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If you run your own business, or if you’re involved in administering payroll for your organization, you certainly have a project on your hands.
Typically, you’ll have the option of hiring an outside firm or financial professional, doing the job by hand, or using payroll software service to speed up the process. While it can be quite laborious, handling payroll in-house can certainly be more cost effective, provided you ensure it’s done correctly, avoiding the risk of hefty fines and lawsuits.
Most payroll software can automate everything from time tracking to formatting paystubs. Some will even file payroll taxes on your behalf. If you have a medium-to-large roster of employees, this can go a long way to minimize the potential for error. Still, you’ll want to understand how payroll works to make sure the job is done right.
In this guide, we’ll cover all the essential steps to run payroll for your business. We’ll help you understand the initial setup, lay out the steps for calculating employee paychecks, and explain the tax forms to file afterward. If you’re ready to take on the challenge, we’ll start with some setup.
Onboarding and Setup
Before you even begin to calculate gross pay or send out paychecks, there is a good bit of paperwork and preparation that needs to be done ahead of time. Both you and your employees should be properly registered with federal, state, and local governments before moving forward with the payroll process.
Employer Setup
For employers, there are two main pieces of registration that need to be completed before anything else.
EIN
First, you will need to obtain a Federal EIN from the IRS. This stands for Federal Employer Identification Number. Like a social security number for your business, your Federal EIN registers you with the federal government for the purpose of payroll taxes.
EFTPS
Once you have your EIN, you will also need to register with the EFTPS (Electronic Federal Tax Payment System). This is the required method for submitting deposits for payroll taxes later on.
Reporting New Hires
Some states require you to report your new hires and may also place other requirements on your business for pre-registration. Be sure to check with state and local legislation and follow the steps to remain in compliance with reporting practices.
Employee Setup
Before your employees receive their first paycheck, they’ll need to complete a few forms as well. Typically these are part of the day-one onboarding process for all new hires.
IRS form W-4
One of the most common required forms for employees is IRS Form W-4. This lays out the employee’s filing status, exemptions, and allowances for tax withholding on each paycheck. So, make sure every employee completes one as early as possible.
In 2020, the IRS issued a new version of form W-4 that makes a few changes in an attempt to simplify things. The main difference with the new form is the removal of withholding allowances. This means that new employees cannot claim any withholding allowances for dependents or personal reasons moving forward. While you may ask any employees who onboarded prior to 2020 to resubmit using the new form, it is not required by law.
Some states also have their own W-4 that you will need to have your employees fill out for state tax payment later.
IRS form I-9
Another required form for full-time employees is the I-9. This is also known as the Employment Eligibility Verification form. This document must be filled out by both the employer and employee (resident or non-resident) to verify that the employee is authorized to work in the United States.
State / Local Tax Withholding Forms
Aside from the W-4, there may be other state or local laws that require you to withhold tax in other ways. Be sure to check with all state and local legislation to have the correct forms on file for you employees.
Direct Deposit
While you may choose to provide your employees with paper checks, many businesses offer direct deposit as a default method of payment. Authorization typically requires your employee’s bank account number, routing number, and signature. However, there is no standard required form to collect this information. Because this will often take some processing time, be sure to offer direct deposit to your new employees right away.
Your Payment System
Once all necessary forms have been filled out, there are a few other practical things you will want to have in place as well to be sure payroll runs as smoothly and automatically as possible.
Pay Periods and Paydays
If it’s not already set up, be sure to create your payroll schedule and stick to it. Decide when you are going to pay your employees and when each pay period starts or ends. Depending on where your business operates, there may also be certain laws governing how often you pay your staff.
Logging Time
While there are many ways to achieve this, you will want to decide how you’re going to track employees’ billable hours. Set up a system to log this information by having your employees enter their own hours, clock in and out for shifts, or report their time another way. Especially for hourly workers, reported time will be the basis for payment.
Paystubs
After an employee receives a paycheck you will need to issue them a paystub. This is like a receipt showing the gross pay, deductions, tax withholdings and net pay for the period.
Additionally, many states have laws that require certain information be included on paystubs. If you’re using payroll software, this will most likely be automatic. However, you will still want to be familiar with or create a template that standardizes the paystubs you send out.
Know Tax Rates
Finally, you will want to know the federal, state, and local tax rates for your employees. Keep up to date on these consistently and have them handy when we move to the next section about calculating paychecks.
Steps to Running Payroll
Now that you have your forms completed and your payroll system in place, you are ready to calculate paychecks for your employees. If everything is documented properly, the steps are fairly simple. We’ll outline the basic steps here at the start and go through each part of the calculation process so you have a better understanding of each part.
