It doesn’t matter if you have one employee, a dozen, or five hundred: you should still learn how to manage and set up payroll. As an employer, you’re responsible for withholding taxes, calculating employees’ pay, and ensuring everyone — including the IRS! — gets their money on time.
To help you get started, we’ve put together this guide to payroll for small businesses. It unpacks everything a small business owner needs to know, including how to streamline the payroll process, save money, and avoid costly mistakes.
In this guide, you’ll learn:
- What payroll processing is (and the different ways to do it)
- Six steps to setting up payroll for a small business
- Five features to look for in payroll software
- Four payroll mistakes to avoid
What exactly is payroll?
Payroll is the process of calculating and distributing payments to employees for their work within a specified period. This is typically based on an employee’s hourly rate or annual salary and might also include bonuses, overtime pay, and other compensation.
But the process isn’t exactly simple. It involves multiple steps, including gathering and verifying employee time and attendance information, calculating gross pay, deducting payroll taxes (and other withholdings), and distributing the correct net pay to the right employees.
How to do payroll for a small business
While there are a lot of moving parts, setting up payroll isn’t complicated once you understand what’s involved. Here’s what you need to know before you get started.
Step #1: Choose your payroll method
Some small business owners prefer to handle payroll manually, while others prefer to use software to automate the process. Let’s take a closer look at some of the different payroll methods you can choose from:
- Manual payroll: This method involves calculating employee pay and taxes by hand. It can be time-consuming and prone to errors, but it can be a good option for very small businesses with only a few employees.
- Outsourcing payroll: If you don’t have the time or expertise to handle payroll in-house, you can outsource it to a third-party provider. Note that while this can take the payroll burden off your hands, this can become expensive quickly.
- Automated payroll system: This is perhaps the most popular option for small business owners, as it allows you to streamline the payroll process and reduce errors.
An automated or online payroll service is an excellent option for small business owners who want to save time and reduce the risk of errors. This method helps ensure that your employees are paid accurately and on time while freeing time to focus on other aspects of your business.
Step #2: Collect employee information
Whether you’re using a payroll service or doing it in-house with automated software, you need to start with gathering your employees’ information:
- Full name
- Current address
- Date of birth
- Exempt status
- Hiring date
- Compensation details
- W-4 Information
- I-9 Information
You should be able to get most of your employee’s data from their W-4 upon hiring. If there’s ever a change — like your employee wants to update their withholdings, move addresses, or change their name — make sure you update your payroll and records. The IRS recognizes these as significant changes that could affect their (and your) taxes.
Step #3: Determine the pay method
Next, you should decide which method you want to pay employees. Usually, employers will choose one of the following:
- Direct deposit
- Physical check
- Cash
- Mobile payment
More than 90% of U.S. workers are paid by direct deposit, which goes straight into their bank account: So it’s safe to say that convenience always wins.
While some methods, like checks or cash, aren’t necessarily outdated, they come with more security risks, are more time-consuming, may not meet compliance requirements, and are inconvenient for employees.
Step #4: Determine the pay schedule
Most employers use a weekly or biweekly pay period. While you could do monthly, only 4.4% of employers pay this infrequently — and remember, convenience should always be considered.
When making these decisions, consider what your employees want. Unsurprisingly, employees want frequent pay periods. One poll found that 83% of workers want to be paid daily. This might be too much for your small business, but it points to the value of paying weekly or biweekly at the very least.
Step #5: Calculate gross pay and take-home pay
Gross pay is the total amount of money an employee earns before any deductions or taxes are taken, while take-home or net pay is the amount the employee receives after all deductions and income taxes have been taken out.
It’s crucial for employers to accurately calculate gross and net pay for their employees and comply with relevant laws and federal and state regulations regarding employee compensation and taxes.
Here’s how you calculate both:
1. Determine the employee’s pay rate: This may be an hourly rate or a salary rate.
2. Calculate the employee’s gross pay: Multiply the employee’s pay rate by the number of hours worked or days in the pay period.
3. Gross pay = Hourly rate x Number of hours worked
4. For salaried employees: Gross pay = Annual salary ÷ Number of pay periods per year
5. Subtract pre-tax deductions: Pre-tax deductions may include mandatory payments and contributions to retirement plans, social security tax, medicare tax, health insurance premiums, and other benefits deducted from the employee’s gross pay before taxes are calculated.
