With contributions from Ken Boyd
Payroll is the business process of paying employees. Running payroll consists of calculating employee earnings and factoring out federal and state payroll taxes. The term payroll can also refer to:
- A business’s financial records of employees.
- The distribution of employee paychecks.
- Annual records of employee wages.
Payroll can be a business’s greatest overhead expense. And the payroll process is complicated. But understanding each component of payroll may help you better understand your business finances. And it can help ensure you remain compliant with federal and state tax and labor laws.
Steps for processing payroll
1. Collect data
When you hire a new employee, you need to collect their payroll information on Form W-4. Employers must withhold amounts for federal and state taxes and may withhold money to pay for employee benefits.
2. Calculate net pay
The employee’s net pay is their gross pay minus tax withholdings and benefit payments. You’ll also calculate withholdings for Medicare taxes, Social Security taxes, and any applicable local taxes.
3. Issue payments
You must pay the employee’s net pay via direct deposit or by issuing a paper check.
4. Report taxes
You must submit a tax filing for federal tax and state tax withholdings to the IRS and the state department of revenue. You report retirement contributions, state unemployment payments, Medicare taxes, and Social Security taxes to other entities.
5. Withhold and pay taxes
You must forward all tax and benefit payments to taxing authorities, retirement plan firms, and other benefits providers.
Essential payroll components
There are many components in the payroll process. We’ve broken down each component into three categories: employee information, salaries and wages, and deductions.
1. Employee information
Before paying employees, they’ll need to give you some information. First, they need to complete Form W-4. All employees should complete this form as soon as you hire them. The W-4 provides information on an employee’s federal income tax withholding. It also includes an employee’s personal information, such as their name, address, and Social Security number. All of this information will help you process payroll and distribute employee paychecks. The IRS recommends workers review their withholdings every year.
2. Salaries and wages
The second category is an employee’s pay. Either you pay an employee an annual salary or an hourly wage. Salaried employees earn a fixed amount per pay period. Wage-earners, or hourly employees, earn an hourly rate. An employee’s paystub may show their gross pay, time worked, overtime pay, benefits contributions and reimbursements, additional income, and net pay.
Gross pay is the total dollar amount you pay to a worker before subtracting deductions. Gross pay is what a worker makes “pre-tax” or “before taxes.”
Employee time refers to the number of hours an employee worked in a pay period. Most businesses require hourly employees to track time. However, some salaried employees may also track time if they earn overtime pay.
Most nonexempt employees are entitled to overtime pay, as outlined in the Fair Labor Standards Act (FLSA). The FLSA establishes that the overtime pay rate for a nonexempt employee is their regular pay rate multiplied by 1.5. The overtime pay rate applies to hours a nonexempt employee works over 40 in a workweek. Another common term for overtime is “time and a half.” Usually, exempt employees don’t receive overtime pay. Exempt employees include anyone making over $684 per week or $35,568 per year. The U.S. Department of Labor (DOL) enforces the FLSA. Your state labor laws may determine overtime pay rates and requirements for your workforce.
Benefits contributions and reimbursements
Benefits are contributions you might provide your employees. The most common types of benefits include health insurance, retirement plans, and paid leave. However, you must deduct many of the most common benefits from an employee’s wages. After submitting documentation, the worker is eligible for reimbursement of the deducted amounts.
An example of a benefit contribution is a health insurance reimbursement for completing a yearly screening. Another example is educational reimbursements, wherein you may compensate an employee for attending classes related to their job or pursuing a college degree.
Additional income (tips, commissions, and bonuses)
Additional income may apply to service workers, salespeople, and anyone eligible for bonuses. The most common types of additional income include tips, commissions earned on sales, and bonuses. Local and state laws may tax some forms of extra compensation at a higher rate.
Tips are a unique type of additional income. Depending on your state’s minimum wage laws, tips may contribute to an employee’s overall hourly pay. Employees must earn more than $30 in tips in a month, for tips to affect their pay rate, says the FLSA. Additionally, employee tips and pay must not dip below the minimum wage. A state’s minimum wage may differ from the federal minimum wage, which is $7.25 an hour. The federal minimum wage for tipped employees is $2.13 an hour plus tips to equal $7.25 an hour.
After you subtract all deductions, the remaining amount is the employee’s net pay. It’s also called “take-home pay.” Net pay is the amount employees receive on payday.
Deductions are any amount removed from an employee’s paycheck for tax or other purposes. Common deductions include payroll taxes, payroll withholdings, wage garnishments, and benefit deductions.
Payroll taxes are the most common deduction. You withhold these taxes from an employee’s gross pay. Payroll taxes refer to Social Security and Medicare taxes. “FICA tax” is another common term for these taxes.
FICA is the Federal Insurance Contributions Act, which established the Social Security tax. The FICA tax rate is 7.65%. The individual Social Security tax rate is 6.2%, and the Medicare tax rate is 1.45%.
These deductions refer to income and unemployment taxes. The employee’s W-4 determines how much you should withhold for federal income taxes. Both income and unemployment taxes will vary depending on your location. There are federal, state, and sometimes local income tax rates. Federal and state laws determine unemployment tax rates.
