If you’re a small business owner who hires employees, you need to know how to run payroll. Doing so will not only ensure you pay employee’s wages accurately, it can also help ensure you remain compliant with United States tax law.
Below, you’ll find a complete guide to payroll to help you better understand how to pay employees properly.
What is payroll?
Payroll is the total amount of wages that a company pays its employees. Running payroll involves taking out federal, state, and local taxes from the employee’s gross pay.
For this reason, “payroll” doesn’t typically apply to independent contractors. Independent contractors are required to pay the entirety of their tax burden. Employees are only responsible for paying half, and the employers are responsible for the other half.
Since a freelancer is not an employee, this type of worker receives his or her gross pay with nothing deducted. Freelancers are responsible for paying all of their own taxes and benefits. Understanding the differences between employees and independent contractors will help simplify your payroll efforts.
Your payroll software may allow you to pay independent contractors when you run payroll. But for the sake of consistency and simplicity, assume we are only talking about employees in this article.
Your company’s payroll could very well be one of your firm’s largest business expenses, and processing payroll is complicated. You must collect insurance premiums, retirement plan contributions, and tax withholdings from employee pay.
While hiring full-time employees can help your business grow, it also adds complexity and cost to the operation. This shouldn’t deter you from hiring, but you should understand how much each worker will cost beyond their salary, as well as the work involved in managing payroll. Here’s an overview of how payroll is processed and how to comply with federal and state requirements.
The components of payroll
You can separate your firm’s payroll into four component parts. Here’s a look at each one.
1. Gross wages
This is the total dollar amount paid to the worker before any deductions. The items listed below are deducted from gross wages to arrive at the worker’s net pay. Gross wages may include commissions, bonuses, tax deductions, and other payment arrangements.
Typically, employee’s salaries, or wage figures, are considered gross pay. For instance, if an employee is salaried at $60,000, that individual won’t see that much money in his or her bank account.
Instead, the take-home amount on the employee’s paycheck will be lower after accounting for payroll deductions. The same is the case for hourly workers. Someone who makes, say, $18 per hour, earns that amount prior to the removal of deductions.
Your company may provide health insurance, retirement plans, and other benefits to workers. Although your business may pay some of these costs, the employee may also be responsible for paying some of them as well.
Many of these deductions are taken out of pay before taxes are calculated, depending on whether they’re pre-tax or post-tax accounts.
An example of this is a 401(k) retirement plan. Many employers offer matching deposits for 401(k) plans, meaning they will match employee contributions up to a certain amount. Let’s say, for example, an employer offers a pre-tax 401(k) plan with matching for up to 5% contributions. A salaried employee makes $60,000 a year and elects to put 10% into the 401(k) account.
The individual would invest $6,000 into the 401(k), while the employer would invest an additional $3,000 on the employee’s behalf. Because it is a pre-tax account, the employee’s gross income is now $54,000.
3. Social Security and Medicare
You must deduct the employee’s portion of Social Security and Medicare payments from gross wages.
This is known as the Federal Insurance Contributions Act (FICA). According to the Internal Revenue Service, in 2019, the social security rate was 6.2% for the employer and 6.2% for the employee. The Medicare rate was 1.45% for the employer and 1.45% for the employee.
4. Tax withholdings
Your employees may have additional deductions required by federal or state law. The employer must withhold the employee’s share of federal and state income taxes from payroll.
Depending on the location, the company may also need to withhold city or local income taxes from payroll. Employees should also complete a W-4 tax form to withhold additional pay.
After you take these deductions from an employee’s gross pay, you’re left with net pay. Net pay is the amount of money the employee actually receives in their paycheck. If you’ve set up direct deposit, net pay is the amount you’ll send to the employee’s bank account.
Payroll taxes vs. income taxes
It’s important to note that payroll taxes are different from income taxes. Generally speaking, the employer is responsible for withholding and paying payroll taxes on the employee’s behalf. The employee is responsible for paying income taxes. Income taxes are filed in April each year.
Payroll taxes are flat, meaning that every worker pays a proportional amount. For instance, every worker pays 6.2% in Social Security tax, no matter how much they earn. Income taxes, on the other hand, are progressive.
The more income you earn, the more you’ll have to pay in taxes. The IRS sets the tax brackets each year. Below, you’ll find a more in-depth breakdown of payroll vs. income taxes and how each relates to small business owners.
Calculating and paying federal and state payroll taxes
We’ve touched on the four different categories that employees may have withheld from their paycheck. Employers also must pay 6% of gross wages, up to a cap of $7,000 per worker, to fund federal unemployment taxes (FUTA) for each employee. This is another business expense, and the amount is not deducted from the worker’s pay.
