How to Do Your Own Payroll for a Small Business

Undertaking payroll responsibilities for a small business means more than simply issuing paychecks to employees. It encompasses a detailed process of tax withholding, accurate reporting to government agencies, and maintaining strict compliance with various regulations. Business owners who choose to manage payroll internally must commit to understanding these intricate requirements. This approach offers direct control over financial operations and can potentially save costs associated with third-party services. However, it also places the entire burden of precision and timely execution squarely on the business, necessitating careful attention to every step.

Essential Payroll Components

Understanding the fundamental elements of payroll is a prerequisite for any business owner considering self-management. Gross pay represents an employee’s total earnings before any deductions or taxes are applied, calculated based on an hourly rate or fixed salary.

From gross pay, various pre-tax and post-tax deductions are subtracted. Pre-tax deductions, like health insurance or 401(k) contributions, lower taxable income. Post-tax deductions, such as wage garnishments or Roth 401(k) contributions, are applied after tax calculations. These deductions influence an employee’s take-home pay.

Net pay is the final amount an employee receives after all withholdings and deductions. This is the actual funds deposited or provided as a physical check. Accurate net pay calculation relies on correctly identifying and subtracting every applicable deduction.

Beyond wages, employers incur additional payroll costs. These include the employer’s portion of FICA taxes (Social Security and Medicare) and federal and state unemployment taxes (FUTA and SUTA). The employer’s share of Social Security tax is 6.2% on wages up to an annual limit, and Medicare tax is 1.45% on all wages. FUTA applies to the first $7,000 of wages paid to each employee at 6%, though state unemployment tax credits often reduce this to 0.6%. SUTA varies by state and employer experience ratings, ranging from less than 1% to over 6% on a state-defined wage base.

Withholding taxes are amounts employers must deduct from gross pay and remit to tax authorities. These include federal income tax (determined by Form W-4 and IRS tax tables) and applicable state income tax. FICA taxes are withheld from both employee and employer contributions.

Initial Setup Steps

Before processing the first payroll, a business must complete several foundational setup steps. Obtaining necessary identification numbers is a primary requirement. Every employer needs a Federal Employer Identification Number (EIN) from the IRS for all federal tax filings. Businesses must also secure any required state tax identification numbers for state withholding and unemployment insurance.

Gathering comprehensive employee information is another step. Each new employee must complete a Form W-4, Employee’s Withholding Certificate, to calculate federal income tax withholding. This form specifies filing status, dependents, and any additional income or deductions. If the business operates in a state with income tax, employees also complete a corresponding state withholding form.

Employers are legally mandated to complete Form I-9, Employment Eligibility Verification, for every new hire. This form verifies identity and eligibility to work in the United States, requiring the employee to present specific documents. Employers must examine these documents and attest to their apparent genuineness.

Establishing a consistent payroll schedule is important for predictable operations and employee satisfaction. Common pay periods include weekly, bi-weekly, semi-monthly, or monthly. The chosen schedule influences how often wages are calculated and taxes are deposited, impacting cash flow and reporting frequencies.

Deciding on a payment method for employees is also part of the initial setup. Direct deposit is an efficient method, requiring employees to provide bank account and routing numbers for electronic funds transfer. This involves setting up an Automated Clearing House (ACH) file. Alternatively, issuing paper checks requires printing, signing, and distributing physical checks each pay period.

Understanding state-specific requirements is important. States have unique regulations concerning new hire reporting, minimum wage laws, and other labor laws governing overtime and final paychecks. Businesses must report new hires to the relevant state agency within a specified timeframe, usually within 20 days of hire. Familiarity with these mandates helps ensure legal compliance and avoids potential penalties.

Calculating and Paying Employees

Once initial setup is complete, the regular process of calculating and paying employees begins each pay period. First, accurately determine each employee’s gross pay. For hourly employees, multiply their hourly rate by regular hours worked, and calculate overtime pay at 1.5 times the regular rate for hours exceeding 40 in a workweek, as defined by the Fair Labor Standards Act (FLSA). Salaried employees receive a fixed amount per pay period.

Next, calculate all applicable withholdings. Federal income tax withholding is calculated using the employee’s Form W-4 data and IRS Publication 15-T withholding tables. This publication details methods like the wage bracket and percentage methods to determine federal tax based on gross wages, filing status, and adjustments.

FICA taxes (Social Security and Medicare) are also withheld. For 2025, Social Security tax is 6.2% on wages up to $176,100, and Medicare tax is 1.45% on all wages. An additional Medicare tax of 0.9% applies to wages exceeding certain thresholds (e.g., $200,000 for single filers). State income tax withholdings, if applicable, are calculated using state-specific forms and tax tables.

Beyond taxes, calculate and subtract any pre-tax or post-tax deductions. Pre-tax deductions, such as health insurance or traditional 401(k) contributions, are taken out before income taxes, reducing taxable income. Post-tax deductions, like loan repayments or Roth 401(k) contributions, are subtracted after all taxes. These deductions are based on employee elections, company policies, or legal requirements like wage garnishments.

