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Payroll: What It Is And How to Do It Properly

By Rachel Smith on May 28, 2019

If you currently have employees or plan to hire in the future, you’ll need to know the ins and outs of running payroll. It can all feel a bit complicated. So we’ve laid out a simple guide to doing payroll, including some common pitfalls you’ll want to avoid.

What is payroll?

Payroll can refer to either your list of paid employees (the people “on your payroll”) or the total amount of money you pay to that list of individuals. The act of processing those salary or wage payments, along with benefits and taxes, is typically called “running payroll.”

To be successful at all things payroll, you’ll need to:

  • keep accurate records
  • figure out who to pay and how much to pay them
  • calculate the taxes to withhold
  • pay everyone, accurately and on time
  • submit withheld taxes to the government

Keeping payroll records

Keeping accurate records is a basic requirement for running a business, but what exactly do you need to track for payroll? First, you need to keep an individual record for each employee. You should record the amount they were paid each pay period, along with any income that was withheld—for example, taxes or pension contributions.

Further reading: The Small Business Guide to Recordkeeping

Different rules apply to overtime pay, depending on if your employee is salaried or paid an hourly wage. Hourly employees are entitled to time-and-a-half pay (1.5 times their regular hourly rate) for all hours worked over the standard 40-hour week. Salaried employees do not have this entitlement, but tend to receive other benefits, like a 401(k).

Key information to track for each employee includes:

  • Current pay rate
  • Total hours worked during the pay period (for hourly employees)
  • Time off taken (including paid and unpaid vacation, sickness, and parental leave)
  • Time off owed (not used)
  • Overtime, double time, or other variations in pay rate
  • Tips, gratuities, commissions, or bonuses

You’ll also need to make sure your paperwork is in order for each employee. When you bring someone on board, have them fill in the following forms:

  • An I-9 (proving their eligibility to work in the States)

  • A W-4 (this lets you know how much to withhold in taxes each pay period)

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Recurring tax forms

You should also familiarize yourself with Form 941 (which employers must submit quarterly to the IRS to record the amount of income, social security and Medicare taxes withheld from pay), and the W-2, a combined wage and tax statement you provide to your employees once a year.

Calculating payroll taxes

Before you start payroll, make sure you’ve set up an EIN (Employer Identification Number) for your business. It only takes a few minutes to apply online or by phone, and you’ll need it to process payroll taxes.

Some taxes are paid by both the employer and the employee, and some aren’t. The tax rates are updated each year by the IRS, and published under the title Publication 15 (Circular E) — The Employer’s Tax Guide. Rates are described as a percentage of the employee’s gross (pre-tax) pay.

Employees typically pay these five payroll taxes:

Tax How It Works
Federal Income Tax Determined by the Form W-4 that an employee submits, showing their filing status and any relevant exemptions.
State Income Tax Each state has a guide for how to calculate this, although Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming don’t have State Income tax.
Social Security This is shared evenly by the employer and employee, with each responsible for 6.2% of the employee’s taxable earnings.
Medicare This is shared evenly by the employer and employee, with each responsible for 1.45% of the employee’s taxable earnings.
Local Taxes Variable by region.

Employers typically pay these four payroll taxes:

Tax How It Works
Federal Unemployment Tax Typically, once a month, the employer will deduct and pay 6% of the employee’s salary (up to a maximum taxable earnings of $7,000) to cover unemployment tax. Note that if you pay your state unemployment tax on time, you could receive a deduction of up to 5.4% on your federal unemployment, making the overall federal rate only 0.6%.
State Unemployment Tax Variable by state, although in Alaska, New Jersey and Pennsylvania, both the employer and the employee share the tax burden.
Social Security This is shared evenly by the employer and employee, with each responsible for 6.2% of the employee’s taxable earnings.
Medicare This is shared evenly by the employer and employee, with each responsible for 1.45% of the employee’s taxable earnings.
Local Taxes Variable by region.

