How to Prepare Payroll for Employees

Payroll preparation is a financial operation for any business with employees. It ensures workers are compensated accurately and on time, while fulfilling legal and tax obligations. Payroll involves calculations, tax withholdings, and record-keeping. Effective payroll management helps maintain employee satisfaction, financial accuracy, and adherence to federal and state regulations. It impacts a business’s compliance and financial health.

Setting Up Your Payroll System

Setting up a payroll system is the first step before paying employees. Businesses can choose manual processing, payroll software, or outsourcing to a service provider. Manual processing offers control but requires time and tax law knowledge, making it error-prone. Payroll software automates calculations and filings, balancing control and efficiency. Outsourcing offloads the burden, providing expertise and compliance, but comes with a fee.

Most businesses must obtain an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). This nine-digit number acts as a federal tax identification number, similar to a Social Security number for individuals. Businesses need an EIN to report taxes, hire employees, and open business bank accounts. The IRS provides an online application service for obtaining an EIN.

Businesses must also obtain state and potentially local tax identification numbers. These are necessary for remitting state unemployment insurance contributions, state income tax withholdings, and any applicable local payroll taxes. Requirements vary by jurisdiction, so businesses must research and register with relevant state and local revenue departments or labor agencies.

Gathering employee information is another foundational step. Every employee must complete a Form W-4, Employee’s Withholding Certificate. This form provides information to determine federal income tax withholding from wages, reflecting marital status, allowances, and additional amounts. Employers must also complete and retain a Form I-9, Employment Eligibility Verification, for each new hire. This form confirms an employee’s identity and eligibility to work in the United States.

Employers need to collect personal details from each employee, including their full legal name, current address, Social Security number, and date of birth. For direct deposit, the employee’s bank name, account number, and routing number are required. Establishing payroll policies is also important, such as defining regular pay periods (e.g., weekly, bi-weekly, semi-monthly, or monthly). Policies should also outline how overtime hours will be handled and detail any pre-tax or post-tax benefit deductions.

Calculating Employee Pay and Withholdings

Payroll preparation involves calculating each employee’s gross pay, applying deductions, and determining their net pay. Gross pay is the total earnings an employee receives before taxes or deductions. For hourly employees, gross pay is their hourly wage multiplied by regular hours worked. Overtime hours, typically beyond 40 hours in a workweek, must be paid at least one and a half times the regular rate, as mandated by the Fair Labor Standards Act (FLSA).

Salaried employees receive a fixed gross pay per period, if they meet FLSA exemption criteria. Commissions, bonuses, and other supplemental compensation are added to regular wages to determine total gross earnings.

Pre-tax deductions reduce an employee’s taxable income. Examples include contributions to retirement plans like a 401(k) or 403(b), health insurance premiums, and Dependent Care Flexible Spending Account (DCFSA) contributions. These deductions are subtracted from gross pay before income taxes are calculated.

Federal income tax (FIT) is withheld based on information from the employee’s Form W-4 and IRS tax tables. Employers use these tables, which factor in filing status, to determine the amount to withhold for each pay period.

Federal Insurance Contributions Act (FICA) taxes are also withheld from employee wages. The employee’s Social Security tax is 6.2% of gross wages, up to an annual wage base limit. The Medicare tax is 1.45% of all gross wages, with no wage base limit. An additional Medicare tax of 0.9% applies to wages exceeding certain thresholds, such as $200,000 for single filers.

Many jurisdictions require withholding state and local income taxes. Rates, rules, and forms for these taxes vary by location. Employers must comply with withholding requirements where their employees work.

Post-tax deductions are subtracted after all taxes have been calculated and withheld. These include wage garnishments mandated by court orders, union dues, or contributions to a Roth 401(k). The final amount after all deductions is the employee’s net pay.

Employer Payroll Tax Contributions

Employers have payroll tax obligations beyond employee wages and withholdings. These contributions are part of a business’s overall payroll expense.

