How to Do Your Own Payroll for Small Business

Payroll management is a fundamental aspect of operating a small business, encompassing the accurate calculation of employee wages, the timely payment of earnings, and the fulfillment of tax obligations. While many businesses opt for external payroll services, managing payroll internally can offer greater control over financial data and operations, potentially proving cost-effective for smaller entities. Accurately handling payroll helps ensure employee satisfaction and avoids penalties from regulatory bodies. Businesses that manage payroll in-house commit to a detailed administrative process that requires careful attention to compliance and financial precision.

Initial Payroll Setup

Before a business can process its first payroll, several foundational steps are necessary to ensure compliance with federal and state regulations. A primary requirement involves obtaining a Federal Employer Identification Number (EIN) from the Internal Revenue Service (IRS), which serves as a unique tax ID for the business. This nine-digit number is required for all federal tax filings and can be acquired from the IRS website.

Beyond the federal level, businesses must also register with appropriate state agencies to manage state-specific payroll taxes and unemployment insurance. These registrations involve the state’s department of revenue for income tax withholding and the state’s labor or unemployment agency for unemployment insurance contributions. Requirements and processes vary by state, necessitating specific research for the business’s operating location.

Collecting employee information is another preparatory step, beginning with federal Form W-4, Employee’s Withholding Certificate. This form provides employers with details for calculating federal income tax withholding, based on the employee’s marital status, dependents, and any additional income or deductions. Employers must also complete federal Form I-9, Employment Eligibility Verification, to confirm an employee’s legal authorization to work in the United States. This form requires employees to present specific identity and employment eligibility documents.

Establishing a consistent pay period is also a decision that impacts payroll processing frequency and cash flow management. Common options include weekly, bi-weekly (every two weeks), semi-monthly (twice a month), or monthly pay cycles. The chosen schedule dictates how often wages are calculated and disbursed.

Understanding the components of employee pay forms the basis for accurate payroll calculations. Gross pay refers to the total earnings an employee receives before any deductions, including regular wages, overtime, and bonuses. Pre-tax deductions, such as contributions to a 401(k) plan or health insurance premiums, are subtracted from gross pay before taxes are calculated, reducing the employee’s taxable income. Post-tax deductions, conversely, are taken out after taxes have been calculated and withheld, examples of which include wage garnishments or Roth 401(k) contributions. Net pay is the final amount an employee receives after all applicable taxes and deductions have been subtracted from their gross pay.

Calculating Wages and Withholdings

Once the initial setup is complete, the next step involves calculating wages and all applicable withholdings for each employee. For hourly employees, gross wages are determined by multiplying their hourly rate by the total number of hours worked, including any overtime. Overtime pay, mandated by the Fair Labor Standards Act (FLSA), requires payment at one and a half times the regular rate for hours worked beyond 40 in a workweek.

Salaried employees receive a fixed amount per pay period, regardless of the exact hours worked. Their annual salary is divided by the number of pay periods to determine the gross amount per cycle.

Calculating federal income tax withholding relies on the information provided by the employee on their Form W-4 and the IRS’s Publication 15, Employer’s Tax Guide (Circular E). Employers use wage bracket tables or the percentage method described in Publication 15 to determine the correct amount of federal income tax to withhold. The accuracy of this calculation depends on the employee’s chosen filing status and any adjustments indicated on their W-4.

Federal Insurance Contributions Act (FICA) taxes, comprising Social Security and Medicare taxes, fund these federal programs. For 2025, the Social Security tax rate is 6.2% for both the employee and employer, each on wages up to an annual wage base limit, which is subject to change each year. The Medicare tax rate is 1.45% for both the employee and employer, applied to all wages without a wage base limit. Additionally, an employer must withhold an Additional Medicare Tax of 0.9% from an employee’s wages that exceed a certain threshold ($200,000 for single filers, $250,000 for married filing jointly, etc.), though the employer does not pay a matching portion for this additional tax.

State and local income tax withholdings are also calculated, with specific rates and regulations varying significantly by jurisdiction. Some states do not impose a state income tax, while others have flat rates or progressive tax structures. Employers must consult their specific state’s tax department guidelines to ensure proper calculation and remittance of these taxes.

