal, state or local agency to make sure you’re keeping the right documents for the correct length of time.
Additionally, many states have wage theft prevention laws, which require you to provide your employees with specific information in writing about their pay and other benefits. This generally must be done on the date of hire and whenever there are updates. You have to retain these notices for the period of time designated by the state.
Step 6 – Report new hires
New hire reports are shared with the National Directory of New Hires (NDNH) and matched against child support records at the state and federal levels to locate parents. For this reason, you’re required by federal law to collect and report seven data elements within 20 days of hiring a new employee to a designated state agency. Some states require additional data or have shorter deadlines, so check with local authorities.
How to do payroll using professional services
As your small business grows and you hire more employees, DIY payroll may become too difficult and time consuming. Or, you may decide that your efforts would be better spent on improving your products and services instead of administrative tasks. At that point, it makes sense to outsource payroll.
You have several options in this regard – work with a payroll service provider, outsource your entire HR department with a professional employer organization (PEO) or hire an accountant. Of the three, payroll service providers tend to be the most cost effective and offer a host of benefits, including accuracy, compliance support and data security.
Step 1 – Provide tax info and documentation
When you’ve decided on a payroll service provider, you’ll need to provide them with all your payroll records. These may include:
- Employee personal information
Now is a good time to have your employees verify that all of their details are correct. A vendor that offers self-service will make future updates easier. Also remember to provide information on employees who may have left the organization in the previous year so they receive a Form W-2.
- Job information
Among other details, you’ll need worker classification, exempt status, compensation, hire date, Form W-4 details and garnishment orders for every employee.
- Company information
Your federal and state tax ID numbers and year-to-date and quarter-to-date tax payment totals will be necessary for your provider to file payroll taxes on your behalf.
- Applicable regulations
Notify your new provider of all the government regulations that apply to your business.
Step 2 – Report agent authorization
The IRS requires that you notify them if you choose to work with a payroll service provider. This is done via Form 8655, Reporting Agent Authorization Form. It permits your provider to perform payroll tasks on your behalf, such as:
- Pay employees
- Prepare and deliver Forms W-2
- File certain tax returns (e.g., Forms 940 and 941)
- Receive payroll and tax deposit correspondence
- Pay the federal government on behalf of your business
Step 3 – Process your payroll
Thanks to automation, payroll software makes running payroll much less labor intensive. In most cases, all you have to do is enter your employee and business data into the system once and update only as needed. The software then handles the calculations, employee payments and tax filings on your behalf.
To get maximum value from your purchase, consider integrating payroll with other HR functions. Many providers can sync their payroll software with time clocks, general accounting ledgers and benefits administration. Such integrations can improve efficiency and make tasks easier for both you and your employees.
Helpful payroll tools to get payroll done
Whether you’re running payroll manually or working with a service provider, you’re not in this alone. ADP offers a host of tools that can help both you and your employees manage payroll-related finances:
- Payroll calculators
Estimate salary wages, hourly wages and the value of stock options.
- Retirement calculators
See how much you should contribute to a 401(k), plan a withdrawal rate and more.
- Glossary of terms
Get easy-to-understand definitions of common tax lingo and acronyms.
- Tax guides and forms
Find copies of the latest documents you need for tax compliance.
Common payroll mistakes
Automating payroll is the best way to help help eliminate payroll mistakes. Short of that, you can save money and headaches by avoiding these common payroll errors:
- Misclassified worker status
Misclassifying workers as independent contractors when they are actually employees may result in penalties.
- Inaccurate payroll records
There are both federal and state mandates for how long you must keep payroll records. Know what’s required of your business before destroying documentation.
- Late tax payments
If you’re using a payroll calendar, track your payment dates and create tax deadline reminders to avoid late filings.
- Misprocessed garnishments
You can be fined for failing to deduct garnishments or withholding them incorrectly.
- Underreported taxable compensation
If you offer stock options or employee discounts, this must be reported to the government.
- Payroll fraud
Updates to employee bank accounts and Forms W-4 should be done in person, instead of email, to prevent payroll phishing scams.
For as much as advancements in technology have made payroll easier, an evolving workforce and compliance regulations continue to make it complex. Our frequently asked questions can help you understand the basics of payroll.
What is payroll?
The term payroll can mean different things to different people. An employee might think of it in terms of how often and how much they are paid. While you, as the employer, may see the bigger picture of the process – the calculations, worker classifications and tax deductions – that goes into creating a paycheck. In reality, payroll is all of these things.
How do I start and do payroll?
To begin processing payroll, you will need to gather information about each of your employees and your company. This includes worker classifications, tax withholding details, Social Security numbers, business tax ID numbers and more. You’ll also have to determine your payroll frequency and the sort of benefits you’ll offer employees, since these are usually deducted from their wages. If you’re switching from a manual payroll process to a payroll service provider, you may need training so you can become proficient using the product.
What are the benefits of using a payroll system?
One of the main benefits of partnering with a payroll service provider is that it gives you more time to focus on your small business operations instead of burdensome administrative tasks. It can also save you money because you’ll be less likely to make miscalculations or miss tax filing deadlines, which can result in expensive penalties. All of this is possible through automation. Payroll software pays employees and files taxes on your behalf and can help you keep pace with evolving compliance regulations.
How are payroll taxes calculated?
Payroll taxes are typically calculated by deducting the following from the employee’s gross pay:
- Federal income tax, based on Form W-4 details
- Social Security tax (6.2% of wages)
- Medicare tax (1.45% of wages)
- State and local taxes
As an employer, you’re required to match the Social Security and Medicare tax contributions and pay an additional 6% to federal unemployment tax, although this rate may be less if state unemployment tax applies.
This guide is intended to be used as a starting point in analyzing an employer’s payroll obligations and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
Tax figures provided are as of the 2020 tax year.
1There are additional requirements for the basic records that an employer must maintain under various federal and state laws. Remember to check each jurisdiction’s requirements for compliance.