What makes payroll such a complex task is knowing the right deductions to take from each paycheck, each period. Some deductions (like payroll taxes) are required by law. Others (like insurance benefits) are agreed upon by the employer and employee. In any case, the process of calculating a paycheck can be broken down into a simple equation like the one below:
Gross Pay
- Pre-Tax Deductions
= Taxable Wages
Taxable Wages
- FICA
- Federal Income Tax Withholding
- Other Deductions
= Net Pay
Methods
You will also want to know which method you will be using to calculate your tax withholdings. The 2 acceptable methods for calculating payroll are the wage bracket method and the percentage method. While an exhaustive explanation of both is beyond the scope of this article, the IRS does provide detailed steps and tables for each in Publication 15-T.
Percentage Method
If your employee makes $100,000 per year, exceeds the salaries listed in the wage bracket tables, or has more than 10 allowances on his or her W-4, you will need to use the percentage method. While this method can be more complicated and involves more steps, it does not have any wage or allowance limits when calculating the final amount.
Wage Bracket Method
You may use the wage bracket method for employees that make less than $100,000 per year. Refer to IRS Publication 15-T for wage bracket tables used in this calculation. Since the wage bracket is often the simplest and most common approach to calculating an employee’s paycheck, we will mainly cover the steps involved in this method.
Gross Pay
When calculating a paycheck, you first need to know how much you owe your employee before any deductions. This is known as the employee’s gross pay.
To obtain the gross pay, make sure you know how your employee is paid. An hourly employee will be paid differently than an employee that is on salary. However, both will have consistent pay periods.
For hourly employees, you will want to multiply the total number of hours worked in a given period by the hourly wage for that employee. You can illustrate this with the equation below:
Hours Worked (This Period) x Wages per Hour = Gross Pay for Current Period
For a salaried employees, the calculation works like this:
Total Salary (Per Year) / Number of Pay Periods = Gross Pay for Current Period
Be sure you also add in other parts of an employee’s pay like tips, commission, paid leave, sick days, vacation time and overtime.
Pre-Tax Deductions
Once you do the math for your employee’s gross pay, you can start to make your first round of deductions. Pre-tax deductions are amounts subtracted from the employee’s gross pay that are not subject to FICA or Federal Income Tax (FIT). They often lower the employee’s taxable income in later steps.
Most pre-tax deductions include things like health insurance and other benefits, retirement plans, and disability insurance.
Once these amounts are taken out, the amount you are left with is the employee’s taxable income. You can illustrate it like this:
Gross Pay ($1000)
- Health Insurance ($100)
- Vision and Dental Insurance ($50)
- 401(k) contribution ($30)
- Disability Insurance ($10)
= Taxable Income ($810)
It’s also worth noting that while some retirement benefits are non-taxable, many are still subject to FICA tax. Be sure to know whether the employee’s retirement deductions can be subtracted from the gross wages or if they must be subtracted after FICA taxes are taken out.
FICA
As part of your payroll calculations, you will need to account for FICA taxes during each pay period. FICA stands for Federal Insurance Contributions Act which is the portion of payroll taxes used to fund Social Security and Medicare benefits.
FICA taxes are shared by the employer and employee, and both pay half of the 15.3% required from the employee’s wages. For this, you will want to withhold 6.2% of the employee’s taxable wages and match that amount in taxes you pay yourself.
Federal Income Tax Withholdings
As part of the taxable deductions, you will also need to calculate federal income tax withholdings. This is where the wage bracket and percentage methods both come into play.
To start this part of the calculation, you will need your employee’s W-4 to reference filing status, allowances and exemptions. You will also want to have IRS Publication 15-T pulled up to reference wage bracket tables.
The amount of federal income tax you will be required to withhold from each paycheck will be determined by the filing status, pay frequency, and any allowances listed on the employee’s W-4. Remember that the amount being withheld is an estimate based on the projected wages for the year. You will use the information provided in the W-4 to adjust the employee’s taxable wages and withhold estimated amounts based on that figure.
Exactly how much you withhold will also depend on when the employee submitted his or her W-4. Luckily, the IRS provides methods that work for either scenario in Publication 15-T.
Other Deductions
In addition to tax, you may need to make other required deductions. Some employees will have wage garnishments and/or union dues that will be taken out of each paycheck. However, these will need to be deducted after federal income taxes.
Net Pay
Once you have subtracted all deductions from your employee’s gross pay, you will be left with the final amount known as net pay or take-home pay.
With that, it’s time to send out payment. When using payroll software and/or direct deposit, payment is automated based on the pay periods you defined beforehand. Most software also issues paystubs at the same time. Either way, make sure your employees receive what they worked for.
While you are only paying this final amount to the employee directly, be sure to keep track of all the deductions you made from gross pay and what the employee received in net pay. This will need to be listed on the employee’s paystub and kept on hand for tax payment and reporting later.
Payroll Taxes
The full process of running payroll doesn’t end when paychecks go out. Once you pay your employees, it’s time to keep track of the remaining funds and pay your own payroll taxes on time. Remember that employers must pay 6.2% of taxable payroll toward FICA tax, aside from what is deducted from each paycheck. There are also other taxes you’ll be required to pay as an employer.
