How To Do Payroll The Right Way For Small Businesses

Payroll management is an essential aspect of any business, regardless of its size.

Whether you’re hiring your first employee or you already have a whole team, it is necessary to have a deep understanding of payroll management. Payroll is not straightforward, like some would like to think, it’s a complex process that involves intricate tax calculations and deductions. 

It demands a comprehensive knowledge of all the relevant federal and state tax laws. The nuances can be overwhelming, potentially distracting you from your primary focus of growing your enterprise.

This guide provides insightful tips for payroll management whether you are a small or medium-sized company payroll won’t seem so complicated anymore after you finish reading our guide.

Key Components of a Payroll System

An efficient payroll system should contain 3 elements: employee payments, managing and transmitting payroll-related taxes, and submitting tax forms.

Employee Payments

Make sure employees are paid accurately, punctually, and through the proper channels is fundamental for their satisfaction and productivity. This involves tracking work hours, calculating withholding taxes, and issuing paychecks or direct deposits, whether payment cycles are weekly, biweekly, or monthly.

Managing Payroll Taxes

It’s essential to accurately deduct withholding taxes from employee wages and remit them to the correct authorities, namely Federal and State governments. 

Depending on your business location, you may encounter various tax withholding requirements:

• Federal Income Tax
• State and local taxes
• Social Security and Medicare taxes
• Additional Medicare Tax
• Federal Unemployment Tax (FUTA)
• State Unemployment Tax (SUTA)
• Self-Employment Tax
• Workers’ Compensation Insurance

The main tax withholdings include federal income tax, Social Security, and Medicare taxes.

Tax Form Submission

For any business owner, filing tax forms is a daunting and time-intensive task. As an employer, compliance with timely tax form submissions is a legal obligation. Depending on your business’s size and operational flexibility, these submissions can be monthly, quarterly, or annually.

Key tax forms for employers include:

• Form 944, Employer’s ANNUAL Federal Tax Return
• Form 941, Employer’s Quarterly Federal Tax Return
• Form 940, Employer’s Annual Federal Unemployment Tax Return
• Form W-2s for employees, Form 1099s for contractors
• Form 945, Annual Return of Withheld Federal Income Tax

Exploring Payroll Methods

Precise and timely payroll processing is vital for a successful business, especially considering the numerous IRS requirements for tax withholding and submissions. It’s crucial to invest in an optimal payroll system that aligns with your business needs while complying with IRS standards.

Employee satisfaction should also be a priority, as their performance and productivity are linked to efficient and accurate payments.

     1. DIY (Do-It-Yourself) Approach

Many small business owners, especially those with a limited number of employees, opt for manual payroll management. This involves creating spreadsheets to track work hours, calculate taxes, and process paychecks, along with manually computing and filing payroll taxes.

This method is typically suitable for small businesses with a handful of employees and requires up-to-date knowledge of tax deductions and regulations.

Pros:

– Cost-effective

– Complete control over payroll and tax processes

Cons:

• Time-consuming and labor-intensive
• High risk of errors leading to potential IRS penalties

     2. Hiring an Accountant

For businesses aiming to manage payroll internally, enlisting an accountant can be immensely beneficial. Based on your business size and employee count, you might consider hiring an accountant on a part-time, full-time, or contractual basis. This approach is particularly effective for small businesses with a substantial workforce.

Pros:

– Frees up your time and energy to concentrate on business growth.

– An accountant brings specialized expertise in tax processing and reporting, minimizing the risk of expensive errors.

Cons:

– Can be costly, particularly for small businesses watching their budget.

– Offers limited control over financial matters.

3. Payroll Software Solutions

Payroll software can simplify and automate employee payment processes. This includes a variety of tasks including calculating employee benefits, generating payslips, handling employee taxes, and making sure it meets regulatory compliance. The right payroll software can help you efficiently set up business and employee details. By inputting information like pay periods, frequency, hours worked, and pay dates, the software swiftly manages tax calculations. Depending on your budget and business needs, investing in suitable payroll software can be a time and resource saver.

