How to Do It Yourself Payroll for a Small Business

Do-it-yourself (DIY) payroll involves a small business directly handling all employee compensation, rather than outsourcing. This approach offers cost savings and greater control, particularly for businesses in early growth or with few employees.

Identifying Your Employer Responsibilities

Employing individuals involves legal and tax responsibilities at federal, state, and sometimes local levels. Understanding these obligations before payroll processing is fundamental for compliance. Employers must withhold federal income tax from employee wages based on employee information.

Employers and employees share Federal Insurance Contributions Act (FICA) taxes, funding Social Security and Medicare. Social Security tax is 6.2% for both (up to a wage base limit), and Medicare tax is 1.45% for both (no wage base limit). Employers are solely responsible for Federal Unemployment Tax Act (FUTA) taxes, funding state unemployment benefits. The FUTA tax rate is 6.0% on the first $7,000 of wages per employee, though state unemployment contributions can significantly reduce this.

State-level responsibilities include state income tax withholding and State Unemployment Insurance (SUI) taxes. SUI tax rates and wage bases are state-specific and fluctuate based on an employer’s experience rating. Some states may levy additional payroll taxes, like disability insurance or paid family leave contributions, which might be shared. Local jurisdictions can impose their own payroll taxes or reporting requirements, necessitating localized review.

Accurately classifying workers as employees or independent contractors is crucial. Misclassification can lead to significant penalties, back taxes, and interest from federal and state agencies, as payroll tax responsibilities differ. Employers withhold and pay employment taxes for employees; independent contractors handle their own tax obligations. This distinction guides applicable payroll tax rules.

Preparing for Payroll Processing

Before payroll calculations, businesses must complete administrative and registration steps for legal compliance. Obtaining an Employer Identification Number (EIN) from the IRS is a primary requirement for all employers, serving as a federal tax ID. This nine-digit number is crucial for reporting and remitting federal taxes and can be acquired online.

Employers also register with state agencies for state tax ID numbers for unemployment insurance and, if applicable, state income tax withholding. Registration processes vary by state, typically involving the Department of Labor for unemployment taxes and Department of Revenue for income tax withholding. Completing these registrations ensures proper reporting and payment of state payroll taxes.

Collecting accurate employee information is another preparatory step. Federal law requires employees to complete Form W-4, Employee’s Withholding Certificate, which helps employers determine federal income tax withholding. Information on this form, such as filing status and dependents, directly impacts the calculation. New employees must also complete Form I-9, Employment Eligibility Verification, confirming legal work authorization by reviewing identity and employment eligibility documents.

Employers must gather personal details for each employee: legal name, address, and Social Security Number. If direct deposit is offered, collecting the employee’s bank name, routing number, and account number is necessary. This data forms the foundation for accurate payroll processing and compliance.

Establishing a consistent payroll frequency is part of preparation, with options including weekly, bi-weekly, semi-monthly, or monthly payments. The chosen frequency dictates how often wages are calculated and paid, often depending on industry standards, employee preferences, and cash flow. Understanding employee pay components—gross pay (total earnings before deductions), hourly wages, salaries, and overtime—is essential. Employers must distinguish between pre-tax deductions (e.g., retirement contributions, health insurance premiums) and post-tax deductions (e.g., wage garnishments, Roth 401(k) contributions), as these affect taxable income and net pay.

Calculating and Remitting Payroll

After preparatory steps, calculate and remit payroll. First, determine each employee’s gross pay (total earnings before deductions or taxes). For hourly employees, multiply their hourly rate by regular hours worked, plus overtime (typically 1.5 times the regular rate for hours over 40, as mandated by FLSA). Salaried employees receive a fixed amount per pay period.

After determining gross pay, apply deductions. Pre-tax deductions (e.g., 401(k) contributions, health insurance premiums) are subtracted from gross pay before federal income tax and FICA taxes, reducing taxable income. Post-tax deductions (e.g., wage garnishments, Roth 401(k) contributions) are subtracted after all taxes are withheld. Accurate application of these deductions is crucial for correct net pay and tax reporting.

Next, calculate withheld taxes, starting with federal income tax. Employers use Form W-4 information and IRS tax withholding tables or the percentage method to determine federal income tax withholding. The employee’s share of FICA taxes—6.2% for Social Security (up to the annual wage base) and 1.45% for Medicare—is calculated and withheld from gross wages. An additional 0.9% Medicare tax applies to wages over $200,000, which employers withhold without an employer match.

