A Step-by-Step Guide to Setting Up a Payroll System

Any small business owner can tell you that paying employees involves a lot more than writing a check every two weeks.

There are dozens of laws governing employee compensation. If you don't want to run afoul of various government agencies, you have to be well organized and stay up-to-date

The key to staying on top of things is setting up a good system that complies with all the applicable state and federal laws. To get started, try this step-by-step approach to setting up a simple payroll system:

Step one: Get an Employer Identification Number (EIN). You can apply for a number by filling out IRS Form SS-4. To determine if an EIN is really necessary for your business, consult the helpful chart found in Do You Need an EIN?

Step two: Get state and local identification numbers if they are required in the area or areas where your business operates.

Step three: Separate your independent contractors and full-time employees. You don't have to withhold taxes from an independent contractor's pay. Don't think that you can save time by classifying all of your employees as independent contractors, however: The IRS may penalize your business heavily if you designate regular workers as independent contractors. For details, see the IRS Publication 15 Circular E, The Employer's Tax Guide.

Step four: Have each employee fill out and sign IRS Form W-4. The form provides two critical pieces of information: the employee's Social Security Number and the allowances the employee is claiming for income tax withholding purposes.

New workers should fill out a W-4 as soon as possible. Employees who marry or divorce, have children, gain or lose a dependent or want to change withholding amounts for any other reasons should also complete and sign a new W-4.

If you do not have an employee's W-4 on file, you are required by law to treat the employee as a single person with no exemptions for withholding purposes.

Step five: Establish a pay period. Most states require that employers pay workers on regular paydays. A few states allow some employees to be paid once a month, but most require that you pay your employees at least twice a month. Check with your state department of labor for your state's specific guidelines.

Step six: Establish payroll records. For federal tax purposes, you must keep the following information on file:

• the name, address and Social Security Number of each employee
• the total amount and date of each payment
• the portion of each payment that constituted taxable wages
• copies of each employee's W-4
• dates and amounts of tax deposits
• copies of returns you filed
• copies of any undeliverable W-2 forms

Step seven: Decide if you will pay workers for time spent in orientation, sick days, meals or working from home. Your state department of labor can tell you if you are required to pay for this time.

Step eight: Check your local overtime rules. According to most state laws, any work that exceeds 40 hours per week must be compensated with at least one and a half times the employee's hourly wage. Read Which Employees Are Exempt from Overtime Regulations? to determine who in your company is exempt from overtime pay.

Step nine: Figure out what you need to withhold. The IRS expects you to withhold a portion of every employee's paycheck. Chances are your state and even local governments require withholding as well. The government provides tax tables that calculate the amount you must withhold once you have established the appropriate amount of taxable wages. All states except Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming impose a personal income tax. Like the federal government, most states provide tables to help you compute withholding amounts.

Many business owners save time and reduce the risk of errors by hiring a bookkeeper or payroll service. An outside payroll person or service can perform basic payroll-related tasks, deposit tax payments, prepare W-2s and take care of insurance and retirement plans.