It’s ideal for small business owners who are looking to streamline their payroll processes while keeping full financial control of their business.

Pros:

• Simplifies payroll processing, allowing for quick and accurate wage and tax calculations.
• Often comes with a reasonable one-time fee and enhanced data security.
• Grants full control over payroll processes, saving time and aiding in business growth.

Cons:

• There is a learning curve, and it’s important to train staff on using the software effectively.

     4. Payroll Outsourcing

Outsourcing your payroll enables you to allocate valuable internal resources towards business development while managing payroll efficiently offsite. It’s akin to having a virtual accountant dedicated solely to payroll tasks. 

Outsourcing makes sure that your payroll is securely managed. Simply submit your workforce’s timesheet to the service provider, and they handle employee payments and tax form submissions. 

Ideal for small businesses with large workforces, outsourcing offers peace of mind and more time to focus on business expansion.

Pros: 

– Saves time, allowing you to focus on other business aspects.

– Expert knowledge of tax regulations gives you efficient, accurate payroll processing, reducing errors and potential IRS penalties.

Cons:

– Effective communication with the payroll provider is crucial to avoid errors.

– It’s vital that the provider is well-versed in federal and state tax laws.

Payment Method Varieties

Payment methods vary based on business type, industry, accounting practices, technological advancements, and employee numbers. Common payment methods include:

     1. Cash

Suitable for paying contractors or temporary workers for sporadic tasks.

     2. Checks

Favored by small businesses for their low cost and traceability. Payroll checks are often printed on blank check paper with MICR encoding.

3. Direct Deposit via ACH

Preferred by small businesses, especially in tech or professional fields, for its efficiency in scheduling fixed-date payments to employees.

4. Pay Cards

Pay cards function like debit cards and are another efficient way to compensate employees, usable at ATMs.

Monitoring Employee Hours

Efficiently tracking employee hours is a key component of payroll management, balancing the need for precision without becoming burdensome. Accurate tracking is vital, particularly for businesses where staff are paid hourly, as inaccuracies can lead to lost productivity and compensation issues.

Here are some methods for tracking work hours:

– Manual timesheets or spreadsheets

– Time management software

– Biometric systems

– Employee ID card swipes

Adhering to Labor Laws

The Fair Labor Standards Act (FLSA) of 1938 addresses practices in industries using time clocks, advocating for the rounding of time records to the nearest five minutes, tenth, or quarter of an hour. This makes sure that employees are fairly compensated for all their work time.

Under FLSA, employers must adhere to regulations concerning overtime, minimum wage, recordkeeping, and youth employment. 

Common wage and hour oversights include:

• Not paying employees on termination day.
• Inadequate or missing I-9 documentation.
• Misunderstanding on-call pay regulations.
• Not compensating for certain travel times.
• Misuse of comp time.
• Unauthorized deductions from wages.
• Salary reductions for salaried employees.
• Misclassifying exempt employees.
• Miscalculating overtime.
• Insufficient record-keeping.

Understanding Overtime Compensation

Overtime pay is mandated for employees working over 40 hours per week. In some states like California, daily overtime rules require compensation for work exceeding eight hours in a day. However, some employees are exempt from overtime pay. For specifics, consult your local Department of Labor (DOL) office.

Hourly employees working over 40 hours must receive at least 1.5 times their regular pay for each additional hour, as per the Fair Labor Standards Act.

Example of overtime calculation:

An employee working 50 hours at $20 per hour earns $800 for the first 40 hours, plus $300 (1.5 times rate) for the 10 overtime hours, totaling $1100 for the week.

Payroll Tax Withholding Compliance

Adhering to IRS regulations is crucial for all employers. The IRS’s Circular E outlines Federal payroll tax withholding guidelines.