Employers must calculate their own tax contributions, including their matching share of FICA taxes (6.2% for Social Security and 1.45% for Medicare). They also calculate FUTA tax liability: 6.0% on the first $7,000 of each employee’s wages, though a credit for timely state unemployment contributions reduces the effective federal rate to 0.6%. State Unemployment Insurance (SUI) taxes are calculated based on the state’s rate and wage base, fluctuating annually based on the employer’s experience rating.

After calculating deductions and taxes, subtract all withholdings and deductions from gross pay to determine net pay. This net amount is the take-home pay disbursed via direct deposit or check. Provide employees with a clear pay statement (pay stub) detailing gross pay, deductions, and net pay for the current period and often year-to-date totals.

After payroll calculations, employers remit withheld employee taxes and their own employer tax contributions to government agencies. Federal payroll taxes (withheld federal income tax, employer and employee FICA portions) are typically deposited via the Electronic Federal Tax Payment System (EFTPS). Deposit frequency (monthly or semi-weekly) depends on the employer’s total tax liability. State payroll taxes (e.g., state income tax withholding, SUI) are remitted through state-specific online portals or payment methods, with varying schedules.

Completing Required Payroll Filings

Beyond regular tax deposits, employers file periodic reports with federal and state tax authorities to summarize payroll activity and tax liabilities. For federal taxes, employers file Form 941, Employer’s Quarterly Federal Tax Return, by the last day of the month following each calendar quarter. This form reports total wages paid, federal income tax withheld, and both employee and employer shares of Social Security and Medicare taxes for the quarter, alongside total tax deposits.

Annual federal filings include Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, due by January 31 of the following year (or February 10 if all FUTA taxes are deposited on time). Employers prepare and distribute Form W-2, Wage and Tax Statement, to each employee by January 31 of the following tax year. The W-2 reports an employee’s annual wages, tips, other compensation, and federal, state, and local taxes withheld.

A copy of each Form W-2, along with Form W-3, Transmittal of Wage and Tax Statements, must be submitted to the Social Security Administration (SSA) by January 31. Form W-3 summarizes total earnings and withholdings reported on all W-2s. These forms are crucial for employees to file individual income tax returns and for the SSA to track earnings for Social Security benefits.

State and local payroll tax reporting requirements mirror federal obligations but are specific to each jurisdiction. Employers file quarterly or annual unemployment and withholding tax reports with their state departments of labor and revenue. These forms reconcile wages paid, taxes withheld, and tax deposits, ensuring state compliance. Deadlines often align with federal deadlines, but employers must verify specific dates on their state’s official websites.

Managing Payroll Records

Effective payroll management includes diligent record-keeping, essential for compliance and operational efficiency. Employers must maintain various payroll records, including employee information (e.g., Forms W-4 and I-9) and detailed timekeeping records for hourly employees. Payroll registers, summarizing each pay period’s wages, deductions, and net pay for all employees, are also critical.

Copies of all filed tax forms (Forms 941, 940, W-2s, W-3s) and tax deposit records must be retained. The IRS requires employers to keep employment tax records for at least four years after the tax is due or paid. The Fair Labor Standards Act (FLSA) mandates records like employee names, addresses, occupations, pay rates, hours worked, and wages paid be kept for at least three years; pay computation records for two years.

Employers can choose various methods for maintaining records: physical files, digital spreadsheets, or payroll software. Digital record-keeping offers advantages in accessibility, organization, and backup. Regardless of the method, accuracy and organization are paramount for successful payroll management. Well-maintained records facilitate audits, help resolve employee pay disputes, and ensure a clear historical account of payroll transactions.

Citations:
The Social Security Administration. “Social Security & Medicare Tax Rates.” Accessed August 4, 2025.
Internal Revenue Service. “Topic No. 751 Social Security and Medicare Withholding Rates.” Accessed August 4, 2025.
Internal Revenue Service. “Topic No. 759 Federal Unemployment Tax (FUTA).” Accessed August 4, 2025.
Internal Revenue Service. “Apply for an Employer Identification Number (EIN) Online.” Accessed August 4, 2025.
Electronic Federal Tax Payment System. “EFTPS: The Easy Way to Pay Your Federal Taxes.” Accessed August 4, 2025.
Internal Revenue Service. “Form 941, Employer’s Quarterly Federal Tax Return.” Accessed August 4, 2025.
Internal Revenue Service. “Recordkeeping for Employers.” Accessed August 4, 2025.