How to do payroll for small business

Most people who start a business are thinking of the big picture — the products they hope to sell, the audience they intend to reach, and of course, the net profit they hope to bring in. But it's the small, sometimes overlooked, details that often make the difference between success and potential failure.

Drawing in and maintaining a diverse pool of talented, trusted employees is essential to stay nimble and thrive in an ever-faster changing business landscape.¹ Countless studies conducted over the years on the subject of employee retention and motivation have shown that there are a few key factors for attracting and keeping good people: building and sustaining a strong company culture, opportunity for growth, flexibility, a strong work-life balance, and of course pay.^2,3 As an employer you’re responsible for:

• Paying your employees well and on time
• Calculating your employee’s earnings
• Withholding any applicable taxes
• Social Security, Medicare, and/or any other deductions under the Federal Insurance Contributions Act (FICA)
• Recording payroll activity
• Preparing and filing tax documents for federal, state, and local agencies⁴

All that important paperwork can be time-consuming, confusing, expensive — and it can distract from the tasks that need your focused attention and cannot be delegated to someone else. There are options for a small business owner that include hiring an internal bookkeeper full or part time, or outsourcing the payroll duties entirely to a vetted payroll vendor.

We've put together some resources to help you make the decision.

How does payroll work?

By definition, payroll refers to “the business process of paying employees and factoring out payroll taxes”. Businesses of any size must handle payroll —and the larger the organization, the more complicated and time consuming the payroll process becomes. Administrative complexities arise from seemingly endless tax-related responsibilities making the task all the more arduous. Each employee, freelancer, or outsourced consultant or consulting service has its own set of tax and payment guidelines. If you're not an expert in payroll and/or tax law, it’s possible that you could run into issues with the IRS.⁵ If you have questions, you should seriously consider consulting an accountant or payroll professional to ensure you're compliant with any and all state and federal tax and employment requirements.⁶

Here’s a truncated list of the steps involved in payroll for a small business:⁷

1. Ensure employee paperwork is up-to-date (Employer Identification Number, W-2, W-4, etc.)
2. Set a payroll schedule
3. Calculate employees’ gross pay
4. Factor in tax deductions, Social Security deductions, etc.
5. Choose an in-house or external service for administering payroll
6. Pay employees
7. Report payroll taxes as needed on quarterly and annual basis

The IRS maintains the Employer’s Tax Guide, which provides guidance on all federal tax filing requirements that could apply to the obligations for your small business. Check with your state tax agency for employer filing stipulations.

How to process payroll

Whether you're starting a company or in expansion mode, here are some ways to improve the accuracy and consistency of your payroll process.

Step 1: Establish your employer identification number (EIN)

Priority number one is determining your employer identification number and establishing your state and local tax IDs. This is what will be used by the IRS to track your payroll taxes and ensure you're meeting all necessary requirements.

Step 2: Collect all relevant employee tax information

Prior to even processing payroll, employees are required to fill out various tax forms to establish allowances and other tax and income-related details. Forms include W-4, I-9, W-2, and 1099 for contract-based employees or consultants.

Step 3: Find the right payroll schedule for you

Choosing a schedule that works best for your business and employees is important. Typically, the pay schedules are either monthly, semi-monthly, biweekly or weekly, or a combination of two or more if there are contract employees or consultants involved. Be sure to let your employees know their pay schedule, account for holidays, quarterly tax dates, annual tax filings or any delays you may come up against. You'll also need to establish how each employee prefers to be paid. This could mean paper check, direct deposit or other various new methods.

Step 4: Calculate gross pay

Gross pay is simply the total number of hours an employee worked in a pay period multiplied by his or her hourly rate. Make sure to account for any overtime, also known as time and half, for any hourly employee working more than 40 hours.

