How to Run Payroll for Your Small Business: A Step-by-Step Guide

aying your employees isn’t always a straightforward process. Depending on your industry, correctly administering your payroll usually entails much more than issuing paychecks.  

Small business payroll processing is the process of running payroll for all of a company’s employees, both contract and full-time. In addition to paying wages, payroll processing includes the calculation of taxes and deductions.

Setting up payroll and administering it accurately, as difficult as it may seem at the outset, will save your business both time and money. Timing is important since late payment is one of the most common mistakes small businesses make. More than 40% of small businesses are fined every year, most often for paying payroll taxes late; these fines average $850 per year. 

We’re here to help you avoid these costly mistakes. In this article, we’ll cover all the steps for setting up your small business payroll, as well as the common challenges small businesses face.

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Steps for setting up small business payroll

It’s estimated that 33% of employers make a payroll mistake. Here are the steps to set up your business’s payroll correctly:

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1. Ensure your business is legally allowed to operate as an employer

All businesses that retain employees are required to have an Employer Identification Number (EIN). Think of it like your Social Security number, but for businesses. Applying for an EIN is easy — you can do it online, and the form generally takes less than 15 minutes to complete.  

You may also need a state ID number, depending on your state’s rules. Registering for one probably shouldn’t take you much longer than registering for your EIN.

2. Gather employee information

It is important to determine upfront whether your workers will be classified as independent contractors or employees. This classification will determine your responsibility when it comes to paying payroll taxes. Generally speaking, independent contractors are responsible for paying their own taxes, while employers are responsible for paying taxes on behalf of employees.

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When onboarding new employees or contractors, different states may have different requirements. In most instances, however, you will need the following information from your workers:

• Full name 
• Date of birth
• Current address
• Start and end date of employment (if there is a specific end date in mind)
• IRS Form W-4 for employees or W-9 for contractors
• IRS Form I-9, if necessary, to verify employee eligibility to work in the U.S
• Social Security number or EIN
• Benefits forms for health insurance or an employer-sponsored retirement plan, if applicable

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3. Choose a payroll system

There are three options to choose from when it comes to managing your payroll. You can calculate payroll manually, use a payroll service, or hire an accountant. Below, we explain each option in detail.

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MANUAL PAYROLL

Doing payroll manually is the least expensive option, and about 25% of small businesses take this low-cost approach. Simply put, manual payroll means relying on paper ledgers or spreadsheets. Note that this method carries more risks – not only does it take more time to enter information manually, but you must do research to make sure you’re adhering to federal and state rules. If you make any errors, you could end up paying more in penalties than it would have cost you to outsource this task.

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USE A PAYROLL SERVICE

Using payroll software can save you time by ensuring you get all the details correct. Payroll software manages employee compensation, benefits, and tax compliance. These companies often offer full-service payroll management and will be up-to-date on federal, state, and local regulations. 

To use payroll software, you will often pay a base rate, ranging from $12 to $99, depending on the software, and a small additional fee for each employee. There may also be a one-time fee every time you add an employee. Services like Gusto offer payroll processing solutions optimized for small businesses.

Our one-of-a-kind integration with Gusto will help you avoid payday stress with full financial visibility of your payroll debit date and amount straight from your Novo dashboard, ensuring you and your employees get paid on time, every time.

You can often schedule a demo or sign up for a free trial to see how various software options will work for you. Here are some questions to ask before making your final decision:

• Can I use the software easily? 
• Can I train someone else to use it?
• Does it have the features I need and want? 
• Will it adapt to future business needs?

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In addition to payroll management, payroll providers usually offer the following:

• Detailed payroll reports
• Payslips
• Ensuring your payroll is compliant
• Calculating deductions and benefits

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HIRE AN ACCOUNTANT

When it comes to managing your payroll, the most expensive option is to hire an accountant. Plan on paying $60 – $400 per hour, depending on where your business is located. An accountant will offer you more dedicated support and can also help you file your business tax returns.

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Accountants can help you with:

• Making on-time payments
• Keeping detailed employee and payroll records
• Providing payslips and checks, when necessary

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4. Decide on payroll funding method

The payroll funding method refers to where the money to cover payroll will come from. Some employers use a separate checking account just for payroll, while others rely on a credit card. You can also use payroll financing, where you sell your unpaid invoices to a third-party company to fund your payroll. The financing company will take a portion of your invoice as payment. 

