Calculating payroll correctly can be a challenge, especially when you are a small business owner. Your expertise lies in entrepreneurship — not necessarily in keeping track of the various labor and tax laws that apply to each of your employees. Whether you have a single worker or a large staff, setting up an accurate, reliable payroll system will prevent serious issues for your employees and your business.
Apply for an Employer Identification Number (EIN)
Your EIN is a unique number assigned specifically to your business for IRS purposes. This number identifies your business when reporting information about your employees to federal and state government agencies. Examples of this information include total income and taxes paid on their behalf. You may hear the EIN referred to as a Form SS-4 or a Tax ID — these are the same as the EIN.
Apply for your EIN through the IRS directly. The most convenient way to complete this transaction is through an online application. However, applications are also accepted by fax and mail.
Check State and Local Regulations for Additional EIN Requirements
Though many states and localities accept your federal EIN for identification, some do require separate numbers for tax purposes. Examples include New York, Massachusetts, and South Carolina. You can determine your city and/or state regulations by visiting the appropriate state’s small business website.
Understand the Difference Between Independent Contractor and Employee
Whether you employ independent contractors or employees significantly impacts how income, Medicare, Social Security, and unemployment taxes are paid, so it is critical to understand the distinction between the two.
The basic test boils down to the following three questions:
- Does the employer control when, where and how the work is completed? If so, the worker is probably an employee.
- Does the employer control the financial aspects of the work? For example, are expenses reimbursed? Does the employer provide work-related tools, such as computers? If so, the worker is probably an employee.
- Is the relationship ongoing, or is the worker employed for a specific project with no expectation of continued employment? Does the employer offer benefits, such as health insurance and paid time off, to the worker? If the relationship is ongoing and/or if benefits are offered, the worker is probably an employee.
Obtain Required Employee Forms
Once your own documents are in order, you are ready to hire your employees. Be sure to gather tax and payroll information within the first few days of employment to ensure they receive their first paycheck in a timely manner. You may wish to encourage employee use of direct deposit for faster payments.
Each employee must complete a Federal Income Tax Withholding Form W-4, which allows you to calculate the correct tax withholding. Employees must also complete an I-9 form to verify they are legally permitted to work in the United States.
Choose Your Pay Period
The fewer pay periods you have, the easier it is to complete your payroll. However, some states require that employees are paid according to a certain schedule, for example, weekly or bi-weekly. If you wish to run payroll less often than once a week, contact your State Department of Labor to determine whether your proposed pay period complies with state regulations.
Create Payroll-Related Processes
Before you are able to issue accurate paychecks, you will need a method of tracking employee hours. There are many tools available for this purpose, from basic sign-in sheets to platforms that track employee activity on phones or computers. It is also important to set up policies for paid time off if you plan to offer it, overtime pay and any other benefits.
On the other side, you must have a process in place to ensure that deductions for benefits, taxes and similar are paid to the appropriate vendors and agencies on behalf of your employees.
Select a Payroll Platform
If you plan to handle payroll in-house, be sure that you or your bookkeeper is comfortable with the nuances of this task. There are several high-quality payroll platforms available to make things easier. However, most small businesses prefer outsourced controller services, as these professionals have the knowledge and experience to produce payroll accurately and on time.
Produce Your Payroll
Once you or your controller has entered employees’ personal information into your payroll system, you are ready to produce your first payroll run. Using the timekeeping tools you have in place for hourly (non-exempt) workers, enter or report the number of hours for each. Salaried (exempt) workers do not have to report their hours. They are paid the same amount each week.
Note: If you are doing job costing in your accounting, you will still want salaried employees to track their hours. It will not factor into their weekly pay but you will want to be able to accurately allocate time to jobs to understand costs. Consider using a time tracking program that syncs with your general ledger accounting software to produce these reports. Many will have a sync with your payroll as well so you can use them for salaried and hourly employees alike.
Retain Required Records
Certain payroll-related records must be retained for IRS purposes. As a general rule, you must retain all records for individuals who are actively employed, regardless of the length of their tenure. Many records must be retained for a certain period after employment is terminated. For example, employment tax records must be retained for at least four years. Specific instructions are available through the IRS.
Calculate and Pay Federal and State Payroll Taxes
Finally, you as an employer are responsible for making payroll tax payments and producing certain reports. Generally, reports are due either quarterly or annually. Utilize resources available through the IRS and your state tax office to ensure all taxes and reports are handled appropriately.
Accurate, on-time payroll is one of the most important responsibilities of your business. First, payroll errors are a surefire way to upset employees. Second, tax errors can result in significant fines and penalties. Carefully consider how your payroll will be handled to ensure you avoid the most common pitfalls.