In addition to FUTA, each state has its own unemployment plan. If you have employees in more than one state, your firm may have to comply with multiple state unemployment requirements.
Taxes assessed by state employment agencies are a business expense that the employer pays. There are two factors that determine the tax calculation: the wage base and the tax rate.
The wage base is the maximum amount of earnings taxed in a calendar year, and base is determined by each state. Both the wage base and the rate of tax may change from one year to the next.
Companies can take steps to minimize state unemployment taxes because the tax rate assessed is based on the number of employees who have filed unemployment claims in the past.
Businesses with high employee turnover generate more unemployment claims, so the system taxes those firms at a higher rate. If your firm can reduce employee turnover, you may be able to keep the unemployment tax rate from increasing.
Calculating and paying federal and state income taxes
Employers must calculate federal and state income taxes and forward the payments to the appropriate government agency. Companies also submit tax withholding reports with the payments.
To start the process, each employee fills out IRS Form W-4 to compute withholding allowances. Allowances exempt a portion of an employee’s yearly salary from withholding.
More allowances mean that less tax is withheld from gross pay. This system allows the worker to adjust their tax withholdings to fit their individual tax situation.
Once allowances are factored in, federal income taxes are calculated using the tax tables found in IRS Publication 15. Federal taxes withheld are generally paid at the same time you make Social Security and Medicare payments, and are reported using IRS Form 941.
The employer deducts the applicable percentages for Social Security and Medicare from each employee’s gross wages. Your firm must match each employee’s contribution, and those payments are an expense for your company. The business submits both the employee’s and the company’s contributions to Social Security and Medicare.
Assume, for example, that Frank is owed $1,120 in gross pay for the latest payroll period. Here is the calculation of Social Security and Medicare payments for Frank and the business:
- Social Security taxes withheld from Frank’s wages: $69.44 ($1,120 x 0.062)
- Company matching Social Security tax amount: $69.44
- Medicare taxes withheld from Frank’s wages: $16.24 ($1,120 x 0.0145)
- Company matching Medicare tax amount: $16.24
Total = $171.36
The total federal tax amount due for this pay period is $171.36. In this case, the employer is responsible for paying $171.36 to the IRS. $85.68 is a direct expense to the company, while the other $85.68 comes from withholdings on the employee’s paycheck.
Social Security and Medicare tax payments are reported quarterly using IRS Form 941.
How to run payroll
Processing payroll correctly requires careful planning because this task may be the most time-consuming work your business performs each month. There are ongoing tasks that need attention, as well as setup procedures for new employees and changes to withholdings, benefits, commissions, etc., for current employees.
Typically, a large firm’s human resources department collects the forms needed to compute payroll taxes, and the accounting department performs the tax calculations and payroll processing.
If you’re a small business owner, you may have to do some of this on your own. Here are some common documents that your company may need to obtain to process payroll:
- Health insurance plan: Each employee completes paperwork to document the type of health insurance coverage they want or to decline health insurance if they don’t want to participate in the insurance plan. The type of coverage and the deductible amount determine the insurance premiums that must be deducted from gross pay. The same documents are collected for dental and vision insurance if applicable.
- Retirement plans: If a worker chooses to participate in a company retirement plan, the employee fills out paperwork to indicate the dollar amount of gross pay that will be invested into the retirement plan each pay period.
- Income tax withholdings: Each worker completes IRS Form W-4 to indicate the amount of tax withheld from gross pay for federal income taxes. Employees complete similar forms for state income tax withholding.
Your payroll may require you to collect other documents as well. Here are the steps required to process payroll for full-time employees:
- Determine gross pay rates.
- Collect all required documents for tax withholdings and deductions.
- Calculate taxes and withholdings.
- Pay the net pay amounts to employees and provide employees with a pay stub.
- Forward deducted amounts to insurance companies and benefits providers.
- Submit taxes withheld to each taxing authority.
- Complete all paperwork and submit paperwork to insurance companies, retirement plans, and taxing authorities.
Don’t go it alone
Payroll is complicated and time-consuming even if you only have a single employee. The process is much more complex than merely paying your employees for the number of hours they worked.
Employee’s gross wages must have deductions taken out before they hit the employee’s bank account. And employers must send money to respective agencies.
Luckily, companies like QuickBooks can help by providing a payroll system that can do all the calculations, cut the checks, and even pay taxes and file the documents with state and federal agencies. Even better, it integrates perfectly with your bookkeeping software to keep your books in order.