Beyond statutory taxes, employers must also calculate and apply various other deductions. These can include pre-tax deductions such as health insurance premiums, contributions to retirement accounts like a 401(k), or flexible spending accounts. Post-tax deductions might involve union dues, charitable contributions, or wage garnishments. Each deduction must be accurately calculated and subtracted from the employee’s gross pay in the correct order to arrive at the net pay.

Paying Employees

After wage and withholding calculations are finalized, the next step involves disbursing wages to employees. Common methods for paying employees include direct deposit and physical checks.

Direct deposit is an efficient method where funds are electronically transferred into an employee’s bank account. This process requires employees to provide their bank name, account number, and routing number, which are then entered into the payroll system.

Alternatively, businesses can issue physical payroll checks. This method involves printing checks with the employee’s net pay amount and distributing them on payday.

Regardless of the payment method, providing a pay stub is important for each employee. A pay stub serves as a detailed record of an employee’s earnings and deductions for a specific pay period and year-to-date. It itemizes gross pay, all pre-tax and post-tax deductions, and the resulting net pay. This transparency helps employees understand how their wages are calculated and provides a record for their personal financial management.

The timing of payments must consistently align with the chosen pay period. For instance, if a business operates on a bi-weekly pay period, employees should receive their pay every two weeks on a designated payday.

Remitting Payroll Taxes and Filing Reports

After employees are paid and taxes are withheld, employers must remit these withheld taxes to the appropriate government agencies and file required reports.

Federal payroll taxes, including federal income tax withholding and FICA taxes (Social Security and Medicare), are deposited to the IRS 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. Most small businesses follow a monthly deposit schedule, which requires deposits by the 15th day of the following month.

State and local payroll taxes, such as state income tax and state unemployment insurance (SUI), must be remitted to their respective state and local agencies. The methods and schedules for these remittances vary significantly by state, often requiring online payments or specific forms. Employers need to consult their state’s tax authority for precise guidelines and deadlines.

Several federal payroll forms are required to be filed with the IRS to report wages paid and taxes withheld and remitted. Form 941, Employer’s QUARTERLY Federal Tax Return, reports income taxes, Social Security tax, and Medicare tax withheld from employee wages and the employer’s share of Social Security and Medicare taxes. This form is filed quarterly. Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, reports the annual federal unemployment tax liability, which is solely an employer-paid tax. This form is filed once a year.

At the end of each calendar year, employers must prepare Form W-2, Wage and Tax Statement, for each employee. This form reports the employee’s annual wages, tips, and other compensation, along with federal, state, and local taxes withheld. Copies of Form W-2 are provided to employees by January 31st of the following year, and also submitted to the Social Security Administration (SSA). Form W-3, Transmittal of Wage and Tax Statements, is a summary form that accompanies the paper filing of Forms W-2 with the SSA.

In addition to federal forms, state unemployment tax reports and other state-specific annual reconciliation forms are required. These state forms often summarize quarterly filings and ensure that all state tax obligations have been met. Adhering to all federal, state, and local deadlines for tax remittances and form filings helps avoid penalties.

Keeping Payroll Records

Maintaining accurate and organized payroll records is an ongoing requirement that supports compliance, facilitates audits, and provides a historical account of financial transactions.

Businesses must retain various types of payroll documentation. These include:

• Employee information, such as names, addresses, Social Security numbers, and dates of birth if under 19.
• Records of hours worked, wage rates, and total wages paid for each pay period.
• Documentation of all additions to or deductions from wages, such as health insurance premiums or retirement contributions.
• Copies of all payroll tax forms filed with federal, state, and local agencies, including Forms 941, 940, W-2, and W-3.
• Records of tax deposits made, along with confirmations of these payments.

Federal law, specifically the IRS and the Fair Labor Standards Act (FLSA), mandates specific retention periods for payroll records. Employment tax records, including Forms W-2 and W-3, should be kept for at least four years after the date the tax becomes due or is paid, whichever is later. FLSA records, such as timecards and earnings records, must be retained for at least three years. State laws may impose additional or longer retention requirements, so businesses should adhere to the longest applicable period.

The accurate and organized maintenance of these records is important for several reasons. It provides a clear audit trail for tax authorities and can be evidence in the event of a dispute with an employee. Proper record-keeping helps ensure legal compliance and can significantly streamline the process if a business undergoes an audit.