Whether you have one employee or 50, setting a payroll system not
only streamlines your ability to stay on top of your legal and
regulatory responsibilities as an employer, it can also save you time
and help protect you from incurring costly IRS penalties (according to Inc.com, the IRS typically
penalizes one out of every three business owners for payroll errors).
Here are 10 steps to help you set up a payroll system for your small
business.
1. Obtain an Employer Identification Number
(EIN)
Before hiring employees, you need to get an employment identification
number (EIN) from the IRS. The EIN is often referred to as an Employer
Tax ID or as Form SS-4. The EIN is necessary for reporting taxes and
other documents to the IRS. In addition, the EIN is necessary when
reporting information about your employees to state agencies. You can apply for an EIN online or contact
the IRS directly.
2. Check Whether You Need State/Local IDs
Some states/local governments require businesses to obtain ID numbers
in order to process taxes. Check whether this applies in your state
with this State Tax Guide.
3. Independent Contractor or Employee - Know
the Difference
Be clear on the distinction between an independent contractor and an
employee. In legal terms, the line between the two is not always clear
and it affects how you withhold income taxes, withhold and pay Social
Security and Medicare taxes, and pay unemployment taxes. Business.gov
offers guidance on the distinction in this Guide to Hiring Independent Contractors.
4. Take Care of Employee Paperwork
New employees must fill out Federal Income Tax Withholding Form W-4. Your employee must complete the form and
return it to you so that you can withhold the correct federal income tax
from their pay (the IRS provides guidance on how to do this as well as
how to report withholdings and taxes at the end of the year in this Employment Tax Guide).
5. Decide on a Pay Period
You may already have a manual process for this, but setting up a
pay-period (whether monthly or bi-monthly) is sometimes determined by state law with most favoring bi-monthly payments. The
IRS also requires that you withhold income tax for that time period
even if your employee does not work the full period.
6. Carefully Document Your Employee
Compensation Terms
As you set-up payroll, you’ll also want to consider how you handle paid time off (not a legal
requirement, but offered by most businesses), how you track employee
hours, if and how you pay overtime, and other business variables. For
more on Fair Labor Law, and how it impacts overtime pay, etc. check out
Business.gov’s guide to wage and hour laws.
Don’t forget that other employee compensation and business
deductibles such as health plan premiums and retirement contributions
will also need to be deducted from employee pay checks and paid to the
appropriate organizations.
7. Choosing a Payroll System
Payroll administration requires an acute attention to detail and
accuracy, so it’s worth doing some research to understand your options.
Start by asking fellow business owners which method they use and if they
have any tips for setting up and administering payroll.
Typically, your options for managing payroll include the following
in-house or outsourced options (remember whichever option you choose,
you, as the employer, are responsible for reporting and payment of all
payroll taxes):
- Commercial Accounting Software - There
are many basic desktop software applications and online services that
small businesses can use in-house to manage check processing, direct
deposits, and tax collection. These include Sage
Peachtree, Intuit Online Payroll, PayChex Online Payroll, and ADP (who are now branching out into
the small business market). Just be careful that you purchase only the
options you need and make sure you understand if these services "impound" payroll taxes or let you keep them until they are due for
payment.
- Outsource to an Accountant or Payroll Service -
If you want to take the matter of payroll administration out of your
hands, consider outsourcing to an accounting service. This article from
Inc.com - How to Choose a Payroll Service -
offers tips on saving time and money by outsourcing payroll. For advice
on choosing an accountant, read this article on Business.gov: Selecting a Small Business Accountant.
8. Running Payroll
Once you have all your forms and information collated you can start
running payroll. Depending on which payroll system you choose you’ll
either enter it yourself or give the information to your accountant.
9. Get Record Keeping Savvy
Federal and some state laws require that employers keep certain
records for specified periods of time. For example, W-4 forms (on which
employees indicate their tax withholding status) must be kept on file
for all active employees and for four years after an employee is
terminated. You also need to keep W-2s, copies of filed tax forms and
dates, and amounts of all tax deposits. Read more about setting up records for withholding taxes
(refer to Step 3). For record keeping tips read, I Keep Good Records - But How Long
Should I Keep Them For?
10. Report Payroll Taxes
There are several payroll tax reports that you are required to submit
to the appropriate authorities on either a quarterly or annual basis.
Generally, each quarter, employers who pay wages subject to income
tax withholding, social security, and Medicare taxes must file IRS Form 941, Employer's Quarterly Tax Return. Small
businesses with an annual income tax liability of $1,000 or less may
file IRS Form 944, Employer's Annual Federal Tax Return
instead of Form 941.
You must also file IRS Form 940, Employer's Annual Federal
Unemployment (FUTA) Tax Return, if you paid wages of $1,500 or more in
any calendar quarter or you had one or more employees work for you in
any 20 or more different weeks of the year.
If you are in any way confused about your obligations, take a look at
the IRS's Employer's Tax Guide, which provides
some very clear guidance on all federal tax filing requirements.
Visit your state tax agency for specific tax
filing requirements for employers.
Additional Resources
- 10 Regulatory Steps You Must Follow When
Hiring Your First Employee
- Handling Employer Tax Responsibilities - Legal and small business expert Barbara Weltman provides a brief
outline of what you need to do to stay compliant.
- Employee Benefit Plans - What’s Law and
What’s Optional
- An overview of the basic employee benefits thatthe law requires you to provide, as well as guidance on setting up a
more comprehensive plan.
- IRS Employer’s Tax Guide - Includes
end-to-end information about setting up, reporting and managing payroll
taxes
- IRS Guide to Outsourcing Payroll and
Third Party Payers
- Explains the legalities of outsourcing payrollas well as the obligations you continue to maintain as an employer.
