How to Do Payroll Yourself for a Small Business

Managing payroll internally offers small businesses direct control over financial operations. This approach demands attention to detail, understanding regulatory requirements, and accuracy to ensure compliance. Successfully handling payroll involves navigating federal and state mandates, from worker classification to timely tax remittances.

Setting Up Your Payroll Foundation

Establishing a payroll system begins with accurately classifying workers, which has significant tax and legal implications. The Internal Revenue Service (IRS) uses common law rules to determine if an individual is an employee or an independent contractor, focusing on the business’s control over the worker. This assessment considers behavioral control, financial control, and the type of relationship. Correct classification ensures appropriate tax withholding and compliance, as employees have taxes withheld, while independent contractors manage their own.

Once worker classification is clear, obtain necessary identification numbers. Every employer needs an Employer Identification Number (EIN) from the IRS for federal tax purposes. An EIN is required for paying federal taxes, hiring employees, opening business bank accounts, and applying for certain licenses. Businesses can apply for an EIN online through the IRS website.

Businesses must also secure state and local tax identification numbers as required by their operating jurisdiction. These numbers are essential for remitting state income taxes, state unemployment taxes, and any applicable local payroll taxes. Consult respective state tax agencies for guidance.

Gathering employee information is fundamental before running payroll. Each employee must complete Form W-4, Employee’s Withholding Certificate, for federal income tax withholding. This form captures filing status, dependents, and other adjustments.

Every new employee must complete Form I-9, Employment Eligibility Verification, to confirm legal work authorization. This form requires specific documents to establish identity and employment eligibility. Some states may require additional withholding or new hire reporting forms. For direct deposit, obtain employee banking information, including routing and account numbers.

Understanding payroll schedules is another foundational element. Payroll frequency dictates how often employees are paid. Common frequencies include weekly, bi-weekly, semi-monthly, and monthly. Bi-weekly is the most prevalent schedule in the United States. The chosen schedule influences tax deposits and reporting.

Calculating Employee Pay and Withholding

After establishing the payroll foundation, calculate each employee’s net pay. Begin with gross pay, the total earnings before deductions. For hourly employees, gross pay is hours worked multiplied by their hourly rate. The Fair Labor Standards Act (FLSA) generally requires overtime pay for hours over 40 in a workweek. Salaried employees receive a fixed amount per pay period, often exempt from overtime if thresholds are met.

Subtract pre-tax deductions from gross pay to determine taxable wages. These deductions reduce an employee’s taxable income, potentially lowering federal and state income tax liability. Common pre-tax deductions include health, dental, and vision insurance premiums, contributions to qualified retirement plans (e.g., 401(k)), and Health Savings Accounts (HSAs) or Flexible Spending Accounts (FSAs).

The remaining amount after pre-tax deductions is the taxable wage, used to calculate tax withholdings. Federal income tax (FIT) withholding is determined using employee information from Form W-4 and IRS guidance.

FICA taxes, including Social Security and Medicare taxes, are also withheld. For 2025, the Social Security tax rate is 6.2% for both employee and employer, applied up to an annual wage base limit. The Medicare tax rate is 1.45% for both, with no wage base limit. An additional Medicare tax of 0.9% applies to employees earning above a certain threshold.

State and local income tax withholding applies in many jurisdictions, with rates and calculation methods varying by location. Employers must consult specific tax authorities to determine appropriate withholding.

After tax calculations, apply post-tax deductions. These are subtracted from an employee’s pay after taxes and do not reduce taxable income. Common post-tax deductions include Roth 401(k) contributions, certain insurance premiums, union dues, and wage garnishments (e.g., child support or tax levies). After all deductions and withholdings, the final amount is the employee’s net pay.

Managing Payroll Tax Obligations

After calculating pay and withholdings, remit payroll tax obligations to government agencies. For federal payroll taxes, deposit withheld federal income tax and FICA taxes with the U.S. Treasury. The Electronic Federal Tax Payment System (EFTPS) is the mandatory method for these deposits; employers must enroll.

Federal tax deposit frequency depends on accumulated tax liability, classifying a business as a monthly or semi-weekly depositor. Monthly depositors (generally $50,000 or less in prior year employment taxes) deposit by the 15th of the following month. Semi-weekly depositors (over $50,000) have specific rules based on payday.

Filing federal payroll tax forms is also required. Form 941, Employer’s Quarterly Federal Tax Return, reports total wages paid, federal income tax withheld, and FICA taxes. This form is due quarterly: April 30, July 31, October 31, and January 31 of the following year.

Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, reports FUTA tax liability, which funds state unemployment benefits. Form 940 is an annual return, generally due by January 31 of the following year.

Managing state and local payroll tax obligations involves similar processes, though forms and deadlines vary by jurisdiction. Most states require state tax identification numbers and electronic payment systems for remitting state income and unemployment taxes (SUTA). These state-level forms are typically filed quarterly or annually.

Year-end reporting culminates the payroll tax cycle. Form W-2, Wage and Tax Statement, reports each employee’s annual wages and taxes withheld. Employers must issue Form W-2 to employees by January 31 of the following year. 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 by January 31.

Paying Employees and Maintaining Records

The final step in the payroll process is compensating employees. Common payment methods include direct deposit and paper checks. Direct deposit is an efficient method, electronically transferring funds into an employee’s bank account. This requires collecting accurate banking information.

Issuing paper checks remains an option. Regardless of payment method, providing a clear pay stub to each employee is a legal requirement. Pay stubs must detail gross pay, all pre-tax and post-tax deductions, and net pay.

Maintaining accurate payroll records is an ongoing obligation with specific retention requirements. The Fair Labor Standards Act (FLSA) mandates keeping payroll records for at least three years. The IRS generally requires keeping all employment tax records, including Forms 941, 940, W-2s, and W-4s, for at least four years.

Specific records that must be maintained include:
Timecards and attendance records detailing hours worked.
Payroll registers summarizing calculations for each pay period.
Copies of all filed federal and state tax forms (e.g., Form 941, Form 940, W-2s, W-3s).
Employee information, including Form W-4, Form I-9, name, address, and Social Security number.
Records of all tax deposits made to federal and state authorities.