Learn How to Do Payroll for Your Business

Payroll management is a foundational responsibility for any business employing individuals. It encompasses precise calculations, adherence to tax laws, and systematic reporting to government entities. Effective payroll processing ensures employees receive accurate and timely compensation, fostering trust and compliance. This function involves meeting federal and state legal obligations for tax withholdings and employer contributions, safeguarding the business from penalties and legal issues. Properly managing payroll is essential for operational stability and regulatory adherence.

Initial Payroll Setup

Establishing a payroll system begins with securing employer identification numbers. Businesses must obtain a Federal Employer Identification Number (EIN) from the IRS. State tax identification numbers are also required for state-specific tax obligations, such as state income tax and unemployment insurance.

Defining consistent pay periods determines how often employees are paid. Common frequencies include weekly, bi-weekly, semi-monthly, or monthly, and this choice impacts withholding calculations and tax deposit schedules. Once pay periods are established, gathering employee information ensures accurate processing and compliance.

For each employee, the employer must collect personal details like name, address, and Social Security number. The Federal W-4 Form, “Employee’s Withholding Certificate,” provides information to calculate federal income tax withholding from an employee’s wages.

Employers must complete Form I-9, “Employment Eligibility Verification,” to confirm an employee’s identity and legal authorization to work in the United States. The employee completes Section 1 of Form I-9 no later than their first day of employment. The employer completes Section 2 within three business days of the employee’s first day of work. If offering direct deposit, obtain the employee’s bank name, routing number, and account number.

Businesses select a payroll system that aligns with their operational needs. Options range from manual processing and specialized software to outsourcing to a payroll service provider. The decision depends on the number of employees, the complexity of the payroll, and the available internal resources, with each method offering different automation and administrative burdens.

Calculating Employee Compensation

Calculating employee compensation starts with determining gross pay, the total earnings before deductions. For hourly employees, gross pay includes regular hours worked and overtime pay. Salaried employees receive a fixed amount per pay period, while other compensation, such as bonuses or sales commissions, must also be included in gross pay calculations.

Once gross pay is determined, pre-tax deductions are applied, reducing an employee’s taxable income. Common examples include contributions to a 401(k) retirement plan or premiums for health insurance. After these deductions, the amount is the employee’s taxable wages, which are subject to various payroll taxes.

Federal income tax (FIT) withholding is calculated based on the employee’s W-4 Form and guidance provided by the IRS in Publication 15-T. FICA (Federal Insurance Contributions Act) taxes, which fund Social Security and Medicare, are also withheld from employee wages.

For Social Security, the employee and employer each contribute 6.2% of wages, up to an annual wage base limit. Medicare tax is 1.45% for both the employee and employer, applied to all wages without a wage base limit. An additional Medicare tax of 0.9% applies to individual wages exceeding $200,000, withheld by employers. State and local income taxes are also withheld if applicable.

Post-tax deductions are subtracted from the employee’s pay. These can include wage garnishments, contributions to a Roth 401(k) plan, or charitable contributions. The amount remaining after all deductions is the net pay.

Handling Payroll Taxes and Reporting

Beyond employee withholdings, employers are responsible for paying their share of payroll taxes and submitting regular reports to government agencies. Employer payroll taxes include the matching portion of FICA taxes (Social Security and Medicare), Federal Unemployment Tax Act (FUTA) contributions, and State Unemployment Tax Act (SUTA) contributions.

FUTA tax is levied at 6.0% on the first $7,000 of wages paid to each employee annually. Most employers receive a credit of up to 5.4% against their FUTA tax liability for timely payments into state unemployment insurance programs, effectively reducing the federal rate to 0.6%. State unemployment taxes (SUTA) vary by state, with rates and wage bases determined by individual state laws, and these contributions are important for the FUTA credit.

Federal payroll taxes, encompassing withheld income tax, FICA taxes, and FUTA taxes, must be deposited electronically. The Electronic Federal Tax Payment System (EFTPS) is the primary method for making these federal tax deposits. Businesses are generally classified as either monthly or semi-weekly depositors. State tax deposit requirements and methods also vary by jurisdiction.

Employers file various payroll tax forms to report wages and taxes. Form 941, “Employer’s Quarterly Federal Tax Return,” is filed quarterly to report federal income, Social Security, and Medicare tax withholdings. The deadlines for Form 941 are April 30, July 31, October 31, and January 31 for the respective quarters. Annually, employers file Form 940, “Employer’s Annual Federal Unemployment (FUTA) Tax Return,” to report their FUTA tax liability, with a general deadline of January 31 of the following year.

At year-end, employers prepare Forms W-2, “Wage and Tax Statement,” for each employee, due by January 31 of the following year. Employers file Copy A of all W-2s along with Form W-3, “Transmittal of Wage and Tax Statements,” with the Social Security Administration by January 31. State-specific payroll tax forms, such as state unemployment or withholding reports, also have their own filing deadlines and requirements.

Maintaining Payroll Records

Accurate and organized record-keeping is essential for payroll compliance. Employers must retain a variety of documents related to employee compensation and tax activities. These records include employee personal information and detailed timekeeping records.

Payroll registers or journals, summarizing wages, deductions, and net pay, are also essential. Copies of all filed wage and tax statements (Forms W-2, 941, 940) must be kept, along with records of all tax deposits made. Documentation for employee benefits, direct deposit authorizations, and the original Forms W-4 and I-9 completed by employees are important for auditing purposes.

Federal law mandates retention periods for payroll records. Most employment tax records (Forms 941, W-2s, W-4s) are kept for at least four years from the date the tax became due or was paid, whichever is later. Form I-9, verifying employment eligibility, is retained for three years after the date of hire or one year after the date of termination, whichever period is longer.

Maintaining these records in an organized and secure manner is important. It ensures compliance with federal and state regulations during potential audits by tax authorities. Well-maintained records help resolve any disputes with employees regarding pay or benefits, and they provide a clear historical account of all payroll transactions.