Can You Do Payroll Yourself? What You Need to Know

Payroll is the process a business uses to compensate its employees, involving tracking hours, calculating wages, withholding taxes, and distributing payments. For small business owners, managing payroll internally can reduce operational costs and maintain direct financial control. This approach requires a thorough understanding of financial and regulatory requirements, including precise calculations and timely submissions.

Understanding Payroll Fundamentals

Payroll encompasses core components determining an employee’s final take-home pay and an employer’s tax obligations. Gross wages represent the total amount an employee earns before any deductions, including regular pay, overtime, bonuses, and commissions.

From gross wages, mandatory deductions are withheld. Federal income tax is one such deduction, with the amount determined by the employee’s Form W-4 and applicable tax brackets. The Federal Insurance Contributions Act (FICA) also mandates deductions for Social Security and Medicare. While Social Security taxes apply up to an annual wage base limit, Medicare taxes do not have a wage cap. State and local income taxes, where applicable, are also withheld based on specific regulations.

Employers are responsible for additional taxes not deducted from employee wages. The employer pays a matching share of FICA taxes, mirroring the employee’s contribution. The Federal Unemployment Tax Act (FUTA) requires employers to contribute to a federal unemployment insurance program. This federal tax is 6% on the first $7,000 of an employee’s wages annually, though credits can reduce this rate.

State Unemployment Tax Act (SUTA) taxes, also known as State Unemployment Insurance (SUI), are paid by employers to fund state-level unemployment benefits. SUTA rates and wage bases vary by state, influenced by an employer’s claim history. After all mandatory and voluntary deductions are subtracted from gross pay, the remaining amount is the employee’s net pay. Voluntary deductions, such as health insurance premiums or retirement plan contributions, are also made.

Essential Information Gathering

Before processing payroll, businesses must gather specific information. Obtaining an Employer Identification Number (EIN) from the IRS is a primary step, serving as the business’s federal tax identification. This nine-digit number is necessary for any business with employees.

Businesses also need to register for state tax identification numbers. These state-specific IDs are used for reporting and remitting state income tax withholding and state unemployment taxes. The process for obtaining these numbers varies by state, often involving registration with the state’s department of revenue or labor. If a business operates in multiple states, a separate state tax ID number is required for each.

Collecting accurate employee data is crucial. Each new employee must complete Form W-4, Employee’s Withholding Certificate, which provides information for calculating federal income tax withholding. Employees also need to complete Form I-9, Employment Eligibility Verification, which verifies their identity and eligibility to work in the United States.

Businesses need to establish clear internal payroll parameters. This includes setting wage rates for each employee, whether hourly or salaried, and determining the pay period frequency. If offering direct deposit, employees must provide their bank information through a signed authorization form.

The Payroll Calculation Process

Payroll management involves computing each employee’s earnings and deductions for a given pay period. The first step is determining gross pay, the total compensation earned before withholdings. For hourly employees, this is their hourly rate multiplied by hours worked, including overtime. Salaried employees’ gross pay is their annual salary divided by pay periods.

Once gross pay is established, various deductions are calculated. Federal income tax withholding is determined using information from the employee’s Form W-4 and the IRS’s Publication 15-T. FICA taxes, comprising Social Security and Medicare, are also withheld from employee wages.

For Social Security, employees contribute 6.2% of their wages, with employers paying a matching 6.2%, up to an annual wage base limit. Medicare tax is 1.45% for both employees and employers, applied to all wages without a wage base limit.

State and local income tax withholdings are calculated based on specific regulations and tax tables. After mandatory taxes, voluntary deductions, such as health insurance premiums or retirement contributions, are applied. Subtracting all these deductions from gross pay yields the employee’s net pay.

Employers must also calculate their own tax liabilities. This includes the employer’s matching share of FICA taxes. Federal Unemployment Tax Act (FUTA) tax is an employer-paid tax, 6.0% on the first $7,000 of each employee’s wages, though credits can reduce this. State Unemployment Tax Act (SUTA) rates and wage bases vary by state and are solely employer responsibilities.

Filing and Remitting Payroll Taxes

After calculating payroll, the next step involves filing necessary forms and remitting collected taxes to the appropriate government agencies. Federal payroll taxes, including withheld income tax, Social Security, and Medicare taxes, are reported quarterly on Form 941, Employer’s Quarterly Federal Tax Return. This form is due by April 30, July 31, October 31, and January 31 for the preceding calendar quarters.

Federal Unemployment Tax Act (FUTA) taxes, which are solely employer-paid, are reported annually on Form 940, Employer’s Annual Federal Unemployment Tax Return. The deadline for filing Form 940 is January 31 of the year following the tax year.

Employers must prepare and furnish Form W-2, Wage and Tax Statement, to each employee by January 31 of the following year. Employers must also file Form W-3, Transmittal of Wage and Tax Statements, with the Social Security Administration by the same January 31 deadline.

Federal payroll tax deposits are made electronically through the Electronic Federal Tax Payment System (EFTPS). Businesses are assigned a deposit schedule, either monthly or semi-weekly, based on their tax liability. New employers begin on a monthly deposit schedule, remitting taxes by the 15th day of the following month. Larger tax liabilities require a semi-weekly schedule. FUTA tax deposits are required quarterly if the liability exceeds $500, due by the last day of the month following the end of the quarter.

State and local payroll tax filing and remittance procedures vary by jurisdiction. States require quarterly tax and wage reports, due by the last day of the month following the end of the quarter. States mandate electronic filing and payment through their online portals. State unemployment insurance (SUI) reports are also filed quarterly.

Payroll Record Keeping

Maintaining accurate payroll records is important for compliance and operational transparency. Businesses must keep employee details, including names, Social Security numbers, and addresses, alongside wage data like hours worked, pay rates, and total earnings. Tax forms filed, such as Forms 941, 940, W-2, and W-3, should be retained, along with proof of tax payments and employee-provided Forms W-4 and I-9.

Employment tax records must be held for at least four years after the tax due date or payment. General payroll records, including wage computation documents like timecards, are kept for three years under the FLSA. Form I-9s must be retained for three years from the hire date or one year post-termination, whichever is longer. Record keeping helps demonstrate compliance during audits, address employee questions, and mitigate legal risks.