Jump to Main Content
USA flagAn Official Website of the United States Government
Archive

Blogs.Archive

Register

Setting up a Payroll System; A 10 Step Guide for Small Business

Comment Count:
10

Comments welcome on this page. See Rules of Conduct.

Setting up a Payroll System; A 10 Step Guide for Small Business

By Caron_Beesley, Contributor
Published: July 6, 2010 Updated: March 28, 2013

Whether you have one employee or 50, setting a payroll system not only streamlines your ability to stay on top of your legal and regulatory responsibilities as an employer, it can also save you time and help protect you from incurring costly IRS penalties (according to Inc.com*, the IRS typically penalizes one out of every three business owners for payroll errors).

 

Here are 10 steps to help you set up a payroll system for your small business.

 

1. Obtain an Employer Identification Number (EIN)

Before hiring employees, you need to get an employment identification number (EIN) from the IRS. The EIN is often referred to as an Employer Tax ID or as Form SS-4. The EIN is necessary for reporting taxes and other documents to the IRS. In addition, the EIN is necessary when reporting information about your employees to state agencies. You can apply for an EIN online or contact the IRS directly.

 

2. Check Whether You Need State/Local IDs

Some states/local governments require businesses to obtain ID numbers in order to process taxes. Check whether this applies in your state with this State Tax Guide.

 

3. Independent Contractor or Employee; Know the Difference

Be clear on the distinction between an independent contractor and an employee. In legal terms, the line between the two is not always clear and it affects how you withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes. Business.gov offers guidance on the distinction in this Guide to Hiring Independent Contractors.

 

4. Take Care of Employee Paperwork

New employees must fill out Federal Income Tax Withholding Form W-4. Your employee must complete the form and return it to you so that you can withhold the correct federal income tax from their pay (the IRS provides guidance on how to do this as well as how to report withholdings and taxes at the end of the year in this Employment Tax Guide).

 

5. Decide on a Pay Period

You may already have a manual process for this, but setting up a pay-period (whether monthly or bi-monthly) is sometimes determined by state law with most favoring bi-monthly payments. The IRS also requires that you withhold income tax for that time period even if your employee does not work the full period.

 

6. Carefully Document Your Employee Compensation Terms

As you set-up payroll, yo-ll also want to consider how you handle paid time off (not a legal requirement, but offered by most businesses), how you track employee hours, if and how you pay overtime, and other business variables. For more on Fair Labor Law, and how it impacts overtime pay, etc. check out Business.go-s guide to wage and hour laws.

 

Do't forget that other employee compensation and business deductibles such as health plan premiums and retirement contributions will also need to be deducted from employee pay checks and paid to the appropriate organizations.

 

7. Choosing a Payroll System

Payroll administration requires an acute attention to detail and accuracy, so i's worth doing some research to understand your options. Start by asking fellow business owners which method they use and if they have any tips for setting up and administering payroll.

 

Typically, your options for managing payroll include the following in-house or outsourced options (remember whichever option you choose, you, as the employer, are responsible for reporting and payment of all payroll taxes):

 

- Commercial Accounting Software' There are many basic desktop software applications and online services that small businesses can use in-house to manage check processing, direct deposits, and tax collection. These include Sage Peachtree*, Intuit Online Payroll*, PayChex Online Payroll*, and ADP* (who are now branching out into the small business market). Just be careful that you purchase only the options you need and make sure you understand if these services'impoun' payroll taxes or let you keep them until they are due for payment.

 

- Outsource to an Accountant or Payroll Service How to Choose a Payroll Service*' offers tips on saving time and money by outsourcing payroll. For advice on choosing an accountant, read this article on Business.gov: Selecting a Small Business Accountant.

8. Running Payroll

 

Once you have all your forms and information collated you can start running payroll. Depending on which payroll system you choose you'll either enter it yourself or give the information to your accountant.

 

9. Get Record Keeping Savvy

Federal and some state laws require that employers keep certain records for specified periods of time. For example, W-4 forms (on which employees indicate their tax withholding status) must be kept on file for all active employees and for four years after an employee is terminated. You also need to keep W-2s, copies of filed tax forms and dates, and amounts of all tax deposits. Read more about setting up records for withholding taxes (refer to Step 3). For record keeping tips read, I Keep Good Records - But How Long Should I Keep Them For?

 

10. Report Payroll Taxes

There are several payroll tax reports that you are required to submit to the appropriate authorities on either a quarterly or annual basis.

Generally, each quarter, employers who pay wages subject to income tax withholding, social security, and Medicare taxes must file IRS Form 941, Employer's Quarterly Tax Return. Small businesses with an annual income tax liability of $1,000 or less may file IRS Form 944, Employer's Annual Federal Tax Return instead of Form 941.

 

You must also file IRS Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, if you paid wages of $1,500 or more in any calendar quarter or you had one or more employees work for you in any 20 or more different weeks of the year.

 

If you are in any way confused about your obligations, take a look at the IRS's Employer's Tax Guide, which provides some very clear guidance on all federal tax filing requirements.

 

Visit your state tax agency for specific tax filing requirements for employers.

 

Additional Resources

 

*Note: Hyperlink directs reader to non-government Web site.

