When processing payroll for your small business, make sure you know about these essential components and requirements.
Payroll is one of the most essential parts of running a business. It’s how you’re able to compensate employees correctly and on time — which affects employee morale and retention.
In fact, a survey from The Workforce Institute at Kronos Incorporated found that 49% of U.S. workers will start looking for a new job after experiencing 2 problems with their paycheck. So it’s crucial to get payroll right.
What do you need to know to process payroll correctly? Keep reading for the essential components and requirements.
When building your payroll process, look into which pay schedule works best for your employees. Will you pay weekly, bi-weekly, monthly, semi-monthly, or monthly?
Weekly pay schedules are common in many organizations and work best for companies who pay hourly wages. They pick a standard weekday, such as Friday to disburse paychecks.
Although weekly pay is convenient for employees, it’s the most work for administrative professionals.
Bi-weekly pay schedules are the most popular for large and small organizations. Employees receive paychecks on the same day every other week. Employees always know when they get paid so they can budget for expenses easily with this schedule. It’s also less work for payroll staff as it doesn’t require them to run payroll every single week.
Semi-monthly pay schedules distribute paychecks twice a month. Dates usually fall on the beginning, middle, or end of the month, including the 1st, 15th, and 31st. With this schedule, payday can vary from month to month, which means sometimes it will fall on a weekend or holiday. However, many other systems run on a monthly basis, such as benefits packages (typically).
If payroll is linked directly to employees’ benefits packages, semi-monthly paychecks will make the two easy to sync.
Monthly pay is the least time-intensive for HR staff, but also the least popular among employees. It works best in industries in which the income is irregular, making it difficult to pay employees more frequently. Paychecks are received once a month on a specific, recurring date, e.g. the 20th of every month.
Benchmark positions, meaning jobs with similar duties, are the best sources for comparing salaries across positions.
As you bring on employees, you may be wondering what you should pay them. We recommend using industry benchmarks. Benchmark positions, meaning jobs with similar duties, are the best sources for comparing salaries across positions. For some positions, such as an accountant, it’s relatively easy to find an average range of salaries.
For less clearly established positions, you may need to write out a position’s required duties and then search for jobs that have the most comparable set of requirements.
There are several salary comparison tools to help aggregate data for specific roles. The Bureau of Labor and Statistics offers years of comparative wage data for many occupations at the national, state and metropolitan level. Indeed also provides a free tool for salary comparisons. Other tools like PayScale, Salary.com, and LinkedIn Salary require a subscription or payment to access data but contain a larger number of job titles and data sets. Zenefits also has a compensation management tool that aggregates anonymized salary data from hundreds of thousands of U.S. small and medium-sized businesses managed on their platform.
Once the right data is in hand, it’s time to put it to work by matching internal job descriptions to external job data. This process is called compensation benchmarking. It’s intended to help ensure employees are paid fairly. The goal is to promote a happy, engaged workforce.
The first step in compensation benchmarking is to build a list of salary ranges for current and future job roles. This data can come from traditional salary surveys, paid salary software programs, or custom surveys which are performed by a consulting firm.
Earnings refer to the compensation an employee receives in exchange for work, and includes wages, salaries, and overtime pay. Wages are determined by calculating the number of hours worked by the employee’s hourly rate.
You want to keep track of supplemental earnings, which are any wages or payments to workers that are part of normal hourly or salaried wages. These include commissions, tips, bonuses, PTO, or reimbursements. Taxes for supplementary earnings may be taxed differently.
A payroll deduction is a reduction of income from an employee’s earnings, and deductions are the mechanism for collecting employee contributions to pay for benefits and/or taxes or other withholdings.
In general, employers may take certain deductions from an employee’s wages as a matter of course (for example taxes based on the employee’s elections in their Form W-4) while other deductions require the employee to explicitly ask an employer to deduct an amount from their wages (such as a benefits-related deduction).
If an employee’s deductions don’t match the amount owed on their account, catch-up deductions can be used to resolve the difference. Catch-up deductions are needed when the correct deductions aren’t pushed, which causes a discrepancy between what’s owed and what’s been paid.
Discrepancies can be caused by multiple reasons, including having the wrong number of dependents listed, a pay period being skipped, or the wrong effective date being entered. For example, if an employee has 30 days to enroll in insurance and they don’t enroll until after the effective date, they may have a catch-up deduction.
Direct deposit is the top payment choice for most employees, but not all employees have it.
Under federal law, you can make direct deposit mandatory, provided the employee is able to pick the bank they want their wages to be deposited into. In some states, however, employers cannot mandate direct deposit.
If you prefer, you can simply encourage all employees to sign up. In this case, you’ll need to demonstrate the benefits of direct deposit, such as:
- Convenience: Employees will receive their paychecks in their bank accounts on payday, without having to physically visit the bank. No more waiting for the mail person to arrive.
- Safety: Eliminates the probability of lost, damaged, or stolen checks, and reduces the spread of infectious disease.
