How to Run Payroll: A Step-by-Step Process

Payroll is the process of managing employee compensation, from tracking hours to distributing payments. This system ensures accurate, timely payments and compliance with legal and tax obligations. Effective payroll management is fundamental for employee morale, compliance with labor laws, and business financial health. It involves record-keeping and adherence to federal, state, and local requirements.

Establishing Your Payroll Framework

Before any payments can be made, a business must establish a payroll framework. This begins with obtaining identification numbers from government agencies. The Internal Revenue Service (IRS) requires every employer to have an Employer Identification Number (EIN), a federal tax ID. Businesses must also acquire state tax identification numbers, such as those for state unemployment insurance and state income tax withholding, which vary by jurisdiction.

Once identifiers are secured, a consistent pay schedule is established. Common pay frequencies include weekly, bi-weekly, semi-monthly, and monthly. The choice of frequency can depend on industry norms, employee preferences, and administrative capacity, with bi-weekly being the most common. Consistency is important for both employee budgeting and efficient payroll processing.

Gathering employee information is another foundational step. Before an employee’s first payroll run, they must complete Form W-4, the Employee’s Withholding Certificate. This form provides employers with details, such as filing status and dependents, to accurately calculate federal income tax withholding. Additionally, employers must complete Form I-9, Employment Eligibility Verification, for every new hire to verify their identity and legal authorization to work in the United States. If offering direct deposit, employees must provide their bank name, routing number, and account number.

Understanding different pay types is essential for accurate payroll setup. Employees may be compensated through hourly wages, salaries, or commissions. Hourly employees are paid based on the hours they work, including overtime pay, which is 1.5 times their regular rate for hours exceeding 40 in a workweek. Salaried employees receive a fixed amount of pay regardless of the hours worked, while commissions are often performance-based earnings.

Computing Employee Wages and Withholdings

The core of running payroll involves calculating each employee’s gross pay and deductions to arrive at their net pay. Gross pay is the total earnings before any deductions are applied. For hourly employees, this is determined by multiplying their hourly rate by regular hours worked, plus any overtime hours calculated at their overtime rate. For salaried employees, gross pay for a period is their annual salary divided by pay periods in a year.

Once gross pay is determined, pre-tax deductions are subtracted. These deductions reduce an employee’s taxable income, meaning taxes are calculated on a lower wage base. Examples include contributions to 401(k) retirement plans, health insurance premiums, and contributions to Health Savings Accounts (HSAs) or Flexible Spending Accounts (FSAs). The types and limits of these deductions are governed by IRS regulations.

After pre-tax deductions, various tax withholdings are calculated from the remaining taxable income. Federal income tax withholding is determined using the information provided on the employee’s Form W-4 and IRS tax tables or wage bracket methods. Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare, are also withheld.

The Social Security tax rate is 6.2% for both the employee and employer, applied to wages up to an annual wage base of $176,100. The Medicare tax rate is 1.45% for both, applied to all wages without a wage base limit. An additional Medicare tax of 0.9% applies to individual employee wages exceeding $200,000 (or $250,000 for married filing jointly), which employers withhold but do not match. State and local income taxes also vary by jurisdiction and are calculated based on state-specific forms and tables.

Finally, post-tax deductions are subtracted from wages after all taxes have been calculated and withheld. These deductions do not reduce taxable income. Examples of post-tax deductions include Roth 401(k) contributions, wage garnishments (court-ordered payments), and union dues. After all deductions and withholdings, the remaining amount is the employee’s net pay, or “take-home” pay.

Managing Payments and Employer Tax Contributions

After calculating each employee’s net pay and all tax withholdings, the next phase involves distributing payments to employees and fulfilling employer tax responsibilities. Methods for paying employees include direct deposit, an electronic transfer to an employee’s bank account, or issuing paper checks. Other options like pay cards may be used. Employers must ensure timely payment according to their established pay schedule.

Beyond employee wages, employers have tax obligations. Businesses are required to match the FICA taxes withheld from employees’ wages, contributing an additional 6.2% for Social Security (up to the annual wage base) and 1.45% for Medicare. This effectively doubles the FICA tax paid for each employee.

Employers also pay federal unemployment tax under the Federal Unemployment Tax Act (FUTA). The FUTA tax rate is 6.0% on the first $7,000 of wages paid to each employee, though a credit for state unemployment taxes paid can reduce this rate. State Unemployment Tax Act (SUTA) taxes are solely an employer responsibility, with rates and wage bases varying by state.

Timely deposit of federal payroll taxes is a requirement. Employers use the Electronic Federal Tax Payment System (EFTPS) to make these deposits. The frequency of federal tax deposits, whether monthly or semi-weekly, depends on the business’s total tax liability during a specified “lookback period.” Businesses with $50,000 or less in tax liability during the lookback period follow a monthly deposit schedule, with deposits due by the 15th of the following month.

If the tax liability exceeded $50,000, a semi-weekly schedule applies, requiring deposits on specific days based on the payday. If accumulated tax liability reaches $100,000 or more, the deposit must be made by the next business day. State and local payroll taxes have separate deposit requirements and methods, which vary by jurisdiction.

Maintaining accurate payroll records is essential for compliance. Employers should keep records of hours worked, pay rates, gross and net wages, deductions, and copies of all tax forms. Federal regulations require employment tax records to be retained for at least four years after the tax is due or paid, whichever is later. Supporting documents, such as time cards, should be kept for at least two to three years.

Annual Payroll Reporting

At the close of each calendar year, businesses must complete annual payroll reporting tasks to summarize wages paid and taxes withheld. Businesses must prepare and distribute Form W-2, Wage and Tax Statement, for each employee. This form summarizes an employee’s annual wages, tips, and other compensation, along with federal, state, and local taxes withheld. Employers must distribute W-2 forms to employees by January 31 of the following year and submit copies to the Social Security Administration (SSA) by the same deadline.

For payments made to independent contractors, businesses may need to issue Form 1099-NEC, Nonemployee Compensation. This form is required for each non-employee to whom at least $600 was paid for services in the course of a trade or business during the year. Like W-2s, Form 1099-NEC must be provided to contractors and filed with the IRS by January 31.

Several annual federal tax forms require attention. Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, reports the annual FUTA tax liability and is due by January 31. Form 941, Employer’s Quarterly Federal Tax Return, is filed quarterly and reports federal income tax withheld and FICA taxes. An annual reconciliation of these quarterly filings is performed through cumulative reporting. Businesses are subject to similar annual reconciliation and summary reporting requirements at the state and local levels, which vary by jurisdiction.