Step 5: Determine deductions

Take federal and state requirements from your employees’ W-4s, including insurance and benefit requirements to determine each employee's deductions. Each state has different laws and requires different taxes be taken from small businesses at various times. Some of the most common deductions come in the form of:

• Federal taxes
• Social Security
• State taxes
• Local taxes
• Medicare
• 401(k) contributions
• Workers' compensation contribution

Step 6: Paying your employees

Take each employee's gross pay and subtract their deductions. What's left is the employee's net, or “take-home” pay and this is what you’re responsible for paying each employee.

Step 7: Record keeping

It’s imperative that you keep all records of your transactions for tax as well as for legal compliance purposes. It’s crucially important to maintain organized, easily accessible records should you need to reference them in the future. The Department of Labor has a wealth of information on the topic of recordkeeping.

Using a dedicated payroll processing software can be a far more efficient way to not only handle all the minutiae but also ensure that records are properly stored. Apart from being a time saving measure, many offer automatic updates to tax regulations, reminders, and an additional layer of security. Quality payroll processing software will also help to remove human error from the equation.⁸

In-house payroll

The decision to process payroll in-house is one that should not be taken lightly, after all, accurate, timely payments to your employees as well as all IRS obligations will rest solely in your hands. The biggest advantage to processing your payroll in-house is complete oversight and control over the entire process. If your IT security systems are in good shape, processing in-house means that your employee data will be more secure than if it were potentially outsourced to a third party. It also allows for more flexibility for bonuses, raises, late changes, and/or corrections.⁹

There are stark differences between processing your payroll in-house and utilizing full-service payroll services. Taking advantage of a paid full-service organization means that all payroll processing, direct deposits, printing of checks, tax payments, withholdings, and tax filings will all be taken care of. Typically, a service like this, while coming at a cost, mitigates errors, ensures that payroll runs smoothly, and saves time. Time savings is one of the most valuable perks of using a full-service, so you can focus your strengths and skills more on your business and less on processing payroll.¹⁰

Should I outsource payroll?

Payroll processing services handle the entire payroll process, from filing forms to deposits; but there are disadvantages, too. Depending on the provider you select, you may run into some difficulty obtaining or updating wage data, payroll history or personal employee information due to the fact that all the information resides on a third-party server. Should an error occur in the payroll a full-service payroll organization may not respond and fix the issue as quickly as you or your employees had hoped. In addition, the company you pick could go out of business leaving you to have to go through the selection process all over again. Then, of course, there is the cost. In most cases you get what you pay for, and the time savings cannot be understated, but not all full-service payroll organizations can or will tailor services to fit your needs. Make sure you’re doing your research and looking for a service that best fits the needs of your business and your financial situation.^8,10

How to choose an outside payroll vendor

When choosing an outside Payroll vendor, your payroll processing should become more reliable, less expensive, and all around easier for your business. Some larger providers may try to bundle your payroll package with additional services that you might not need, quickly driving up costs. A simple solution is to create a list of services you think you’ll need from a vendor and be prepared to ask lots of questions.^8,10

Intuit and Gusto both excel at providing payroll services to small businesses. Each offers their own flexible packages, perks, and payment options, even going so far as to integrating smoothly with your accounting software. In addition, both companies offer clean, well-designed digital experiences.¹¹ There are countless options for payroll vendors that may best meet the needs of your business. Make sure to do as much research as possible before deciding where to land.

Outsourcing employees: Pros and cons

Outsourcing can be a good way to get the jobs you need done without the complications, time, and expense involved with hiring full-time employees. It can be difficult making sure they are a good fit for the position you are looking to fill, so be sure to have detailed job descriptions and set clear, reasonable expectations for the open position. Independent contractors tend to be more flexible and can, in the long run, save your organization money versus hiring a full-time employee. Before hiring an independent contractor, make sure the individual is up for the task and has been properly vetted. You may even want to ask for samples of work and check references.¹²

Next steps

Understanding the nuanced details of this process is key to setting up a payroll system for your small business. There are countless options and answers out there depending on what you may need to get your business running as efficiently as possible from payroll to outsourcing help. Resources are available for small business owners to ensure that they’re saving time while remaining compliant and profitable.