How to Run Payroll: From Setup to Tax Filings

Payroll is a fundamental process for any business with employees. It involves calculating and disbursing wages, withholding and remitting taxes, and reporting financial information to government agencies. Effective payroll management ensures employees receive compensation while the business adheres to legal obligations. Proper practices help businesses avoid penalties, maintain good standing with tax authorities, and foster trust with their workforce.

Setting Up Your Payroll Foundation

Establishing a solid payroll foundation begins with securing an Employer Identification Number (EIN) from the Internal Revenue Service. This unique nine-digit number acts as a federal tax identification for businesses, essential for reporting federal taxes and opening business bank accounts. Acquiring an EIN is a straightforward process, typically completed online through the IRS website, and is a prerequisite for federal tax filings related to employment.

Businesses must register with relevant state tax agencies before hiring employees. This often includes registration for state income tax withholding and state unemployment insurance (SUI) programs. Depending on the business location, local tax registrations might also be necessary for municipal income or occupational privilege taxes. These registrations authorize the business to withhold and remit taxes according to specific regulations.

Upon hiring new employees, gathering accurate information is a critical step. Employers must obtain a completed Form W-4, Employee’s Withholding Certificate, from each new hire to dictate federal income tax withholding. Form I-9, Employment Eligibility Verification, must also be completed to confirm legal work authorization. Collecting direct deposit information streamlines the payment process.

Choosing a suitable payroll method is a foundational decision. Options range from manual processing to specialized payroll software that automates calculations and compliance. Alternatively, a third-party payroll service can offload the entire function, including calculations, tax filings, and direct deposits. The selection depends on the business’s size, complexity, and resources.

Establishing consistent pay periods is essential for predictable payroll processing and employee expectations. Common pay frequencies include weekly, bi-weekly, semi-monthly, and monthly. The chosen pay period dictates the regularity of wage calculations and disbursements, impacting cash flow and employee financial planning. Selection considers industry standards and administrative capacity.

Calculating Employee Compensation and Withholdings

Calculating an employee’s gross pay is the initial step in determining total compensation. For hourly employees, gross pay is their hourly wage multiplied by hours worked, with overtime at one and a half times the regular rate for hours exceeding 40 in a workweek, as mandated by the Fair Labor Standards Act (FLSA). Salaried employees receive a fixed amount per pay period, with their annual salary divided across the established pay frequency.

After gross pay, pre-tax deductions are subtracted, reducing an employee’s taxable income. Common pre-tax deductions include contributions to qualified retirement plans, like a 401(k), and premiums for certain health insurance plans. Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs) also allow employees to set aside pre-tax money for eligible healthcare expenses. These deductions lower income subject to federal, state, and local income taxes.

Payroll tax withholdings are a significant deduction from gross pay. Federal income tax (FIT) withholding is calculated based on the employee’s Form W-4 and IRS tax tables. The amount varies depending on marital status, number of dependents, and any additional withholding specified.

Federal Insurance Contributions Act (FICA) taxes are withheld to fund Social Security and Medicare programs. Social Security tax is 6.2% on gross wages, up to an annual wage base limit. Medicare tax is 1.45% on all gross wages, with no wage base limit. Employers contribute an equal matching amount for both Social Security and Medicare taxes.

State income tax withholding is calculated similarly to federal income tax, using state-specific forms and tax tables. The exact calculation depends on the employee’s residency, work location, and state tax rates. Some localities may also impose their own income taxes, requiring additional calculations and withholdings based on local rates.

Post-tax deductions are subtracted from an employee’s pay after all applicable taxes. These deductions do not reduce taxable income and include items such as Roth 401(k) contributions. Other common post-tax deductions can include wage garnishments for debts like child support or unpaid taxes, and voluntary deductions for union dues or charitable contributions. The remaining amount represents the employee’s net pay.

Managing Payroll Tax Payments and Filings

After calculating compensation and withholdings, businesses must deposit federal payroll taxes with the Internal Revenue Service. This includes federal income tax, Social Security, and Medicare taxes, both employee and employer portions, primarily through the Electronic Federal Tax Payment System (EFTPS). Deposit frequency, whether monthly or semi-weekly, depends on the total tax liability.

Businesses must also deposit state and local payroll taxes with relevant authorities. This includes remitting state income tax withholding to the state’s revenue department and state unemployment insurance (SUI) taxes to the state’s labor agency. Payment schedules and methods for these taxes vary by jurisdiction, often requiring monthly or quarterly electronic payments.

Filing federal payroll tax forms is a regular requirement. Form 941, Employer’s Quarterly Federal Tax Return, reports total wages paid, federal income tax withheld, and both employee and employer shares of Social Security and Medicare taxes for each quarter. This form is due by the last day of the month following the end of the quarter. For federal unemployment tax, businesses file Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, by January 31st of the following year.

At the end of each calendar year, employers must prepare and distribute Form W-2, Wage and Tax Statement, to each employee by January 31st of the following year. This form details the employee’s annual wages and amounts withheld for federal, state, and local taxes, plus benefit plan contributions. A copy of all W-2s, along with Form W-3, Transmittal of Wage and Tax Statements, must also be submitted to the Social Security Administration.

Businesses must fulfill state and local payroll tax filing requirements. This commonly includes submitting quarterly or annual state unemployment wage reports, detailing employee wages for unemployment insurance contributions. Many states also require periodic state withholding tax forms that reconcile withheld amounts with deposits. Maintaining accurate payroll records, including timesheets, wage calculations, and tax deposit confirmations, is essential for demonstrating compliance.