6. Calculate taxes: Calculate state, local, and federal income tax based on the employee’s taxable income (gross pay minus pre-tax deductions) and tax withholding information provided by the employee.
7. Subtract post-tax deductions: Post-tax deductions may include voluntary deductions such as charitable donations, wage garnishments, or court-ordered child support payments.
8. Calculate take-home pay: Take-home pay is the money an employee receives after all taxes and deductions are subtracted from their gross pay.
9. The take-home formula: Take-home pay = Gross pay - Pre-tax deductions - Taxes - Post-tax deductions
There’s no doubt that these are tedious steps — especially if you have more than a couple of employees and pay more than once per month. Employers can use payroll software or a payroll service provider to help automate these calculations and ensure accurate tax payments.
Step #6: Run payroll then make tax and benefit payments
Once you have completed all the necessary tax forms and calculations for your employee payroll, the next step is running the payroll and making the appropriate tax and benefit payments. Here are the steps:
- Verify payroll calculations: Before you process the payroll, it’s important to double-check all calculations to ensure that everything is accurate.
- Choose a pay date: Decide on a payment date that works for your business and employees.
- Process payroll payments: Manually calculate or use your payroll software to process the payments for your employees.
- Make tax and benefit payments: After processing payroll for your employees, you must pay the appropriate government agencies and providers.
With every employee’s paycheck here, maintaining accurate records is crucial. This will help ensure that you comply with all relevant laws and regulations and can make things easier if you are ever audited or need to resolve a dispute with an employee.
What to look for in payroll software for a small business
Your payroll software is the backbone of your operations, so you must choose the right software for your business. Here are some key features to look for:
Feature #1: Payroll calculation features
Your software should be able to handle all the nitty-gritty calculations that go into paying your employees. That includes things like bonuses, leave, and salary revisions.
Even if your payroll is simple right now, you want to choose software that can grow with your business. After all, you don’t want to switch software every time your payroll gets more complicated.
(Think of your payroll software like a reliable employee: It should be able to handle all the math and details so you don’t have to. With the right software, you can take the headache out of payroll and focus on growing your business.)
Feature #2: Flexibility to customize settings
Different states and counties have their unique requirements when it comes to payroll. That means you need software that can handle these variations seamlessly without stressing over compliance issues.
You also want software that allows you to customize compensation options to suit your business needs. That includes varying overtime rates and even small details like fuel reimbursements. After all, no two businesses are exactly alike — and your payroll software should be able to accommodate that.
Feature #3: Self-service portal for employees
With an employee self-service portal, your team members can easily view and download their pay stubs and payment information, which helps keep everyone on the same page.
It also means less back-and-forth between you (or HR) and your employee if they need proof of income for things like loan applications, rental applications, or applying for credit cards. Your team will thank you for it!
Feature #4: Payroll automation
Payroll automation is a must-have feature in any payroll software you’re considering. With automation, you can save time and eliminate the risk of errors that come with manual processing.
It should also be able to handle payroll deductions on your behalf (which means it’ll take care of the details so you don’t have to).
Feature #5: Customizable reports
With the right payroll software, you can generate reports that provide an overview of your payroll system. You can see detailed information on employee compensation, including salaries, bonuses, and overtime pay, and better understand how your payroll expenses impact your bottom line.
And the best part? Customizable reports can be generated quickly and easily, so you don’t have to spend hours crunching numbers or digging through paperwork
4 payroll mistakes every small business owner should beware of
Payroll management isn’t just about paying your employees on time. It’s also about avoiding costly mistakes that can lead to fines and penalties. To help you navigate payroll with confidence, here are some common payroll mistakes to be aware of:
- Failing to withhold and remit payroll taxes accurately
- Not keeping accurate records of employee hours, pay rates, and benefits
- Misclassifying employees as independent contractors
- Not withholding garnishments correctly
Automating your payroll processes means instantly reducing the risk of making these mistakes, avoiding fines and penalties and ensuring accurate calculations of withholdings, payroll taxes, record-keeping, and the correct classification of employees.
Stay organized to simplify payroll for your small business
There’s a lot on your shoulders — as a business owner, you’re responsible for paying employees, the IRS, and benefits providers and making contributions. You also have to calculate gross pay, net pay, and everything in between.
BILL helps you stay organized by integrating with your accounting software, expense report software, tax services, and other tools. Try BILL today.
When you have a powerful technology stack for all your financial needs, from payroll to bill payments, running a successful business becomes a whole lot easier.
