How to Do Payroll for Your Small Business

Payroll involves a business managing employee compensation, including wages, deductions, and tax obligations. This process ensures employees receive accurate pay while the business complies with federal and state regulations. Understanding payroll fundamentals helps businesses properly compensate their workforce and meet their financial responsibilities as employers. This guide outlines the fundamental steps for processing payroll.

Gathering Essential Information

Before initiating any payroll processing, a business must systematically collect specific information and documentation from each employee. This includes their full legal name, current residential address, Social Security number, date of birth, and the precise date their employment began. The agreed-upon pay rate, whether an hourly wage or a fixed salary, and the established payment frequency, such as weekly or bi-weekly, are also fundamental details required.

The IRS Form W-4, Employee’s Withholding Certificate, is essential for federal tax compliance. Employees complete this form to inform their employer how much federal income tax to withhold from their paychecks based on their filing status and other adjustments. Employers can find the most current version of Form W-4 directly from the IRS website.

Many states also require state-specific tax withholding forms, as state income tax regulations vary. For direct deposit, businesses must obtain the employee’s banking information, including the bank’s name, account number, and routing number. Details for pre-tax or post-tax deductions, such as health insurance premiums, 401(k) contributions, or wage garnishments, must also be gathered from employees or benefit providers.

The employer also needs an Employer Identification Number (EIN), a nine-digit number assigned by the IRS. This number is necessary for federal tax filings and is obtained directly from the IRS.

Calculating Gross and Net Pay

The first step in determining an employee’s compensation involves calculating their gross pay, which is the total earnings before any deductions. This includes regular wages, whether calculated by multiplying an hourly rate by hours worked or using a fixed salary for the pay period. Overtime hours, typically paid at one and a half times the regular hourly wage for hours exceeding 40 in a workweek, are also added. Bonuses or commissions also contribute to the gross pay.

After calculating gross pay, various deductions are subtracted to arrive at the employee’s net pay. Pre-tax deductions, such as qualified retirement plan contributions or health insurance premiums, are subtracted from gross pay before calculating certain taxes. These deductions reduce the amount of income subject to federal and, in many cases, state income taxes.

Federal income tax withholding (FITW) is then calculated based on the employee’s Form W-4 and the current IRS tax withholding tables and methods. Employers can find these instructions in IRS Publication 15-T. FICA taxes, which include Social Security and Medicare, are also calculated. For 2025, the Social Security tax rate is 6.2% on wages up to the annual wage base of $176,100. The Medicare tax rate is 1.45% on all wages, with no wage base limit.

Employers must withhold the employee portion of FICA taxes and also contribute an equal employer portion. State and local income tax withholding calculations follow state-specific guidelines, which can vary significantly. Finally, post-tax deductions, such as wage garnishments or Roth 401(k) contributions, are subtracted from the pay after all taxes are calculated. The remaining amount after all these subtractions represents the employee’s net pay.

Reporting and Paying Payroll Taxes

After payroll calculations are complete and wages have been paid, businesses must report and pay payroll taxes. Federal payroll taxes, including federal income tax withholding and both the employee and employer portions of FICA taxes, are generally deposited electronically through the Electronic Federal Tax Payment System (EFTPS). The frequency of these deposits, either monthly or semi-weekly, depends on the business’s total tax liability from a lookback period.

State payroll tax deposits and reporting requirements must also be met, with specific procedures and deadlines varying by state. Businesses should consult their state’s revenue department or equivalent agency for instructions. Quarterly federal tax reporting is completed using IRS Form 941, Employer’s Quarterly Federal Tax Return. This form reports total wages paid, federal income tax withheld, and both employee and employer FICA contributions for the quarter. Form 941 is typically due by April 30, July 31, October 31, and January 31 for each calendar quarter.

Annual federal unemployment tax (FUTA) reporting is done using IRS Form 940, Employer’s Annual Federal Unemployment Tax Return. The FUTA tax rate is 6.0% on the first $7,000 of each employee’s wages, though a credit for state unemployment tax payments can reduce this rate significantly. Form 940 is due by January 31 of the following year, with FUTA tax payments generally due quarterly if the liability exceeds $500. Businesses must also prepare and issue Form W-2, Wage and Tax Statement, to each employee by January 31 of the following calendar year. Copies of Form W-2 must also be submitted to the Social Security Administration (SSA) by the same deadline.

Maintaining Payroll Records

Maintaining accurate and organized payroll records is a continuous obligation for businesses. These records must include detailed documentation including time cards or other attendance logs, payroll registers that summarize gross pay, deductions, and net pay for each employee. Copies of all filed tax forms, including employee W-4 forms, W-2 forms, and employer tax returns like Forms 941 and 940, must be retained.

Any direct deposit authorizations or specific deduction authorizations from employees must also be retained. For federal tax purposes, most payroll records should be kept for at least three to four years from the date the tax became due or was paid, whichever is later. State-specific regulations may impose different or longer retention periods for certain records.

Thorough record-keeping is important for demonstrating compliance with federal and state labor and tax laws, and are useful during potential audits by tax authorities. These records also help resolve inquiries from current or former employees regarding their pay or deductions. Organized records ensure a business can quickly access necessary information.