Mandatory Deductions

Payroll taxes heavily rely on mandatory deductions. Therefore, in-house payroll systems should automatically calculate wage deductions and withholdings. Let’s delve into these mandatory deductions.

Federal Income Tax

Employers must deduct federal income tax from employee wages. The deduction amount depends on factors like the employee’s gross income, marital status, and exemptions. Certain deductions, like Public Employees Retirement Systems (PERS) or TIAA/CREF contributions, may influence the federal income tax calculation.

Social Security Contributions

Both employers and employees contribute to Social Security taxes under the Federal Insurance Contributions Act (FICA). As of 2023, the respective tax rates are 6.2% for employees and 6.2% for employers, totaling 12.4%. The income cap for 2023 is set at $160,200, beyond which Social Security taxes are not levied.

Medicare Taxation

Medicare, also under FICA, requires a 1.45% contribution from both employees and employers on earnings. For income exceeding $200,000, the rate increases to 2.35% for the employee portion only.

The Federal Unemployment Tax Act (FUTA)

Employers are mandated to report and pay unemployment taxes quarterly using Form 941. FUTA funds state unemployment programs. The tax applies if over $1500 is paid in wages within a quarter and is levied at 6% on the first $7,000 paid to each employee annually.

State Unemployment Tax (SUTA)

SUTA rates and wage bases vary by state, and in some cases, only FUTA is required.

State Income Tax

Most states impose their own income tax in addition to federal taxes.

Workers’ Compensation Insurance

Small businesses often can deduct workers’ compensation insurance from state and federal taxes, with rules varying by state. For instance, in California, even businesses with one employee need workers’ compensation insurance, while states like Florida and Alabama require it for businesses with four and five employees, respectively.

     1. Mandatory Deductions

Additional mandatory deductions include:

• Court-ordered garnishments for child support 
• Unpaid taxes
• Student loans 
• Creditor judgments.

     2. Voluntary Deductions

These deductions vary and are typically made before mandatory taxes. Outsourcing payroll can help manage these deductions efficiently. 

Examples include:

• Contributions to retirement plans like IRAs or 401(k)s, with IRAs offering tax-advantaged savings and 401(k)s allowing pre-tax contributions.
• Health insurance premiums deducted from wages before taxes.
• Job-related expenses like travel, uniforms, union dues, and training costs.
• Life insurance premiums, often for group term coverage, deducted before payroll taxes.

     3. Employer-Provided Benefits

These are non-monetary benefits offered by employers in addition to regular salaries and wages, including:

• Paid holidays
• Vacation time
• Sick leave
• Various insurance coverages (health, dental, vision, life, & disability)
• Retirement plans
• Profit-sharing plans

Incorporating a New Employee into Payroll

Welcoming a new team member is a sign of growth for your business. It’s crucial to integrate them into your payroll system effectively. 

Here’s how:

     1. Obtain Your Employer Identification Number (EIN)

Before hiring, secure an EIN from the IRS. This number is essential for reporting taxes and employment details to state and federal agencies. 

     2. Collect State/Local IDs

Gather the new employee’s state/local IDs for W-2 and 1099 form preparation.

     3. Distinguishing Between Employees and Contractors

Understand the differences between employees and independent contractors. Employees require W-2 forms, with mandatory tax withholdings. Contractors, who receive 1099 forms, handle their own taxes.

     4. Employee W-4 Forms

Make sure new employees complete the Federal Income Tax Withholding Form W-4, aiding in accurate federal tax deductions from their wages.

     5. Establish Payroll Schedule

Adhere to state-specific pay period regulations. In the absence of such, choose a suitable pay schedule – weekly, bi-weekly, semi-monthly, or monthly.

     6. Clarify Employee Compensation Terms

Define all compensation terms including time tracking, paid leaves, overtime, healthcare premiums, and various deductions. Transparent communication is key to employee understanding of tax implications and net pay.

