A business owner wears many hats, especially a small business owner who doesn’t have any employees. As your business grows, you may decide that there is too much work to handle yourself, or perhaps your business would benefit from having someone with a different skillset from your own. Of course, that means you have to pay someone. If the word “payroll” makes you shudder, hopefully laying it out step by step will alleviate your pain.
Payroll taxes, sometimes referred to as employment taxes, are a necessary expense of having employees and are required by the Internal Revenue Service (IRS). The four categories of payroll taxes are federal income tax, Medicare and Social Security taxes, federal unemployment tax, and state and local taxes.
Federal Income Tax
Federal income tax is withheld from employees’ gross wages and is based on earnings. It is calculated using the employee’s Form W-4 which has information about their tax bracket, allowances, and marital status.
Medicare and Social Security Taxes
Medicare and Social Security taxes are together known as FICA, Federal Insurance Contributions Act, or Federal Withholding. Both the employer and employee pay a portion of the FICA tax and the employer is responsible for withholding the appropriate amounts. The withholding rate for Social Security is 6.2 percent of the employee’s gross wages for the employer and 6.2 percent for the employee. The withholding rate for Medicare is 1.45 percent for the employer and 1.45 percent for the employee. This is a total of 15.3 percent that will be paid to the IRS; 7.65 percent from the employer and 7.65 percent from the employee.
Federal Unemployment Tax
Federal unemployment tax, or FUTA tax, is paid and reported by the employer. Employees do not pay this tax or have it withheld from their wages.
State and Local Taxes
State withholding and other local employment taxes vary depending on the state and you will need to contact your state governments to see if there are any taxes that need to be withheld and reported. [1]
Related: Hiring your first employee
How to Process Payroll Yourself – 5 Steps
1. Set Up Your Company to Hire Employees
When you’re ready to hire your first employee, you need to apply for a Federal Employer Identification Number (FEIN, which is also referred to as an EIN) through the IRS. The EIN is a unique identification number for a business, much like a social security number is for an individual. This EIN will allow you to set up payroll. An EIN is available for sole proprietors, LLCs, estates, trusts, corporations, and non-profits. After you have your EIN, you will need to get workers’ compensation, state unemployment taxes, and disability insurance; and display workplace posters which are all required by the federal government. [2]
After you have an EIN and are properly insured, it’s time to set up your payroll schedule by deciding on pay frequency and pay dates.
Related: How to apply for an EIN
2. Make Sure the Employee is Eligible to Work in the US
For each employee hired an I-9 Form will be required along with a copy of documentation from the employee such as a Social Security card, visa, driver’s license, and birth certificate. I-9 Forms are used to verify if someone is eligible to work in the United States and the employer is responsible to report new hires to their state’s new hire bureau.
3. Calculate Employee’s Paychecks
Now that you have a payroll structure, you can hire your first employee! In order to calculate their payroll, they need to fill out a W-4 form so you have all of their information about deductions, tax brackets, etc. The first step is to calculate their gross pay, which is the number of hours an employee worked in a pay period multiplied by their hourly rate. Then, you need to determine withholdings, deductions, and allowances. A helpful tool is the IRS withholding calculator (https://www.irs.gov/individuals/tax-withholding-estimator).
You will also need to keep track of your portion and the employee’s portion of payroll taxes and report and deposit your share on a timely basis (see step 4).
Any employee benefits or fringe benefits, such as health insurance, will have to be calculated as they are considered a form of payment for work performed. Also, any deductions like charitable contributions, life insurance or wage garnishments can be deducted from the employee’s paycheck.
4. Record Payroll
Once you have calculated the gross pay, deductions, and net pay (or “take-home pay” for your employee, you can create a pay stub for your employee and cut them a check or direct deposit their take-home pay into their bank account. You will also be recording these payments and tax withholdings in your books.
If you plan to run payroll expenses manually, journal entries will need to be made to record the transaction. A journal entry is the recording of debits and credits and if you are using an accounting program like QuickBooks or payroll software like Gusto, the journal entries are being created behind the scenes when you enter them in the program.
5. File and Pay Payroll Taxes
Payroll taxes need to be reported and deposited to the IRS throughout the year. The full schedule for reporting and depositing can be found here: https://www.irs.gov/businesses/small-businesses-self-employed/employment-tax-due-dates.
Important reporting due dates to remember are January 31st (report wages, tips, and other compensation paid to employees), February 28th (Form 1096 – Annual Summary and Transmittal of U.S. Information Returns), and March 31st (electronic Form 1099 and electronic Form 8027). Reporting dates for Form 941 (Employer’s Quarterly Federal Return) are April 30th, July 31st, October 31st, and January 31st.
For depositing federal income tax withheld and both employer and employee FICA taxes (which are a combination of the Social Security tax and Medicare tax, you either need to use a monthly or semi-weekly deposit schedule. Which schedule you use is based on the total tax liability you reported on Form 941. FUTA deposits are due quarterly. [3]
Additionally, W-2s will need to be generated at the end of the year.
Use a Payroll Service
Doing your own payroll manually can be time-consuming and can expose you to costly payroll mistakes even if one tiny formula goes wrong in your spreadsheet, which is why 41% of small businesses use a payroll service. [4] There are countless numbers of payroll services such as Gusto that provide a range of services depending on how much you want to do yourself. If keeping track of payroll taxes and reporting everything to the IRS seems daunting for you, a payroll service can take care of all of it for you, and you can rest easy knowing that your employees are being paid properly and your business is in compliance with the IRS.
Hire an Accountant
If outsourcing your payroll feels a bit risky to you, you can always hire an accountant to work in-house and process payroll for the company. There are many payroll service providers that integrate with your accounting or ERP system and can be managed by your accountant.
Common Payroll Mistakes
According to ADP, one of the largest payroll processors, the 5 most common payroll mistakes are misclassifying employees (independent contractor, exempt, non-exempt), inaccurate records, missing federal deposit deadlines, failing to report all taxable forms of compensation, and misprocessing garnishments. [5] These mistakes can be costly if they incur penalties and late fees, and can lead to some angry employees if they are paid incorrectly. Using a payroll service is the best way to safeguard yourself against these mistakes unless you have a meticulous system of review for your own payroll processing.
Conclusion
Hiring an employee may seem daunting with all of the requirements, but a business owner with a growing business shouldn’t let that get in the way of hiring employees to help reach their goals. Payroll service providers are a great cost-efficient way to get employees in the door and take care of all reporting requirements “behind the scenes” so you can focus on what you do best: running your business.
[1] https://www.irs.gov/businesses/small-businesses-self-employed/understanding-employment-taxes
[2] https://www.sba.gov/business-guide/launch-your-business/get-business-insurance
[3] https://www.irs.gov/businesses/small-businesses-self-employed/employment-tax-due-dates.
[4] https://www.forbes.com/sites/stephendunn/2013/01/22/how-to-use-a-payroll-service-provider/#3f3ae34d6ca9
[5] https://www.adp.com/resources/articles-and-insights/articles/t/top-5-most-common-payroll-mistakes.aspx