- Free: Employees pay nothing to have their wages direct deposited into their bank account or to access the funds.
- Reliable: According to the U.S. Office of Personnel Management, direct deposit is more reliable than paper checks.
As the employer, you stand to gain as well, since direct deposit:
- Eliminates check printing expenses, including costs associated with reissuing lost, damaged, or stolen checks
- Reduces bank service charges, payroll fraud, and payroll administration costs
- Increases productivity, as employees don’t have to take time off to visit the bank
Sometimes employers need to prorate the salary paid to their worker, meaning they need to adjust their wages because they took unpaid time off. In order to do so, you divide an employee’s wages proportionately to the hours they worked. Note: This is only applicable to salaried employees.
To prorate gross regular earnings for a salaried employee:
- Divide the employee’s annual salary by the number of pay periods in a year for their pay schedule to get their normal gross salary for each period. For example, an employee paid semi-monthly will be paid 24 times in a year.
- Then, figure out the number of working days in the period. For the semi-monthly example, this number is usually (but not always) 10.
- Divide their gross pay per period by the number of working days to get their gross daily rate.
- Multiply the daily rate by the number of days they actually worked. For terminations, make sure to include a full day for the date of termination.
For example, consider a salaried employee paid $50,000 on a semi-monthly basis works only 8 of the 10 days in the second pay period of January 2021:
- The employee’s per-period gross pay is ($50,000 / 24) = $2,083.33 per period.
- Their gross daily rate is ($2083.33 / 10) = $208.33.
- The employee worked 8 of 10 days in the period, so their gross prorated regular earnings are ($208.33 x 8) = $1,666.64.
Regardless of where you do business, your employees should receive a pay stub with each paycheck. Pay stub laws fall under each individual state’s purview. Most states have laws requiring employers to issue a pay stub, but there are a few who do not require it. They are:
- South Dakota
There is no federal law that requires employers to provide pay stubs, so if your business is in one of the states listed above, you might not technically be required to create pay stubs. However, the Fair Labor Standards Act (FLSA) does require you to keep records of certain employee information, including payroll information.
Many employers find it easiest to do this by creating pay stubs. Pay stubs also make it convenient for employees to understand how and how much they are getting paid, and it might save you the trouble of answering repeated questions about withholdings and overtime pay.
the Fair Labor Standards Act (FLSA) does require you to keep records of certain employee information, including payroll information.
Recommended information to include in pay stubs
At a minimum, we recommend including the following information in pay stubs for hourly employees:
- Employer/company name
- Employer’s address
- Employee’s name
- Either the last 4 digits of the employee’s Social Security number, or the employee number
- Pay period covered, including start and end dates
- An itemized list of payroll deductions
- Gross earnings
- Custom earnings (like vacation pay, bonuses, etc)
- Total pre-deduction earnings
- Federal taxes withheld
- State and local taxes withheld, where applicable
- Total deductions
- Net earnings
- Check amount, which should equal gross pay minus taxes and deductions
- A year to date total of the employee’s gross salary, taxes, deductions, and net salary
If you have hourly employees, their pay stubs should include a bit more information:
- Per hour pay rate, including regular and overtime rates
- Hours worked in each rate category
- The total amount due for each pay rate
Aside from federal, state, and local income tax, you should also include the employee’s portion of so-called “payroll taxes,” like Social Security, Medicare, and State Disability Insurance where applicable.
Additionally, your employees might have certain expenses deducted directly from their paychecks, like insurance premiums and retirement plan contributions. You might also offer employees the opportunity to deduct pre-tax dollars to pay for transportation expenses or contribute to a flexible spending account.
Finally, some employees must have paycheck deductions due to judgements rendered against them, such as child support payments or another legal settlement.
As you will recall from Chapter 6, independent contractors are businesses in their own right, they (not you) are responsible for paying their own federal, state, Social Security, and Medicare taxes, unlike W-2 employees. So setting up the proper paperwork upfront is a must. To set up a contractor in your payroll system, you must obtain forms W-9.
Additionally, you will need to get the EIN (Employer Identification Number) for your contractor’s business. If they provide individual services, a Social Security number will suffice. Establishing their tax-status at the start of your business relationship is a vital part of how to hire a professional contractor. If you don’t have a valid W-9 with this information, then the IRS will assume that they are an internal employee and you may be saddled with additional taxes, fees, and legal liabilities.
You will also need to keep track of payments and provide each contractor with a Form 1099-MISC every January if the payment sum exceeds $600 per year. This is followed up with Form 1096, which must be sent to the Social Security Administration (along with copies of your 1099 forms) by the end of February of the following year.
It’s important to mention the definition of an independent contractor can vary based on the state they’re hired in. You should always get concrete proof of a person’s contractor status, valid tax numbers, and hold a binding contract to protect your business.
Beyond that, you should look at your local and state laws to ensure you’re in compliance with them. The lines get a little blurry if a foreign contractor provides you services within the U.S., so pay special attention to employment provisions, country treaties, totals earned, and length of stays. In some cases, you or an intermediary (such as agencies or online freelance marketplaces) may be responsible for reporting and withholding income tax for foreign contractors.