FUTA
Employers are also required to pay FUTA taxes. FUTA stands for the Federal Unemployment Tax Act which requires employers to contribute a portion of payroll tax toward workers that have lost their jobs. This tax ultimately goes toward unemployment checks.
FUTA taxes are paid at a rate of 6% on each employee’s first $7,000.00. This means that you no longer pay FUTA tax on any amount over $7,000.00 for each employee.
However, the employee is not responsible to pay this portion of payroll taxes, and it cannot be taken out of the employee’s paycheck. Because of this, you will need to account for paying these taxes yourself at regular intervals.
State and Local Taxes
Some state and local governments also require a payroll tax payment which you will be responsible for knowing about and planning for accordingly. You will also want to account for SUTA (State Unemployment Tax Act) for each state.
Tax Deposit Schedule
For each type of payroll tax, there is a deposit schedule you’ll need to follow for each. If the proper amounts are not deposited on time, you may receive penalties or fines. To know your deposit schedule, you will want to consider your lookback period and your tax reporting forms which we will discuss in depth later. State and local tax deposit schedules will vary based on legislation.
Lookback Period
The lookback period determines your deposit schedule for FICA and federal income taxes. It is the period of time for which you measure your total gross tax liability for social security and medicare tax. Whether you file IRS form 941 or 944 will determine which period of time you use as an employer.
- Employers who use form 941 have a lookback period between the previous July 1st - June 30th.
- Employers who use form 944 have a lookback period between the previous January - December.
If you report a tax liability less than $50,000 during your assigned lookback period, your FICA / FIT deposit schedule is monthly. If you report more than $50,000 your lookback period, your deposit schedule is semi-weekly. This figure can be found on line 12 of form 941.
If you have not used either forms 941 or 944 because you are a newly registered employer (and you do not have a lookback period), your deposit schedule is monthly by default. Specific due dates for each type of deposit will depend on your scheduled payday.
FUTA Deposit Schedule
While the lookback period determines your FICA and federal income tax deposit schedule, FUTA tax is on a different routine.
Your FUTA deposit schedule is determined by the amount owed within a given quarter. You do not need to make a deposit until you exceed $500 in FUTA tax liability within a 1-year period. Once you meet or exceed this amount, you will need to make your deposit for the quarter in which this occurs.
If you do not exceed this amount within your first quarter, the liability amount carries over to the next quarter until you exceed this amount or to the end of the fourth quarter. If you still do not exceed $500 in FUTA tax liability by the end of the year, you must pay the full amount for which you are liable by January 31st.
It’s also worth noting that you can receive credits for on-time deposits on some taxes. In many states, if you make your FUTA tax deposits on time, you can receive a 5.4% tax credit in return.
Payroll Tax Forms
Employers are also responsible for filing and reporting payroll taxes by using a number of forms. Which specific forms you use will depend on the type of business and what type of employees are being paid.
IRS Form W-2
IRS form W-2 is filed for each employee. This form reports total wages, deductions, and tax withholdings for the year. This form is due annually at the beginning of the year (usually January 31-February 1).
You can either mail in this form or file it electronically using form W-3. One copy will go to the Social Security Administration (SSA) and the other copy will go to the employee’s state or local tax department. You will also need to send a copy to your employees.
IRS Form 941
IRS form 941 is your quarterly federal tax return, due every 3 months. It is used to file and pay for social security tax, medicare tax, and other withholdings of this kind. This is also the form you will use to understand your lookback period.
Most employers have to file this form as part of the required payroll tax reporting. You do not have to file this form for household or seasonal employees. For farm employees, you will file IRS form 944 instead.
IRS Form 940
IRS form 940 is used to report FUTA tax. This form is due annually, in February of each year. However, you may have an extension on your filing deadline if all of your FUTA deposits were made on time for the year.
IRS Form 1099-MISC
IRS form 1099-MISC is used to report miscellaneous income paid to an individual who is not necessarily a registered employee with your business. If you hire independent contractors or give out prizes, this is the form you will use to report the amount you paid to those individuals.
However, this is only used if your business pays someone more than $600 for the year. According to the IRS, you will also have to file this form if you paid “at least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest.”
Aside from these forms, you will also be responsible for filing with each employee’s state or local government based on varying requirements. Be sure you are up to date on what forms you have to file and the deadlines for each so that you don’t incur any additional fines for late filing.
TIP: Keep a calendar that’s marked up specifically with important filing and deposit dates.
Final Thoughts
Running payroll can be a tricky task. With payroll taxes, deposit schedules, and multiple forms on top of the basic math of payroll, it can be tough to do it all accurately. It can also be time-consuming if you have to run it by hand.
Luckily, there are tools that can make this far easier. Criterion’s HCM software includes a robust payroll solution that takes the pain out of payroll, letting you easily calculate tax rates, process payments, and file the appropriate paperwork.
If you’re interested in seeing how Criterion can make payroll simple and keep you compliant - book a demo today.
