How to Do Manual Payroll for a Small Business

Manual payroll involves managing all aspects of employee compensation, deductions, and tax obligations without the use of specialized software. This process requires a thorough understanding of various federal, state, and local labor and tax laws. While it can be a feasible option for very small businesses with a limited number of employees, it demands meticulous attention to detail and can be quite time-consuming. Any errors in manual payroll can lead to significant issues, including fines, audits, and potential legal problems.

Setting Up for Manual Payroll

Before processing any payroll, employers must complete several foundational steps to ensure compliance and accuracy. An important initial step is obtaining the necessary identification numbers for tax purposes. This includes a Federal Employer Identification Number (EIN) from the IRS, which is unique to your business and used for all federal tax filings. Depending on state and local regulations, additional tax identification numbers may be required for state unemployment insurance or state income tax withholding.

Establishing a clear payroll policy is also an important step. This policy defines operational aspects such as the pay period, which could be weekly, bi-weekly, semi-monthly, or monthly. It also outlines overtime policies, adhering to federal Fair Labor Standards Act (FLSA) requirements, which mandate “time and a half” pay for hours worked over 40 in a workweek for non-exempt employees. The policy should also specify payment methods offered, such as direct deposit or physical checks.

Collecting employee information is another requirement for manual payroll. Before an employee’s first paycheck, you must gather their full legal name, address, Social Security Number, and date of birth. Two federal forms are particularly important to collect from each new employee: Form W-4, Employee’s Withholding Certificate, and Form I-9, Employment Eligibility Verification.

Form W-4 dictates the amount of federal income tax to withhold from an employee’s wages, based on their filing status, the number of dependents they claim, and any additional withholding amounts they specify. Form I-9 is used to verify an employee’s identity and their authorization to work in the United States. Many states also have their own withholding forms, similar to Form W-4, for state income tax purposes. If offering direct deposit, collecting bank account and routing numbers from employees is also necessary.

Understanding different pay structures is important before calculations begin. Hourly wages are based on a set rate per hour worked. Salaries involve a fixed amount paid over a period, regardless of hours worked. Commissions are compensation based on a percentage of sales or revenue generated. Each type of pay impacts how initial gross pay is determined.

Calculating Employee Pay

Once the foundational setup is complete, the next step involves calculating each employee’s gross and net pay for the given pay period. For hourly employees, tracking time worked is important. This can be done through methods like timesheets or punch clocks. These records form the basis for calculating their gross pay, which includes regular hours multiplied by the hourly rate, plus any applicable overtime.

Gross pay for salaried employees is determined by dividing their annual salary by the number of pay periods in a year. For example, a bi-weekly paid employee would have their annual salary divided by 26. Commissioned employees’ gross pay is calculated by applying their commission rate to their sales or revenue. Other forms of gross pay, such as bonuses or reported tips, must be included.

After calculating gross pay, pre-tax deductions are subtracted. These deductions reduce an employee’s taxable income before taxes are applied. Examples include contributions to health insurance premiums, 401(k) retirement plans, or Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs). The specific rules for each type of pre-tax deduction must be followed to ensure correct tax treatment.

Federal income tax (FIT) withholding is then calculated based on the employee’s Form W-4 and the IRS tax withholding tables. Employers use IRS Publication 15-T, “Federal Income Tax Withholding Methods,” which provides worksheets, tables, and instructions for this purpose, to determine the withholding amount based on the employee’s pay period, filing status, and taxable income.

Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare, are also withheld from employee wages. For Social Security, the employee share is 6.2% of wages, up to an annual wage base limit. For Medicare, the employee share is 1.45% of all wages, with no wage base limit.

An additional Medicare tax of 0.9% applies to wages exceeding certain thresholds. Employers are responsible for matching both the Social Security and Medicare contributions.

State and local income taxes are calculated next, varying significantly by jurisdiction. Employers must consult state tax agencies for their withholding tables or formulas, which operate similarly to the federal guidelines. These taxes are based on the employee’s gross pay, less any state-specific deductions or exemptions.

Finally, post-tax deductions are subtracted. These deductions are taken from an employee’s pay after taxes have been calculated and withheld. Examples include wage garnishments, union dues, or Roth 401(k) contributions. After all gross pay additions and deductions, the remaining amount is the employee’s net pay.

Payroll Tax Payments and Filings

After calculating employee pay, the next phase involves distributing paychecks and fulfilling tax payment and filing obligations. Distribution of employee paychecks is important, whether through physical checks or direct deposit, adhering to the established payroll policy and relevant labor laws.

Employers must make federal tax deposits to the IRS for withheld federal income tax, Social Security, and Medicare taxes. The frequency of these deposits, either monthly or semi-weekly, depends on the total tax liability accumulated in a lookback period. These deposits are made electronically through the Electronic Federal Tax Payment System (EFTPS).

Federal Unemployment Tax Act (FUTA) taxes require deposits. The FUTA tax rate is 6.0% on the first $7,000 of wages paid to each employee annually. Most employers receive a credit for timely state unemployment tax payments, which reduces the effective FUTA rate. FUTA deposits are made quarterly if the accumulated liability exceeds a certain threshold.

Several federal payroll forms must be filed throughout the year. Form 941, Employer’s Quarterly Federal Tax Return, reports wages, tips, and taxes withheld from employee paychecks and is due quarterly. Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, is filed annually to report FUTA tax liability.

Annually, employers must prepare and distribute Form W-2, Wage and Tax Statement, to each employee. This form reports the employee’s annual wages and the taxes withheld, and copies are filed with the Social Security Administration. State and local tax payments and filings also have their own requirements, which vary widely by jurisdiction. Employers must consult state and local tax agencies for reporting and payment deadlines for income tax withholding and unemployment insurance.

Maintaining Payroll Records

Record-keeping is an important administrative requirement for manual payroll. Employers must retain essential documents to ensure compliance with federal and state regulations, for audits or employee inquiries. These records include timesheets or other time records for all employees to substantiate hours worked.

Payroll registers are important, providing a summary of gross pay, deductions, and net pay for each employee. Copies of filed federal and state tax forms, such as Forms 941, 940, W-2s, and state-specific forms, must be kept. Employee information forms, including Forms W-4, I-9, and direct deposit authorizations, should be maintained.

Records of tax deposits made to federal and state authorities are necessary. Federal law requires employment tax records to be kept for at least four years after the date the tax return was due or the tax was paid, whichever is later. The Fair Labor Standards Act (FLSA) requires retention of payroll records for three years for non-exempt workers. Maintaining organized records is important for demonstrating compliance and addressing discrepancies.