How To Process Payroll and Payroll Taxes

Professional Chartered Accountant Woman Doing Tax
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Processing payroll is a key responsibility for your business if you have employees, Doing it right is important because you must make sure payment amounts are correct for employees, and payroll taxes are calculated, reported, and paid to the IRS and states according to the law.

Unless you want to do your own payroll by hand, you have two options for doing payroll:

In either case, you'll need to know the basics of payroll processing so you can discuss options and deadlines and input the original information.

This article details the process of paying employees and collecting, reporting, and paying payroll taxes for those employees. It doesn't, however, include the process of paying non-employees, including independent contractors.

What Does Processing Payroll Include?

Payroll processing, often called "doing payroll," includes:

  • Deciding how much to pay employees, and how often, and in what way (salaried or hourly)
  • Getting withholding information from employees at hire
  • Calculating paycheck amounts, including withholding payroll taxes and deductions
  • Writing paychecks
  • Reporting payments and payroll tax information to the IRS and states
  • Paying those payroll taxes when they are due

Doing payroll also includes dealing with the IRS for federal employment taxes and your state's taxing authority for state taxes.

Take a look at this yearly payroll calendar to get an idea of the due dates for reporting and paying payroll taxes.

Before You Begin Processing Payroll 

As you hire employees, you as the employer have forms to complete. Each new employee must have new hire forms signed and placed in a specific file. The most important form is the employee's W-4 form for withholding federal income taxes

To help you set up payroll, here's a checklist of tasks that must be completed and decisions that must be made about how you will pay employees. 

Sign Up With Taxing Entities

You will need to sign up with the IRS before you hire employees and begin payroll processing. If your state requires income tax payments (nine states don't), you'll need to contact them too.

Processing Payroll

Payroll is processed at the end of each payroll period (weekly, bi-weekly, semi-monthly, or monthly). 

Prepare Each Employee's Paycheck

Your first task is to prepare a paycheck for each employee. To do this, you must calculate the gross pay for the employee, based on whether this person is salaried or hourly. Gross pay is the pay the employee receives before any tax withholding or deductions.

  • For hourly employees, it's the employee's pay rate times the hours worked.
  • For salaried employees, it's usually the employee's annual pay divided by the number of pay periods in a year.

Subtract amounts for:

  • Federal income tax (based on the employee's W-4) and tax tables
  • State income tax (if any)
  • FICA taxes for Social Security and Medicare (explained below)
  • Other deductions for employee contributions for health plans, retirement plans, and other voluntary deductions

The result is the employee's net pay, which the amount of their paycheck.

After You Prepare Paychecks

After you have done the paycheck calculations and prepared a paycheck for each employee, you have some other tasks to complete before the payroll process for that pay period is complete.

Calculate the amount you will owe for both the employer and employee portions of FICA taxes (Social Security and Medicare) and set aside an amount equal to both the employee and employer portions of these taxes, to be paid later, through payroll tax deposits. 

FICA taxes are calculated at 15.3% of the employee's gross pay (12.4% for Social Security and 2.9% for Medicare). The employer and employee each pay 7.65% (6.2% for Social Security and 1.45% for Medicare). The employee's 7.65% is the amount you must withhold from their paycheck. The employer's 7.65% is the amount you must set aside in your accounting system and pay to the IRS.

The FICA calculation also includes two special situations:

  • The employee portion of the Social Security tax is capped each year at a maximum amount, so you must stop withholding the employee's portion of this tax at that amount.
  • Higher-income employees must pay an additional Medicare tax for that year of 0.9%, beginning when their earnings reach $200,000 for the year.

Neither of these situations affects your payment of FICA taxes as an employer.

Then, total all the withholding for all employees and your employer portion and all deductions and set aside the total to be paid later.

Employers must also pay unemployment tax (FUTA) based on the gross pay of employees. These taxes pay for funds in each state that give employees unemployment benefits if they leave a company involuntarily. The basic FUTA rate is 6% (on the first $7,000 of income for each employee). You must also pay unemployment taxes to your state. See this IRS article on Tax Form 940 for more details.

Making Payroll Tax Payments

Depending on the size of your payroll, you must make periodic payroll tax payments to the IRS and to state taxing entities. For federal payroll taxes, you must make payments on a semi-weekly or monthly basis for:

  • The amounts you withheld from employee pay for federal and state income taxes
  • The amounts you deducted from employee pay for Social Security and Medicare
  • The amounts you owe as an employer for Social Security and Medicare.

You must make your payroll tax deposit payments using the IRS electronic filing system (EFTPS).

Other Payroll Tax Deposits

In addition to federal withholding and Social Security/Medicare deduction payments, you must:

  • Make payments for federal unemployment tax payable each quarter.
  • Make payroll tax deposits to your state, and possibly your locality, in addition to federal payroll tax deposits.

Payroll Tax Reporting

Businesses are also required to submit payroll tax reports on a regular basis. You must:

  • Submit a quarterly report to the IRS on Form 941 showing the amount of your payroll tax liability and the amounts you have paid on this liability during the previous quarter.
  • Submit an annual unemployment tax report on Form 944 to the IRS showing the amount of your unemployment tax liability and the amounts you have paid on this liability.
  • Submit other state unemployment and worker's compensation reports.

Key Takeaways

  • By law, employers must pay employees a minimum wage promptly and they must collect, report, and pay payroll taxes when they are due.
  • Paying employees is required by both federal and state laws. The Fair Labor Standards Act sets requirements for minimum wage amounts, overtime, and hours worked. State wage and hour laws set minimum wage standards and require when payments must be made.
  • Paying payroll taxes in full and on time is required by the IRS and by state taxing authorities. For example, the IRS assesses employers penalties and interest for unpaid or underpaid payroll taxes.
  • Business owners can be personally liable for non-payment of payroll taxes.
  • If you don't think you'll get caught, note that the IRS and state taxing authorities can audit your business unannounced.