Employers must match the employee’s portion of FICA taxes. This means the employer pays 6.2% for Social Security on wages up to the annual wage base and 1.45% for Medicare on all wages.

The Federal Unemployment Tax Act (FUTA) imposes a tax on employers. The FUTA tax rate is 6.0% on the first $7,000 of each employee’s wages paid during a calendar year. Employers typically receive a credit of up to 5.4% for timely paid state unemployment taxes, reducing the effective federal FUTA tax rate to 0.6% on the first $7,000 of wages.

The State Unemployment Tax Act (SUTA) requires employers to pay unemployment taxes to state agencies. SUTA rates vary by state and are adjusted based on an employer’s “experience rating,” which reflects their history of unemployment claims. These state funds provide financial assistance to eligible unemployed workers.

Workers’ compensation insurance is another employer contribution, providing wage replacement and medical benefits to employees injured on the job. The cost is calculated based on total payroll, categorized by job risk level.

Employers may also make other contributions as part of employee compensation. These can include health insurance premiums, matching 401(k) retirement plan contributions, or payments for other fringe benefits.

Filing and Paying Payroll Taxes

After calculating employee pay, withholdings, and employer contributions, the next step is filing reports and remitting taxes to the appropriate government agencies. Federal payroll taxes, including withheld federal income tax and both employee and employer portions of Social Security and Medicare taxes, are paid through the Electronic Federal Tax Payment System (EFTPS).

The frequency of federal tax deposits depends on the business’s total tax liability. Employers follow either a monthly or semi-weekly deposit schedule. Monthly depositors remit taxes by the 15th day of the following month. Semi-weekly depositors have more frequent deadlines. Failure to deposit taxes on time can result in penalties.

Employers file Form 941, Employer’s Quarterly Federal Tax Return, each quarter. This form reports wages paid and federal income, Social Security, and Medicare taxes. Form 941 is due by:
April 30 for the first quarter
July 31 for the second quarter
October 31 for the third quarter
January 31 for the fourth quarter

For federal unemployment taxes, employers file Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, annually. Form 940 is due by January 31 of the following year. FUTA tax deposits may be required quarterly if the accumulated liability exceeds a threshold.

State and local payroll taxes have their own deposit schedules and reporting forms. These vary by jurisdiction, so businesses must consult their state and local tax authorities for requirements and deadlines. Many states offer online portals for electronic filing and payment.

At the end of each calendar year, employers are responsible for year-end reporting. This includes furnishing Form W-2, Wage and Tax Statement, to each employee by January 31 of the following year. Employers also submit copies of all W-2s, along with Form W-3, Transmittal of Wage and Tax Statements, to the Social Security Administration (SSA) by the same deadline.

Maintaining Payroll Records and Compliance

Payroll management involves record-keeping and compliance with labor laws. Businesses must maintain payroll records for specific periods to satisfy federal and state requirements and for potential audits.

Essential payroll records to retain include:
Employees’ names, addresses, Social Security numbers, and dates of birth
Hours worked each day and week
Basis on which wages are paid
Regular hourly pay rates
Total daily or weekly straight-time earnings
Total overtime earnings
All additions to or deductions from wages
Total wages paid each pay period
Date of payment and pay period covered
Tax forms like W-4s, I-9s, and copies of filed tax returns (e.g., Forms 941, 940, W-2s)

Federal regulations require employment tax records to be kept for at least four years after the tax becomes due or is paid. The Fair Labor Standards Act (FLSA) mandates that payroll records detailing wages, hours, and other conditions of employment be kept for three years. Records on which wage computations are based must be kept for two years.

Federal labor laws impact payroll preparation and record-keeping. The FLSA establishes minimum wage, overtime pay, record-keeping, and youth employment standards. Employers must track hours worked to comply with minimum wage and overtime provisions.

Adherence to state-specific compliance requirements is also important. States have their own wage and hour laws, which may include higher minimum wage rates, rules for final paychecks upon termination, and requirements for meal and rest breaks. Businesses must consult their state’s labor department resources to ensure compliance.