Wage garnishment is not a common deduction. Employees who have their wages garnished do so under a court order over a credit or civil matter.
Types of age garnishments include
- Credit, medical bills, or personal loan payments.
- Consumer debt or bankruptcy payments.
- Child support or alimony payments.
- Federal student loan repayments.
The amount to withhold will depend on the court order. Federal law sets benchmarks on wage garnishment based on an employee’s total earnings. State laws around wage garnishment vary.
Benefit deductions may include health insurance costs, 401(k) contributions, life insurance, or other fringe benefits. Unlike benefit contributions, these benefits have a cost for employees in exchange for a service or coverage.
Typically, employers and employees pay a portion of the monthly cost for health insurance. Retirement plans often take a percentage of the employee’s income and place it in a retirement account on their behalf.
Benefits that you take out before tax deductions are called “tax-deferred.” 401(k) is a common example, as employees will pay taxes whenever they withdraw funds. Other benefits are taxable, like a Roth 401(k). You remove taxable benefits from an employee’s gross pay after you deduct taxes. Check local, state, and federal laws around taxed benefits to ensure your business remains compliant.
How to calculate payroll
Although there are many components to payroll, not all of them apply to your business. Keep in mind that your business and your local laws may affect how you calculate payroll.
1. Calculate your employee’s gross pay
You can determine an employee’s gross pay using their pay rate and your scheduled pay periods. Most businesses will pay employees on a schedule. Most commonly, pay periods are weekly, every two weeks, or monthly.
To calculate an hourly employee’s gross pay, multiply their hours worked in the pay period by their hourly pay rate. The formula follows:
Hourly rate x total hours worked in the pay period = gross pay
Let’s look at an example. Say an employee makes $15 an hour. Their employer pays them every two weeks. The employee worked 35 hours the first week and 30 hours the second week for a total of 65 hours for the pay period. So the employee’s gross pay is $975.
To calculate a salaried employee’s gross pay, divide their annual salary by the number of pay periods in the year. The formula follows:
Yearly salary / number of pay periods in year = gross pay
Let’s look at an example. An employee makes $60,000 a year. Their company pays employees every two weeks for a total of 26 pay periods. So the employee’s gross pay is $2,307.69.
2. Make pre-tax deductions
After determining gross pay, you’ll need to factor out deductions. These are tax deductions, but other pre-tax deductions may also apply.
Some common pre-tax deductions include:
- 401(k) and some retirement plans.
- Health insurance plans.
- Health Savings Account (HSA) or Flexible Spending Account (FSA) contributions.
- Some life insurance plans.
3. Deduct taxes (FICA, unemployment, and income taxes)
Once you make pre-tax deductions, the remaining pay is taxed. The FICA tax rate is 7.65%—or 1.45% for Medicare and 6.20% for Social Security taxes. Federal, state, or local laws and your employee’s W-4 selections will determine the other tax rates.
Deduct the 7.65% FICA tax from the employee’s gross pay. Your business must match each employee’s contribution, and those payments are a company expense. The business submits both the employee’s and the company’s contributions to Social Security and Medicare.
For example, say an employee earned $1,120 in gross pay for the latest pay period. To calculate the employee’s Social Security tax contribution, multiply $1,120 by .062 to get $69.44. To calculate the employee’s Medicare tax contribution, multiply $1,120 by .0145 to get $16.24. In total, the employee’s FICA tax contribution is $85.68 for the pay period, which their employer must match. In this case, the employer is responsible for paying $171.36 to the IRS. Half is a direct expense to the company. You withhold the other half from the employee’s paycheck.
Employers don’t match income tax deductions, but they pay federal unemployment taxes. You can determine how much federal income taxes your employees owe by using the IRS’s Income Tax Withholding Assistant.
4. Make voluntary deductions
Once you make an employee’s pre-tax and tax deductions, the next step is to make any other post-tax deductions from the remaining wages. These may include:
- Roth 401(k) contributions.
- Some life insurance plans.
- Some long-term disability insurance plans.
- Wage garnishments.
- Union dues.
5. Determine the employee’s net profit
After all taxes and deductions, the remaining amount is the employee’s net profit. Net profit is how much the employee will take home on payday.
Payroll Best Practices
1. Know your tax filing dates
You should file federal payroll taxes quarterly. Other tax deadlines will depend on state and local laws. The IRS has a list of important small business and self-employed tax deadlines and forms. Create reminders for yourself to file your taxes throughout the year. Missing a tax deadline could result in additional charges. The IRS recommends filing late taxes as soon as possible to avoid potential penalties or interest.
2. Avoid including freelancers and independent contractors in your payroll process
Typically, running payroll only applies to paying employees. When processing payroll, the tax burden is split evenly between employer and employee. However, independent contractors and freelancers are responsible for all their taxes and benefits.
As the business paying the freelancer or contractor, you are purchasing their service. Lumping in contractors and freelancers into your payroll process may complicate your records. Instead, report contractor or freelancer payments as business expenses.
