Payroll 101 for Small Businesses
PAYROLL FOR BEGINNERS
As a small business owner, whether you are just starting out with one or two employees or have successfully grown your business and now employ hundreds of people, payroll is one of your most important responsibilities. And, if you’re like most business owners, with its heavy administrative burden, complex wage and hour laws, and financial risks, it is one of the least favorite parts of owning and managing your business.
Managing payroll effectively starts with defining and understanding what payroll is—or better yet, what it isn’t. Payroll is not just figuring out how much to pay employees, producing paychecks, and remitting payroll-related taxes to the federal, state and local tax authorities. Certainly, payroll processing and paying payroll-related taxes are the primary activities; but, compliance and reporting, as well as governance, are other important activities that make up the payroll function. By having a holistic view of payroll, business owners can better appreciate the complexities involved in administering payroll, what expertise and resources they need, and how best to mitigate the countless risks associated with the payroll function.
This article will help you understand what it takes to get your employees paid, common pitfalls and ways to avoid them, options for getting your employees paid, and how to effectively manage payroll so that you can spend more time doing what you enjoy and focus on growing your business.
SETTING UP AND PREPARING TO RUN PAYROLL
Company information and Pay Schedules
Due to ever-changing federal, state, and local tax laws and other regulatory requirements associated with employing people, most small businesses today choose to use payroll software in combination with services provided by their accountant or an on-line payroll service provider to process payroll. We’ll look at options available to you a little later in this article. Whatever option you choose, there is some basic information and forms you will need to set up and process payroll.
First, you’ll need basic information about your company, your payroll schedule, and your Employer Identification Number (EIN). Think of the EIN as a Social Security Number for your business. If you do not yet have an EIN, go to IRS.gov for more information and to apply on-line. And, be sure to check with your state to determine whether or not you need a state identification number in addition to your federal EIN.
When determining your pay schedule, you will need to decide how often you will pay employees and when the pay-week begins and ends. Typically, employees of small businesses are paid either weekly or bi-weekly and the pay-week, or pay period, begins on Sunday and ends on Saturday. Your state most likely has a payday law mandating how often employees must be paid. In most cases, you will meet the requirement by using a weekly or bi-weekly pay schedule, but laws vary by state and some are more complex than others. If you are not sure what your state requires, check with your attorney, HR professional, or state department of labor. FindLaw has an easy to use state-by-state chart covering payday laws as well as other employment law information you can reference for free.
JOB CLASSIFICATION AND NEW HIRE PAPERWORK
In addition to the company and pay schedule information, you will need some forms and other information about each of your employees. Payroll is one area where a robust new hire process comes into play and adds value. Before the employee is hired you should have a job description that includes the job classification because when it’s time to process payroll you will need to know if the employee performing the job qualifies for overtime. Also, you should develop a new hire onboarding and orientation checklist to ensure that important forms related to hiring, payroll, and benefits are completed.
A written job description for each of the different job functions being performed at your company should include a job title, specific information about job duties, and whether the job is exempt (salaried) or nonexempt (hourly). Most employees for small businesses fall into the nonexempt classification. The federal Fair Labor Standards Act establishes rules for classifying jobs for purposes of overtime and there are state wage and hour laws governing not only job classification but also minimum wage and overtime rules. Improperly classifying jobs and not paying overtime is a common and costly mistake. Back wages and penalties for violating wage and hour laws add up quickly, can destroy your company’s reputation, and force you into bankruptcy. As with payday laws, if you are uncertain about how to classify jobs or aren’t sure what federal, state or local minimum wage and overtime rules apply to your business consult with your attorney, HR professional, state wage and hour division, or the state department of labor.
Most of the employee paperwork you need, not only for payroll but to satisfy other regulatory requirements, should be completed on the employee’s first day during the new hire onboarding and orientation process. To set up payroll, you will need the following from each employee:
- Form I-9.
- Form W-4, as well as state and local tax withholding forms.
- Names of all employees, their date of birth, social security numbers, and home address.
- A signed authorization from each employee along with their bank account and routing number if you plan to offer direct deposit.
- Health and welfare benefit elections, garnishment orders for things like court-ordered child support, and 401(k) contribution forms.
All this work and we haven’t even begun to process payroll! Don’t worry, you’ll get there. Before you can calculate pay for your employees, you’ll need to know what hours each nonexempt, or hourly employee worked. Most small business use either a paper timesheet or a time clock to collect this information. If you decide to go the paper route, make sure your employees sign and date their timesheet when they submit it to you or their supervisor, and that supervisors are checking the timesheet for accuracy. Doing so prevents over or under-paying employees and helps all employees appreciate their responsibility for accurately reporting hours worked.
