How to Set Up Payroll for Your Business

Payroll is a fundamental aspect of operating a business with employees. It encompasses accurate calculation of earnings, timely tax withholdings, and compliance with various federal, state, and local regulations. Managing payroll effectively ensures that employees are compensated correctly and on time. Precise payroll management helps businesses avoid penalties and maintain good standing with tax authorities.

Initial Setup and Registrations

Before processing payroll, a business must complete foundational registrations. A primary requirement for any employer is obtaining an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). An EIN is a nine-digit federal tax ID number that identifies a business entity for tax purposes. This number is necessary for filing federal tax returns, opening business bank accounts, and hiring employees. Businesses can apply for an EIN online through the IRS website, which typically provides the number immediately upon completion. Other application methods include faxing or mailing Form SS-4, though these methods take longer.

Beyond federal requirements, businesses must also register with relevant state tax agencies. These registrations are necessary for state income tax withholding, state unemployment insurance (SUI), and other state-specific payroll taxes. Requirements can vary significantly by state, so businesses should consult their state’s labor or revenue department websites for specific instructions.

In addition to federal and state obligations, some local jurisdictions may impose their own payroll tax requirements. These can include local income taxes or specific business taxes that apply to wages paid within city or county limits. Businesses should research the regulations for all localities where they operate or have employees to ensure full compliance.

Employee Onboarding and Data Collection

Before an employee receives their first paycheck, businesses must collect specific information. A foundational step involves correctly classifying workers as either employees or independent contractors, as payroll tax obligations apply only to employees. The IRS considers factors such as behavioral control, financial control, and the type of relationship to make this distinction. Misclassifying a worker can result in significant penalties.

Employees must complete Form W-4, Employee’s Withholding Certificate, which provides employers with information to determine the correct amount of federal income tax to withhold from their pay. This form collects details such as filing status, the number of dependents, and any other income or adjustments that might affect withholding. Employers use this information in conjunction with IRS tax tables to calculate federal income tax withholding. Employees should complete this form before their first paycheck, and it should be updated if their personal or financial situation changes.

Another essential document is Form I-9, Employment Eligibility Verification, which verifies an employee’s identity and authorization to work in the United States. Employees must present specific documents from a list provided by the U.S. Citizenship and Immigration Services (USCIS) to establish both identity and employment eligibility. Employers must examine these documents and complete their portion of Form I-9 within three business days of the employee’s first day of employment.

Beyond these forms, businesses need to gather other personal and banking information from new hires. This includes their full legal name, current address, and Social Security number. For direct deposit, employees must provide their bank name, routing number, and account number. Collecting emergency contact details is also standard practice.

Payroll Calculation and Withholding

Calculating payroll begins with determining gross pay, the total earnings before any deductions. For hourly employees, gross pay is calculated by multiplying the number of hours worked by their hourly rate, adding any overtime hours at the appropriate premium rate. Salaried employees typically receive a fixed gross amount per pay period.

Once gross pay is established, certain pre-tax deductions are subtracted. These deductions reduce an employee’s taxable income. Common pre-tax deductions include contributions to qualified retirement plans, such as 401(k)s, and premiums for certain health insurance plans.

After pre-tax deductions, the remaining amount is the employee’s taxable wages. Federal income tax withholding is then calculated based on the information provided on the employee’s Form W-4 and IRS tax tables. The employee’s filing status and number of dependents directly influence this calculation. This withholding is an estimate of the employee’s annual income tax liability.

Businesses must withhold FICA taxes, which fund Social Security and Medicare programs. Both the employee and the employer contribute to FICA taxes. For Social Security, the employee and employer each pay 6.2% of wages, up to an annual wage base limit, which is $176,100 for 2025. For Medicare, both the employee and employer each pay 1.45% of all wages, with no wage base limit. An additional Medicare tax of 0.9% applies to employee wages exceeding certain thresholds.

State and local income tax withholdings are also calculated, if applicable, based on the specific rules and tax tables for each state and locality. These rates and calculation methods vary widely across different jurisdictions. Businesses must remain informed about the specific requirements for all areas where their employees work.

Any post-tax deductions are subtracted from the employee’s pay. These deductions are taken after all applicable taxes have been calculated and withheld. Examples include wage garnishments or union dues. After all these calculations and deductions, the remaining amount is the employee’s net pay.

Payroll Processing and Payments

After all gross pay calculations and withholdings are complete, businesses pay employees. Businesses first establish a payroll schedule, which dictates how frequently employees are paid. Common frequencies include weekly, bi-weekly, semi-monthly, and monthly. Bi-weekly is a widely used schedule, offering a balance between frequent payments and administrative efficiency. The choice of schedule can depend on industry standards, company size, and employee preferences.

Businesses have several options for distributing employee wages. Direct deposit is a widely preferred method due to its convenience and security. Funds are electronically transferred directly from the business’s bank account into the employee’s designated bank account. To set this up, businesses collect the employee’s bank name, routing number, and account number during onboarding.

Another common payment method is issuing paper checks. While checks provide a physical record, they can be time-consuming to distribute and may require employees without bank accounts to incur fees for cashing them. Pay cards, which are prepaid debit cards, offer an alternative for employees who may not have traditional bank accounts. Wages are loaded onto these cards, allowing employees to access funds through ATMs or point-of-sale transactions.

Businesses are generally required to provide employees with detailed pay stubs or statements. While federal law does not mandate pay stubs, many states do have laws requiring employers to provide pay stubs. These statements typically include gross pay, itemized deductions, net pay, pay period dates, and hours worked for hourly employees. Providing clear pay stubs helps employees understand their earnings and deductions.

Tax Deposits and Reporting

After payroll is processed, businesses have ongoing obligations to deposit withheld taxes and file regular reports with government agencies. For federal taxes, employers must deposit federal income tax withholding and FICA taxes with the IRS. The Electronic Federal Tax Payment System (EFTPS) is the mandatory method for most federal tax deposits, a free service that allows businesses to schedule payments online or by phone.

Federal tax deposit schedules depend on the total tax liability. Most employers follow either a monthly or semi-weekly deposit schedule. It is important to adhere to these schedules to avoid penalties.

State tax deposits for state income tax withholding and state unemployment insurance (SUI) contributions also have varying methods and frequencies. Businesses typically follow state-specific guidelines, which may include electronic transfers or other approved payment methods. These deposit schedules can differ from federal requirements, necessitating careful attention to state regulations.

Quarterly federal reporting is required using Form 941, Employer’s Quarterly Federal Tax Return. This form reports federal income tax, Social Security, and Medicare taxes withheld from employees, along with the employer’s share. Form 941 is due by the last day of the month following the end of each calendar quarter.

Annual federal reporting includes Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. This form reports the Federal Unemployment Tax Act (FUTA) tax, which is paid solely by the employer. Additionally, businesses must prepare Form W-2, Wage and Tax Statement, for each employee, reporting their annual wages and withheld taxes. These W-2s are provided to employees by January 31 and copies are submitted to the Social Security Administration (SSA) along with Form W-3, Transmittal of Wage and Tax Statements.

States and some localities have their own quarterly and annual reporting requirements, which align with their respective tax deposit schedules. These reports ensure that all state and local payroll tax obligations are met. Businesses should consult state and local tax authorities for specific filing deadlines and forms.