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

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

• 10 Regulatory Steps You Must Follow When Hiring Your First Employee
• Handling Employer Tax Responsibilities - Legal and small business expert Barbara Weltman provides a brief outline of what you need to do to stay compliant.
• Employee Benefit Plans - What's Law and What's Optional - An overview of the basic employee benefits that the law requires you to provide, as well as guidance on setting up a more comprehensive plan.
• IRS Employer's Tax Guide - Includes end-to-end information about setting up, reporting and managing payroll taxes
• IRS Guide to Outsourcing Payroll and Third Party Payers - Explains the legalities of outsourcing payroll as well as the obligations you continue to maintain as an employer.

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

About the Author

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.