Calculating Pay and Paying Your Employees
Now that you have all of the information you need to process payroll, it’s time to calculate pay and issue checks to your employees. Just preparing to set up and run payroll most likely made your head spin and gave you a glimpse into the complexities and very real risks involved in handling payroll. The complex nature of payroll, time involved in producing payroll, and the risks associated with it are why most businesses choose to use payroll software in combination with services provided by their accountant, or an on-line payroll service provider.
If there is one piece of advice that I can share with business owners, both large and small, that is to invest in the resources necessary to efficiently and effectively handle payroll, payroll taxes, and the associated regulatory requirements. The time involved in administering and managing payroll and payroll-related taxes; the complexity of federal, state and local employment and wage and hour laws; and, the financial risks associated with this area of your business are just too great to go it alone using a spreadsheet and a checkbook.
ONLINE PAYROLL SERVICES
Fortunately, thanks to advances in technology, business owners have lots of options from which to choose to meet their needs when it comes to online payroll solutions. A top pick amongst business reviewers is Intuit Payroll which can be fully integrated with QuickBooks, the accounting software used by most small businesses making it an obvious choice for many.
Manually Calculating Pay
For some small businesses, manually calculating pay is the only option. To do this you will first need to calculate Gross Pay. For nonexempt, hourly employees you will use a weekly calculation unless your state or local law requires a daily overtime calculation. For exempt, or salaried employees, simply use an annual calculation.
Weekly Hourly Gross Pay Calculation
For example, Sally is a full-time hourly employee making $19 an hour. She is paid weekly and worked 45 hours last week. The gross pay calculation for Sally is:
40 hours x $19/hour = $760. This is Sally’s gross regular earnings.
Because Sally worked more than 40 hours, she must be paid overtime for all hours over 40 hours in one week. Overtime pay in the US is one and one-half times the employee’s regular hourly rate of pay. Sally’s overtime pay calculation is:
5 hours x $28.50 ($19 x 1.5) = $142.50. This is Sally’s gross overtime earnings.
Sally’s total gross pay is $902.50. This is the amount you will use to calculate tax withholdings to arrive at Sally’s net pay.
Annual Gross Pay Calculation
Declan is a full-time exempt employee and you pay him $75,000 a year. After the weekly staff meeting, he mentioned that he worked around 60 hours last week. Calculating Declan’s gross pay is easy because his job classification does not require that you pay him overtime. Declan’s gross pay calculation looks like this:
$75,000/52 = $1,442.31. This is Declan’s gross pay and the amount you will use to calculate withholdings to arrive at his net pay.
In addition to calculating Gross Pay, you will need to calculate federal, state, and local taxes to determine net pay for each of your employees. For 2019, an employee’s tax withholdings are calculated as follows:
Federal – Using the employee’s W4 and the current federal income tax withholding tables found in IRS Publication 15-A, calculate the amount of federal taxes to be withheld. If you offer benefits, make certain you DEDUCT any pre-tax contributions for things like medical and dental insurance and any pre-tax employee contributions to their retirement plan from their gross wages before you calculate their federal income tax withholding.
FICA – Every employee working in the US is required to pay FICA taxes. Half of the cost is borne by the employee and the other half, which is equal to the amount deducted from the employee’s pay is paid by the employer. To calculate employee FICA tax withholdings, you will need to determine the amount of gross pay that is subject to FICA tax. DO NOT subtract any pre-tax deductions like medical and dental insurance and pre-tax retirement plan contributions. While pre-tax deductions are not subject to federal income tax, they are subject to FICA taxes. There are two components of FICA. For 2019, the following FICA rates and thresholds apply:
- 6.2% Social Security tax on the first $128,700 of total gross wages for the year, which includes overtime pay and bonuses. After the employee’s year-to-date earnings reach the wage cap, Social Security taxes are no longer withheld.
- 1.45% Medicare tax on the first $200,000 of wages. The rate jumps to 2.35% for gross wages over $200,000.
State and local taxes vary, so you’ll need to be familiar with those laws and rates to calculate the appropriate withholdings. Additionally, if you offer benefits and a retirement plan, you will need to subtract the employee contribution amounts for each benefit in which they are enrolled to arrive at Net Pay.
COMPLETING THE PAYROLL REGISTER AND ISSUING CHECKS
Once you have calculated wages and withholdings for your employees, you should check your calculations to ensure they are accurate. Ample time should be planned for this important step. Mistakes will lead to either paying too much or too little to your employees, may subject you to penalties for wage and hour law violations, and lead to errors when you report and remit federal, state and local taxes.
After you are certain your payroll is correct, you can create your payroll register. The payroll register is used to make payroll tax deposits, submit your quarterly Form 941 to the IRS, provide employees with W-2s at year-end, prepare and file annual tax reports to the Social Security Administration, and for a number of bookkeeping and accounting tasks. If you are using payroll software or a payroll service provider, the payroll register is quickly generated once the final payroll is calculated and confirmed. If not, you will need to manually create a spreadsheet. At a minimum, the payroll register should reflect the pay period and include the following information for each employee:
- Name and employee ID number
- Federal tax allowance (Married 2, Single 0, etc.)