Since your payroll will likely make up at least 20%-30% of your business expenses, you’ll want to plan ahead for this significant line item.

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5. Determine a payroll schedule

When choosing the right payroll schedule for your business, first check with your state’s department of labor or state tax office to see if you’re required to meet any specific regulations around payroll schedules. 

Otherwise, you can choose the cadence that works best for your business. About 36% of companies pay their employees every two weeks, according to the Bureau of Labor Statistics.

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6. Determine deductions and allowances

The net amount an employee receives in their paycheck depends first on the withholding allowances they choose. During the onboarding process, the employee will fill out a W-4 and determine the number of withholding allowances for their tax filing status. 

Employees may also opt into additional deductions to fund a 401(k) plan or a Health Savings Account (HSA), for example. 

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7. Calculate employee wages

Once you’ve calculated the employee’s federal tax rate and their deductions and allowances, you can determine how much your employee should be paid and what should be withheld during every pay period.

The IRS has a withholding assistance calculator that employers can use to calculate the correct figure.

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8. Issue payments

Now you can start issuing payments on schedule via check or, more commonly, via direct deposit. Employees will have to share their bank account information to have checks automatically deposited into their bank account. As long as you are following employment laws, you can also pay in cash or on payroll cards.

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9. Keep meticulous payroll records

You need to track federal income tax, Medicare, and Social Security tax for each employee. Having these records in place will make it easier when filing taxes because you must indicate in detail what has been withheld.

You need to store employee tax records for at least three years, according to the U.S. Equal Employment Opportunity Commission. You should also keep forms for both current and former employees, including W-2s, W-4s, I-9s, and state tax forms. You also need to keep copies of pay stubs, tax deposits, timesheets, and any employee overtime. 

Even if you terminate an employee, keep their relevant files on record. Check with your local labor office to see what records you need to keep track of to remain compliant.

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10. Withhold and pay payroll taxes

Before the beginning of each year, you will have to determine your business’s schedule for depositing federal income taxes. As a small business owner, you are responsible for withholding and paying several kinds of payroll taxes to federal and state tax agencies:

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1. Federal Income Tax Withholding

Employees who earn more than $10,000 a year have to pay federal income tax. The employee determines how much the employer should withhold for federal income tax. If an employee withholds too little, they may end up owing money at tax time.

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2. Social Security and Medicare Taxes

Federal Insurance Contribution Act (FICA) taxes are what fund Social Security and Medicare, two programs that most seniors rely on heavily. These taxes are deducted from all employees’ paychecks. The total rate is 15.3%, divided evenly between the employer and the employee.

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3. State and Local Taxes

If your state or county charges income taxes, then you will have to withhold and pay those taxes for the employee.

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4. Unemployment Taxes

Employers are usually the only ones responsible for paying unemployment taxes, but some states let employees contribute to unemployment. According to the IRS, the federal rate for unemployment taxes is 6%. The state rate will differ depending on their rules.

Reporting and paying payroll taxes accurately is key. The IRS can penalize you up to 20% of the underpaid amount, depending on the factors that caused the error.

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Common Challenges in Small Business Payroll Processing and Solutions

Now that we have described the steps to managing your payroll, you can probably see why so many business owners decide to outsource this task. Here are some of the most common challenges you might face when it comes to small business payroll processing:

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Keeping Up with Changes in Tax Laws and Regulations

Tax laws can change frequently, and it’s on you to note and implement these changes properly. If you don’t, you can end up paying thousands in fees and fines. 

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Managing Employee Information

You will have to organize and input information from your employees to ensure payroll is being run and set up correctly. Try to find an efficient system that verifies information before payroll is run.

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Maintaining Confidentiality and Security of Payroll Information

The documents and information you need to run payroll are very sensitive. If your database is hacked and your employees have their Social Security Numbers or bank information leaked, the consequences could be devastating. You need to secure this information and have proper safeguards in place. Another reason to carefully protect your data:  60% of small businesses file for bankruptcy within six months of a cyber attack, according to the National Cyber Security Alliance. 

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Finding Affordable Payroll Processing Solutions

Make sure to compare services carefully and understand what your payroll processor will charge you for the service. You should also verify if they’ll be on the hook for any payroll problems, like incorrectly reporting taxes.

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Takeaways

Tackling your company’s payroll isn’t something you can do on the fly. 

After properly setting up your small business payroll, you need to make sure you institute a payroll system that you can easily manage and that you avoid the common challenges all small businesses make.

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Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.