How to Prepare Payroll for a Small Business

Payroll preparation for a small business involves accurately compensating employees while adhering to legal and tax obligations. Effective payroll management is fundamental for maintaining compliance with federal and state regulations, helping avoid penalties and legal issues. It also aids in financial management by providing insights into labor costs.

Payroll includes calculating wages, managing deductions, and remitting taxes. A well-managed payroll system streamlines operations, reduces errors, and helps businesses track financial obligations.

Gathering Essential Payroll Information

Businesses must gather and organize specific employee and company data before pay calculations. Employee information starts with the federal Form W-4, which employees complete to inform their employer of their tax withholding preferences. This form guides the amount of federal income tax to be withheld from each paycheck.

Employers also need a completed Form I-9, Employment Eligibility Verification, from each new hire. This form verifies an employee’s identity and legal authorization to work in the United States. Collecting personal contact details and bank information is essential for setting up direct deposit, including bank names, account numbers, and routing numbers.

An Employer Identification Number (EIN) is mandatory for businesses with employees. This nine-digit number, issued by the IRS, acts as a federal tax ID for the business, similar to a Social Security Number for an individual. Businesses must also obtain state tax identification numbers relevant to their operations, as states have their own tax requirements.

Company pay policies require clear definition. This includes establishing regular pay periods, such as weekly, bi-weekly, or semi-monthly. Overtime rules, governed by the Fair Labor Standards Act (FLSA), must also be understood and applied. The FLSA generally mandates that non-exempt employees receive one and a half times their regular rate of pay for hours worked over 40 in a workweek. Finally, details regarding benefit deduction amounts, such as health insurance premiums or retirement plan contributions, must be accurately recorded.

Calculating Employee Pay

Calculating an employee’s take-home pay involves determining gross earnings. Gross pay encompasses all compensation earned before any deductions, including regular hourly wages or salaries, overtime, bonuses, and commissions. Overtime pay is calculated at 1.5 times the employee’s regular hourly rate for hours worked beyond 40 in a workweek.

Once gross pay is established, pre-tax deductions are subtracted. These deductions reduce an employee’s taxable income, meaning taxes are calculated on a lower amount. Common examples include contributions to a 401(k) retirement plan or health insurance premiums, provided these benefits are structured as pre-tax. The remaining amount after pre-tax deductions is the taxable gross pay.

Next, mandatory tax withholdings are calculated from the taxable gross. Federal income tax withholding is determined by information provided on the employee’s Form W-4. State income tax, where applicable, is also withheld based on state-specific forms and regulations. Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare, are also mandatory withholdings. For 2025, employees contribute 6.2% for Social Security on wages up to $176,100, and 1.45% for Medicare on all wages, with no wage limit.

After all mandatory tax withholdings, any post-tax deductions are applied. These deductions do not reduce taxable income, as they are taken from an employee’s pay after taxes have been calculated. Common post-tax deductions include Roth IRA contributions, union dues, certain voluntary insurance premiums like life or disability insurance, and wage garnishments. Wage garnishments are legally mandated withholdings for debts such as child support, unpaid taxes, or student loans. The final amount remaining after all deductions is the employee’s net pay.

Understanding Employer Payroll Tax Obligations

Employers have distinct payroll tax obligations beyond the taxes withheld from employee paychecks. One primary obligation is the employer’s portion of FICA taxes. Employers must match the Social Security and Medicare contributions withheld from employee wages. For 2025, employers also pay 6.2% for Social Security on wages up to $176,100 and 1.45% for Medicare on all wages, mirroring the employee’s contribution. The combined employer and employee contribution for FICA totals 15.3% of wages, up to the Social Security wage base.

Another federal employer tax is the Federal Unemployment Tax Act (FUTA) tax. FUTA funds unemployment benefits for eligible workers. The standard FUTA tax rate is 6.0% on the first $7,000 of each employee’s wages per year. Employers receive a significant credit of up to 5.4% against their FUTA tax if they pay their state unemployment taxes on time. This credit can reduce the effective FUTA tax rate to 0.6% on the first $7,000 of wages, resulting in a maximum of $42 per employee annually in most states.

In addition to FUTA, employers are also responsible for State Unemployment Tax Act (SUTA) taxes, often referred to as State Unemployment Insurance (SUI). SUTA taxes are paid to the state and fund unemployment benefits for workers who lose their jobs through no fault of their own. Each state sets its own SUTA tax rate and taxable wage base, which can vary significantly. While most states consider SUTA an employer-only tax, a few states also require employee contributions.

Filing and Remitting Payroll Taxes

The next step involves the timely filing and remittance of payroll taxes. Federal payroll taxes, including withheld federal income tax, Social Security, and Medicare taxes, along with the employer’s share of FICA, are generally deposited using the Electronic Federal Tax Payment System (EFTPS). The frequency of these deposits—either monthly or semi-weekly—depends on the total tax liability accumulated during a lookback period. Businesses with a smaller tax liability typically make monthly deposits, while those with larger liabilities are required to deposit semi-weekly.

Employers must also file Form 941, Employer’s Quarterly Federal Tax Return, with the IRS. This form reports the total compensation paid to employees, the amounts withheld for federal income tax, Social Security, and Medicare, and the employer’s portions of Social Security and Medicare taxes for the quarter. Form 941 is due quarterly: April 30 for the first quarter, July 31 for the second, October 31 for the third, and January 31 of the following year for the fourth quarter.

For federal unemployment taxes, employers file Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. This form reports the FUTA tax liability for the entire calendar year and is due by January 31 of the following year.

State and local payroll tax filing requirements vary by jurisdiction. Businesses must adhere to specific state income tax withholding rules, state unemployment insurance (SUI) reporting, and any other local tax obligations. These often involve separate forms and payment schedules unique to each state.

By January 31 of the following year, employers must prepare and distribute Form W-2, Wage and Tax Statement, to each employee. This form summarizes the employee’s annual wages, tips, and other compensation, along with all federal, state, and local taxes withheld. Simultaneously, employers must file Copy A of all W-2 forms, along with Form W-3, Transmittal of Wage and Tax Statements, with the Social Security Administration (SSA). Form W-3 summarizes the total wages and taxes reported on all W-2s. The deadline for filing W-2s and W-3s with the SSA is also January 31.