     7. Process Payroll

With a chosen payroll and payment method in place, proceed to compensate your workforce accordingly.

     8. Maintain Records

Keep detailed records of employee information, including names, addresses, Social Security numbers, tax deductions, and W-2 and W-4 form details. Store these records for up to three years post-employment as required by law.

     9. Report Payroll Taxes

Employers must report all payroll taxes to the IRS and relevant authorities. Outsourcing this task to a professional payroll service can ensure timely and accurate compliance.

Payroll Reporting Obligations and Tax Remittance

The payroll journey isn’t complete yet. After deducting taxes from employee earnings, you must report and remit these taxes as dictated by various tax authorities. The frequency of these submissions – weekly, monthly, or quarterly – hinges on your total tax liability.

For small businesses, key tax forms include:

1. Form 941, Employer’s Quarterly Federal Tax Return: This quarterly form reports wages, federal income tax, and both employee and employer contributions to Social Security and Medicare.

2. Form 940, Employer’s Annual Federal Unemployment Tax Return: Used for FUTA tax reporting, this form is filed quarterly, but if dues exceed $500, it’s filed annually.

3. Form W-2, Wage and Tax Statement: An annual form detailing each employee’s wages and taxes, with copies distributed to both the employees and the Social Security Administration (SSA).

4. Form W-3, Transmittal of Wage and Tax Statements: A summary of the W-2 information, submitted annually to the SSA.

5. State Payroll Tax Filings and Payments: State-specific regulations apply for state income tax and unemployment tax reporting. Consult your state’s revenue department and unemployment tax agency for details.

6. Form 1099-MISC, Miscellaneous Income: For reporting payments over $600 to independent contractors annually. They handle their taxes, so you only need to report these payments.

Implementing Payroll Best Practices

Effective payroll management can enhance efficiency and cut costs, especially for small businesses. Adopting best practices yields long-term benefits.

Essential practices include:

• Integrating payroll with accounting, timekeeping, and HR systems.
• Tailoring payment methods to employee roles and needs.
• Offering payment method choices to employees, including cash, check, pay card, or direct deposit.
• Centralizing payroll processing at the main office for businesses with multiple locations, ensuring complete financial control.
• Outsourcing payroll when it becomes cumbersome for internal staff.
• Staying vigilant about tax deadlines to avoid IRS penalties.
• Accurately classifying employees and contractors.
• Timely distribution of W-2 and 1099 forms.
• Securely recording and storing payroll data, with regular backups for data loss prevention.
• Training multiple staff members in payroll software usage for businesses with few employees.

Fine-Tuning Payroll Execution

Implementing a meticulous approach to payroll can significantly enhance its accuracy and efficiency.

Keys:

1. Accurate Overtime Calculation and Reporting: Ensuring overtime pay is computed and reported correctly is vital to maintain compliance and fair employee compensation.

2. Diligent Data Verification: Regularly double-checking entries in payroll software and during tax filing is crucial to prevent errors.

3. Conducting Routine Audits: Regular audits help identify and rectify repeated errors, preventing financial losses. For instance, failing to notify your payroll provider about employee resignations can lead to unwarranted salary payments.

4. Basic Payroll and Tax Knowledge: Developing a general understanding of payroll processes, tax deductions, and filing procedures can be beneficial.

Conclusion

Payroll is one of the most critical parts in any business, it requires to be setup properly and managed so that you have a smooth operation throughout the year. An efficient payroll system is not just a time and money saver; it’s also a catalyst that can help your business grow.

And if you need help setting up your payroll and have it managed, contact us we’ll make sure that it is done properly and managed correctly, you don’t need to lose sleep over this problem anymore, we’re on the job!

If this guide help you to get a better understanding of small business payroll, bookmark this page and use it as a reference in the future, and maybe you can consider sharing it with your business associates, colleagues, or your team for so they can learn it, like you just did.