- Pay rate
- Regular hours worked
- Overtime hours worked
- Gross pay amount
- Deduction amounts by type
- Net pay
The register should also reflect employer paid FICA, FUTA, and SUTA taxes. Including the employer paid taxes will enable you to use the payroll register for a wider variety of tax and accounting tasks and give you a better idea of your overall payroll expense.
Once the payroll register is complete, you can print pay checks and/or initiate the direct deposit payroll process step.
PAYING AND REPORTING PAYROLL TAXES
Most small businesses utilize a payroll service or accountant to pay and report payroll taxes. As an employer, you are required to remit federal, state, and local payroll taxes that you withheld from your employees’ pay in addition to the employer portion of taxes. There are also quarterly business tax returns. If you are using an outside service or payroll software, these tasks are easy. Many service providers will do these things for you and many agree to pay interest and penalties for late filings. Just be sure you have funds in your business account to cover paying all taxes due on time.
In the event you are manually depositing and filing your payroll taxes and reports, make sure you consult with a tax attorney or accountant specializing in tax and meet the deposit and filing deadlines. The IRS sets strict rules governing when employers must deposit taxes and deadlines for filing returns. Penalties and interest quickly add up!
When your taxes need to be deposited is determined by your tax liability. The IRS offers monthly or semi-weekly deposit schedules depending on your tax liability. The penalties increase based on the number of days your deposit is late and range between 2% and 10%. You will also be charged interest on any unpaid balance.
In addition to tax deposits, employers must file their federal business quarterly tax return, Form 941, by the last day of the month following the end of a quarter. If you fail to file your quarterly tax return by the deadline, the IRS will charge penalties unless you have a reasonable cause for filing late and can prove that missing the filing deadline was not willful or negligent.
For more information about depositing and reporting federal employment taxes, visit IRS.gov. For information about depositing and reporting state and local taxes, consult with your tax attorney, accountant, or state and local departments of taxation.
PAYROLL MANAGEMENT AND COMPLIANCE
The Importance and Value of Policies and KPIs
Payroll is most likely your largest business expense and is certainly one of the most regulated parts of your business. Mistakes complying with federal, state, and local laws governing payroll are the single biggest risk to your company’s brand and a threat to your company’s financial stability.
Some of the more common mistakes and violations include: not paying overtime, misclassifying jobs, failing to put a good time-keeping process in place; not paying minimum wage, and not depositing or reporting the correct employer taxes on time.
Taking the time to develop policies and set performance standards for how payroll will be handled will help you effectively manage payroll and ensure that everyone understands what is needed to produce consistently high-quality results and keep your company in compliance with federal, state, and local laws.
At a minimum, pay policies and procedures should address:
- Wage and hour law requirements and time keeping.
- Payroll cutoffs and timing, including employer tax deposits and tax return deadlines.
- Payroll processes and data security.
- Authorizations for approving and disbursing funds.
Decide what key performance indicators are right for your business and put them in place to help you control costs and the quality of service. Whether you handle payroll in-house or use a payroll service provider, a good place to start is by measuring:
- Cycle time to process payroll.
- The cost of payroll processes as a percentage of total payroll expense.
- Payment errors as a percentage of total payroll payments.
- On-time submission of employer tax deposits and returns.
The Next Steps on Your Payroll Journey
Hopefully this article has answered important questions about payroll and given you some ideas about how to best manage it for your growing business. Let this be a start to tackling or transforming the payroll function for your company. Above all else, make certain you reach out to obtain additional information on the topic and guidance from your HR professional, legal counsel, and accountant. Pay your employees what they are legally owed for working hard to help your business succeed. Deposit your payroll taxes and file payroll tax returns on time. Put the right policies, processes and resources in place to efficiently handle payroll and effectively manage risks.
Now, go out there and don’t just “do payroll.” Take actions and provide the leadership needed to get payroll done correctly and on time…every time. Manage your company’s payroll function efficiently and well. After all, you don’t have time to waste. You have a vision to share, people to lead, customers to please, and a business to grow!
Disclaimer – The author of this article is not a lawyer and the information contained in this article does not constitute legal advice. Every business owner’s circumstances are different and business owners should with their attorney and tax accountant to ensure they are complying with federal, state, and local employment and tax laws.
May 30, 2019
Debra Richards is a freelance consultant specializing in HR and payroll process improvements and system implementations, as well as merger and acquisition integration. She holds a Six Sigma Black and has a successful history of adding value and leading transformational change for a Fortune 500 company.