3. Maintain accurate records for payroll
Always keep detailed records on your payroll process and employee paychecks. Accurate recordkeeping can protect your business in the event of a tax audit or DOL, FLSA, or other labor lawsuits. The IRS requires businesses to maintain employee tax records for at least four years.
Otherwise, there are 14 basic records employers should keep on every nonexempt employee, according to the FLSA. Employers should maintain these records for at least three years.
- Employee’s legal name and Social Security number
- Employee’s address and ZIP code
- Employee’s date of birth and legal gender
- Employee’s occupation
- Time and day of the week when the employee’s workweek begins
- Hours worked each day
- Total hours worked each workweek
- Basis of pay (hourly or weekly rate, commission, service-based, or salary)
- Regular hourly pay rate
- Total daily or weekly straight-time earnings
- Total overtime earnings per workweek
- All deductions made from the employee’s wages
- Total wages (gross and net pay) paid every pay period
- Pay dates and pay period dates
4. Understand how to classify employees
You can classify workers as either employees or contractors. Additionally, you can classify employees as either exempt or nonexempt. It’s essential that you classify employees and independent contracts properly. Correctly classifying an employee will help protect your business in case of an audit or lawsuit.
Employees and contractors each require different tax forms. To determine the classification, the IRS breaks down the employer-employee relationship into three categories: behavioral control, financial control, and relationship.
The DOL also defines employee-versus-contractor classifications. Employees are entitled to certain employer benefits and FLSA provisions. Independent contractors are not. The DOL explains the employer-employee relationship as it relates to work performed.
You may have to pay employment back-taxes to the IRS if you misclassify an employee as a contractor. For the DOL, the misclassification of an employee as a contractor may result in a lawsuit. State laws, such as those in California, can also affect employee-versus-contractor classifications.
The DOL sets exempt or nonexempt employee classifications. Exempt employees are not entitled to the FLSA’s overtime provisions. Nonexempt employees are entitled to the FLSA’s overtime provisions. Misclassifying a nonexempt employee as exempt may result in a labor lawsuit, as the employee would be entitled to overtime. If you have questions about classifying your workers, consider reaching out to a legal or accounting professional.
Ways to Process Payroll
Now that you understand some of the ins and outs of payroll, it’s time to run payroll. You can run payroll manually, outsource it to an accountant, or use a payroll service provider.
1. Manual payroll
Manual, do-it-yourself payroll is a common choice for many small businesses. But the process can be time-consuming. You’ll have to calculate everything by hand, keep track of records, and file your taxes. Running payroll is complicated, and making mistakes can get costly. Manual payroll might not be the best long-term solution.
2. Outsource payroll
You may outsource payroll to an accountant or bookkeeping firm. Paying someone to run payroll can free up some of your time. Plus, accountants are knowledgeable, so you can rest easy, knowing you have experts on your side. Keep in mind that outsourcing payroll or hiring an in-house accountant can be expensive.
3. Payroll software
In some cases, payroll software is cheaper than hiring an accountant and can help you save time when processing payroll. The right payroll service software will let you access and run payroll from anywhere. Other benefits of payroll software include
- Digitized payroll records and automated recordkeeping.
- Automated tax deductions and alerts for filing dates.
- Automated wage calculations and payday alerts.
How the Coronavirus (Covid-19) Has Affected Payroll
The coronavirus has impacted many businesses and may have affected your payroll process, too. The government has offered several ways to help small businesses. The most significant aid came in the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the Families First Coronavirus Response Act (FFCRA).
If you retained employees amid the coronavirus, you may be entitled to the Employee Retention Credit from the IRS. This credit is a refundable tax credit against certain employment taxes for up to 50% of qualified wages. Additionally, the IRS is deferring some tax payments for businesses.
The CARES Act established the Paycheck Protection Program. This loan program offers small businesses and other eligible organizations access to a forgivable loan through the Small Business Administration. The loans are meant to help small businesses maintain payroll amid the coronavirus. Lenders determine loan amounts on eight weeks of payroll, multiplied by 2.5, for use on eligible expenses.
The FFCRA created two new forms of sick leave that eligible businesses must provide their employees. The first is the Emergency Paid Sick Leave Act that addresses paid sick leave for COVID-19-related illnesses for employees and their family members. Meanwhile, the Emergency Family and Medical Leave Expansion Act expanded the existing Family and Medical Leave Act temporarily.
Making your way through payroll
Payroll can be complicated and time-consuming, but you don’t have to do it alone. No matter how you run payroll, understanding the basics can help you track business finances. And although labor can be any business’s biggest expense, running payroll correctly is necessary for your small business’s health and success.
The Paycheck Protection Program Flexibility Act (“PPP Flex Act”) was signed into law on June 5, 2020. The PPP Flex Act extends the availability of loans under the Paycheck Protection Program (PPP) and adjusts certain rules applicable to PPP loans. Please refer to the latest guidance from the Small Business Administration and the U.S. Department of the Treasury to confirm current program rules and how they apply to your particular situation.
Given the large demand for additional authorized Paycheck Protection Program funds, not every qualified Paycheck Protection Program applicant will receive a loan. The funding described is made available to businesses located in the United States of America and are not available in other locations.
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