About the Author:

Caron Beesley

Contributor

Caron Beesley is a small business owner, a writer, and marketing communications consultant. Caron works with the SBA.gov team to promote essential government resources that help entrepreneurs and small business owners start-up, grow and succeed. Follow Caron on Twitter: @caronbeesley

Comments:

I like the suggestions. I followed the steps and find ezPaycheck payroll software> from halfpricesoft.com and started the trial version. I like ezPaycheck payroll software so far. I would like add one tip to step 7. Test Drive before purchasing. Karen ---This post was edited to remove a commercial link. Read our discussion policies for more Community best practices.
I like the suggestions. I followed the steps and find ezPaycheck payroll software> from halfpricesoft.com and started the trial version. I like ezPaycheck payroll software so far. I would like add one tip to step 7. Test Drive before purchasing. Karen ---This post was edited to remove a commercial link. Read our discussion policies for more Community best practices.
Sunburst: excellent point. I agree. Assisted Payroll is the way to go if you're doing payroll within QuickBooks. Otherwise there's too much risk of making mistakes or missing deadlines in the payroll tax return and deposit process.
Sunburst: excellent point. I agree. Assisted Payroll is the way to go if you're doing payroll within QuickBooks. Otherwise there's too much risk of making mistakes or missing deadlines in the payroll tax return and deposit process.
All great tips!  Thanks so much. One other added piece of info for #7 - choosing a payroll service: Intuit also offers Assisted Payroll which is the best of both worlds.  You enter employee hours in the weekly timesheet (full job costing abilities), transmit that data and Intuit will do direct deposit (if you want), prepare your quarterlies and year end documents, pay your payroll taxes and offers a no penalties guarantee. Using this method keeps your payroll data within your QuickBooks file while offers you the convenience of having an outside service handle all the tax forms and payments.
All great tips!  Thanks so much. One other added piece of info for #7 - choosing a payroll service: Intuit also offers Assisted Payroll which is the best of both worlds.  You enter employee hours in the weekly timesheet (full job costing abilities), transmit that data and Intuit will do direct deposit (if you want), prepare your quarterlies and year end documents, pay your payroll taxes and offers a no penalties guarantee. Using this method keeps your payroll data within your QuickBooks file while offers you the convenience of having an outside service handle all the tax forms and payments.
David - thanks for your comments and insight. Great points! Caron.
David - thanks for your comments and insight. Great points! Caron.
This is an excellent overview. I've helped hundreds of small businesses over the years so here are a few additional observations based on hands on experience: #4 - new employee paperwork - add to the list a Homeland Security I-9 form and state paperwork if applicable (e.g. California has it's version of a W-2 called the DE-4) #6 - documenting compensation terms - great tip! Far too often I see conflicts between employees and employers over this. Prevent such conflicts with a clear job offer letter that spells everything out and a basic employee policy manual. #7 - choosing a payroll service a) Intuit's payroll service that you run through QuickBooks and allows you to job cost wages is great for contractors and other businesses where you need to assign costs to an ever-changing stream of jobs/projects; b) Intuit's online payroll service is now excellent - it used to be terrible but then they scrapped their in-house system and bought PayCycle which did a great job at low cost online payroll so now Intuit's online payroll is excellent - this is appropriate for a company with a strong bookkeeper and good financial discipline because it's very affordable but you do have to press one or two more buttons to make payroll tax payments and file returns so don't use this if there's a chance you'll forget and miss a payroll tax filing deadline; c) PayChex/ADP/e-Chx type of services are good affordable services that guarantee correct filing and payment of taxes; d) if you've got 7-10 or more employees consider using a professional employer organization (PEO) which is far more than a payroll service - it's a full-on outsourced HR department; e) I do not recommend using local CPAs or bookkeepers because of the cost (basic payroll is a low cost commodity now offered by the big national companies) and the risk (why take the chance that your local CPA or bookkeeper makes a mistake and doesn't guarantee their work or worse they steal payroll taxes instead of sending to the government which does happen).  
This is an excellent overview. I've helped hundreds of small businesses over the years so here are a few additional observations based on hands on experience: #4 - new employee paperwork - add to the list a Homeland Security I-9 form and state paperwork if applicable (e.g. California has it's version of a W-2 called the DE-4) #6 - documenting compensation terms - great tip! Far too often I see conflicts between employees and employers over this. Prevent such conflicts with a clear job offer letter that spells everything out and a basic employee policy manual. #7 - choosing a payroll service a) Intuit's payroll service that you run through QuickBooks and allows you to job cost wages is great for contractors and other businesses where you need to assign costs to an ever-changing stream of jobs/projects; b) Intuit's online payroll service is now excellent - it used to be terrible but then they scrapped their in-house system and bought PayCycle which did a great job at low cost online payroll so now Intuit's online payroll is excellent - this is appropriate for a company with a strong bookkeeper and good financial discipline because it's very affordable but you do have to press one or two more buttons to make payroll tax payments and file returns so don't use this if there's a chance you'll forget and miss a payroll tax filing deadline; c) PayChex/ADP/e-Chx type of services are good affordable services that guarantee correct filing and payment of taxes; d) if you've got 7-10 or more employees consider using a professional employer organization (PEO) which is far more than a payroll service - it's a full-on outsourced HR department; e) I do not recommend using local CPAs or bookkeepers because of the cost (basic payroll is a low cost commodity now offered by the big national companies) and the risk (why take the chance that your local CPA or bookkeeper makes a mistake and doesn't guarantee their work or worse they steal payroll taxes instead of sending to the government which does happen).  

Leave a Comment

You must be logged in to leave comments. If you already have an SBA.gov account, Log In to leave your comment.

New users, Register for a new account and join the conversation today!