After all withholdings and deductions, net pay for each employee is determined by subtracting total deductions from gross pay. This final amount is what the employee receives. Accuracy at this stage is important, as errors can lead to employee dissatisfaction and compliance issues.

For direct deposit, an Automated Clearing House (ACH) file is generated with net pay amounts and employee bank details, then submitted to the company’s bank for transfers, usually within one to two business days. Alternatively, paper checks are printed and distributed.

Providing detailed pay stubs to employees is a legal requirement and important transparency measure. A pay stub should clearly itemize gross wages, all federal, state, and local tax withholdings, pre-tax and post-tax deductions, and the final net pay. It should also include year-to-date totals for wages and taxes, ensuring employees understand how their take-home pay was calculated.

Managing Payroll Tax Obligations

After employees are paid, managing payroll tax obligations begins, focusing on timely deposit and accurate reporting to federal and state authorities. For federal taxes, employers deposit federal income tax withholdings, plus employee and employer portions of Social Security and Medicare taxes (FICA).

Deposit frequency (monthly or semi-weekly) is determined by the employer’s total tax liability during a “lookback period” (four quarters ending June 30 of the preceding year). New businesses start monthly for their first year. All federal tax deposits must be made electronically through the Electronic Federal Tax Payment System (EFTPS). Monthly depositors’ taxes are due by the 15th of the following month.

For semi-weekly depositors, taxes for wages paid Wednesday-Friday are due by the following Wednesday. Taxes for wages paid Saturday-Tuesday are due by the following Friday. If $100,000 or more accumulates on any single day, it must be deposited by the next business day.

State tax deposits follow a similar pattern via state-specific portals. These include state income tax withholdings and state unemployment insurance (SUI) taxes. Deposit frequencies vary by state, ranging from weekly to quarterly, based on employer’s total state tax liability or unemployment claim history. Businesses must register with their state’s revenue department and unemployment agency.

Employers must file quarterly federal tax returns. Form 941, Employer’s Quarterly Federal Tax Return, reports wages, tips, federal income tax withheld, and FICA shares for the quarter. This form is due by the last day of the month following the quarter’s end (April 30, July 31, October 31, and January 31). If all taxes were timely deposited, an employer may have an additional 10 days to file.

Annual federal filings are mandatory. Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, reports annual FUTA tax liability. FUTA tax is paid solely by the employer; any accumulated FUTA liability exceeding $500 in a quarter must be deposited quarterly. Form 940 is due by January 31 of the following year, with an extension to February 10 if all FUTA taxes were deposited on time.

Employers must prepare Form W-2, Wage and Tax Statement, for each employee, reporting annual wages and taxes withheld. These forms must be distributed to employees by January 31 and copies submitted to the Social Security Administration (SSA) along with Form W-3, Transmittal of Wage and Tax Statements, which summarizes W-2 data.

State annual or quarterly filings for unemployment and withholding taxes are also required. These reports reconcile state tax deposits and provide detailed wage information. Deadlines and specific forms vary by state, often aligning with federal deadlines. Compliance with both federal and state reporting obligations is important to avoid penalties.

Record Keeping and Compliance

Effective record keeping is important for successful payroll management, ensuring long-term compliance and facilitating audits. Businesses must maintain comprehensive payroll records, including hours worked by non-exempt employees, gross wages, tax withholdings, and authorized deductions.

Records of employee tax forms (Form W-4, state withholding certificates) and Form I-9 must be kept. Pay stubs, tax forms (Forms 940, 941, W-2, W-3), and deposit records are all essential documents.

Retention duration varies by type and regulatory body. Federal tax records (Forms 941, 940, W-2, etc.) must be kept for at least four years from the date the tax becomes due or is paid. Employment records (wages, hours, etc. under FLSA) need to be retained for three years. Form I-9 requires retention for one year after employment ends or three years from hire, whichever is later. State regulations may impose longer retention periods.

Organized and accurate records safeguard against non-compliance penalties and are indispensable during audits by agencies like the IRS, state tax departments, or the Department of Labor. Maintaining detailed, legible, and accessible records is important for demonstrating adherence to payroll and employment laws.

Well-maintained records enable businesses to efficiently respond to inquiries from current or former employees for wage verification or unemployment claims. They also allow for swift and accurate responses to government agencies during audits or investigations, providing proof of compliance.

Beyond tax and wage reporting, businesses must ensure broader compliance with labor laws, including the Fair Labor Standards Act (FLSA). The FLSA governs minimum wage, overtime pay, record keeping, and child labor standards. Businesses must correctly classify employees as exempt or non-exempt from overtime provisions and ensure non-exempt employees are paid at least the federal minimum wage and receive overtime pay for hours worked over 40 in a workweek. State-specific labor laws may have higher minimum wage rates or additional requirements regarding breaks, paid leave, or final paychecks, impacting payroll calculations and record keeping.