Taxes and filings
For business, payroll taxes are a constant, regardless of how revenue ebbs and flows. For everyone receiving a paycheck, you need to properly calculate and pay employee/employer deductions in a timely manner to stay ahead of the IRS.
Businesses must submit payments for withholding taxes either monthly or semi-monthly, depending on the size of the liability. In addition, annual and quarterly reports need to be filed to verify the amounts collected and paid and to make up for any shortfall in payments.
Deductions are made based on employee earnings for nonexempt employees, for both regular and overtime hours worked. For exempt employees, deductions are based on weekly or biweekly pay rates.
Here’s what you need to know:
Form 941: Quarterly Tax Report
Employers must report withholding amounts deducted from employees as well as the amount the business has paid on a quarterly basis, using Form 941. The form is due at the end of each month following the previous quarter. For example, for the first quarter of the year (January, February, March) filing must be done by April 30. Form 941 must include details from the reporting period:
- Number of employees
- Total amount of wages paid
- Total taxes withheld from employees
- Social Security and Medicare wages and taxes
- Total amount due
- Total deposits already made
- Any taxes still owed
Monthly or semi-monthly?
Whether you make tax deposits monthly or semi-monthly depends on the amount of taxes withheld in the past. The IRS has a “lookback period” to help you determine when to pay.
The lookback period is typically the 12-month period prior to June 30th of last year. If taxes and withholding totaled less than $50,000 during the lookback period (or you’re a new employer) then you should make tax deposits monthly. If total taxes and withholding were more than $50,000 during the lookback period, deposits should be made semi-monthly (every two weeks).
- Monthly payments are due the 15th day of the following month, i.e., April 15 for the month of March.
- Semi-monthly payments are due based on payday schedules:
- For paydays on Saturday, Sunday, Monday or Tuesday, payments are due the following Friday
- For paydays on Wednesday, Thursday or Friday, payments are due the following Wednesday
Calculating payroll taxes due
Three types of taxes are withheld from employees and/or matched by employers: Federal Income Tax, FICA (Federal Insurance Contributions Act, including Social Security and Medicare payments), and state/local taxes. Unemployment insurance is an additional tax that is filed separately.
The amount of taxes withheld and due are based on payroll period and status of the employee (married or single).
Federal Insurance Contribution Act (FICA) taxes
There are two parts to the FICA taxes: Medicare and Social Security. Medicare Taxes fund the Medicare hospital insurance system. Social Security taxes fund the federal Social Security system for retirement, survivors, and disability insurance.
- Social Security: The Social Security tax rate is 6.2% for the employee
- Medicare: The Medicare tax rate is 1.45% each for the employee and employer. Employees report Medicare taxes annually on Form 1040.
Employers report their Social Security and Medicare taxes quarterly on Form 941 or annually on Form 944.
Federal unemployment taxes
The Federal Unemployment Tax Act (FUTA) tax helps to pay unemployment benefits to workers who lose their jobs. FUTA taxes are paid only by employers. Employees do not have any amounts withheld for FUTA taxes. Federal unemployment tax reporting must be submitted annually using Form 940. For employers whose FUTA (Federal Unemployment Tax Act) tax is less than $500 per year, payments can be made annually. For those whose liability is over $500 per year, quarterly payments are required.
FUTA is paid for all employees with a few exceptions of household, agricultural, and farm
workers. The FUTA rate is 6% of the first $7,000 of each employee’s wages. If you are required to pay state unemployment taxes, you may be able to reduce the percentage FUTA you pay by the amount of the state tax, up to 5.4%. For example, if you pay 5% SUTA, your FUTA will be reduced to 1%.
State and local withholding taxes are additional and typically paid around the same dates as federal withholding.
State taxes vary, with California the highest at an income tax rate of 13.3%. Today, 9 states have no income tax at all, including Alaska, Texas and Florida.
Local withholding taxes can vary by community. At 10%, 7 school districts in Arkansas have the highest rate to date. In Washington D.C., with no state tax to subsidize spending, the bracketed rate caps out at 8.5%.
Check with your local government agencies to see when taxes are due and in what amounts.
Why you should automate your payroll
If you’re like most small businesses, you’re probably not relying solely on a manual payroll process. But you’re probably relying on a mix of spreadsheets, timesheets, and whatever legacy processes that have been cobbled together in your organization.
The problem is relying on disparate processes can introduce errors, trigger compliance issues, and lead to frustration. Because of its complexity, oftentimes, businesses will automate other HR processes before tackling payroll. This may have you evaluating a payroll system that integrates into your current HR platform, or looking to switch to an all-in-one HRIS that does everything for you.
Put together a team of stakeholders to gain cross-departmental support to help determine the best solution and move the project forward, making sure it gets buy-in from the decision makers at your business.
Consider automating payroll as soon as you have more than 5 hourly employees or it becomes difficult to keep track of workers’ pay schedules.