Remitting payroll taxes

As the employer, you are responsible for calculating each tax, withholding it from your employee’s paycheck, and remitting it to the appropriate place. To calculate what you should withhold, follow our guide to payroll tax calculations.

Your payment schedule for payroll taxes will depend on your history as an employer and how much you are collecting in total payroll taxes.

Schedule How It Works Deadlines
Annual Remitter If your payroll taxes were under $2,500 for the current or previous quarter, you can make your deposit annually, at the same time you report your taxes, as long as you report on time. This rule holds unless you have accumulated $100,000 in taxes. Then you have a next-day deposit obligation. Remit: January 31—the last day of the fourth quarter.

Report: Use Form 941 to report your federal taxes by January 31st.
Monthly Remitter If you are a new employer, had no employees during the last four quarters, or your total payroll taxes are less than $50,000, you are a monthly remitter. Remit: The 15th day of the following month.

Report: Report your total taxes deposited each quarter using Form 941, by April 30, July 31, October 31 and January 31.
Semi-Weekly Remitter If your total taxes are more than $50,000, you are a semi-weekly remitter. Remit: If you paid your employees Wednesday through Friday, remit your taxes by the following Wednesday. If you paid your employees Saturday through Tuesday, remit your taxes by the following Friday.

Report: Report your total taxes deposited for the quarter, using Form 941 by April 30, July 31, October 31 and January 31.
Next-day Remitter If at any point, you accumulate more than $100,000 in taxes during any payroll period, regardless whether you are usually a monthly or semi-weekly, you need to deposit the tax by the next business day. Remit: The next business day.

Report: Report your total taxes deposited each quarter using Form 941, by April 30, July 31, October 31 and January 31.

Now that you’ve calculated your payroll taxes, set aside the correct amount and determined what your remitting and reporting deadlines are, you are all set up to pay your employees.

What about contractors?

Unlike an employee, an independent contractor has the freedom to work the hours and jobs they choose, as determined at the beginning of the contract. Usually, they will work for several clients, supply their own work resources and equipment, do not receive employee benefits (like vacation pay), and invoice for payment, rather than receiving pay on a regular payroll schedule. They are also responsible for the entirety of their taxes.

It’s important to be certain if the person working for you is an employee or an independent contractor; if you’re not sure, check out our post on the difference, or file form SS-8 for an IRS judgement on the situation.

How to pay your contractor

Instead of a W-4, have independent contractors fill in a W-9 at the start of their contract—this will give you all the details you need to report on their earnings later. Although they aren’t employees, and you are not responsible for withholding tax, you will need to file a 1099 to let the IRS know how much you paid them. There are around 20 different variations of this form, so be sure to talk to a professional to make sure you’re using the right one.

The 1099, and its most common variation the 1099-MISC, are submitted annually, detailing all payments made to the contractor. You’ll need to provide a copy to the contractor, retain one for your records, and submit one to the IRS. Some states also require a separate state-level 1099 filing, so check your state’s legislation, or ask your accountant for details.

If you have several independent contractors, you’ll submit multiple 1099s, which means you also have to file a 1096 (a form that summarizes all the 1099s you submitted).

Common payroll mistakes

Your payroll might be incorrect if you miscalculate the wages you owe your employees, or if you miscalculate the amount of tax you need to withhold. The IRS is pretty serious about the tax part, and more than a third of small business owners are fined each year for mistakes made on their payroll taxes. As an employer, you are legally on the hook for all payroll taxes, even if you’ve outsourced your payroll to another company—so read on from some common payroll tips to avoid:

Reporting an employee as an independent contractor

It’s vital to accurately classify your employees and contractors: you might be paying someone as a contractor, but IRS sees them as an employee, you’ll have to pay taxes on their behalf. This can be a major expense if you haven’t been setting tax remittances aside. Make sure you’re clear on their status at the point you hire them, by checking our guide on the differences between an employee and an independent contractor.

Mixing up “exempt” and “nonexempt” employees

There are two different types of employees, and the distinction is important for payroll purposes: you do not pay overtime wages to exempt employees and you do to nonexempt employees. An employee is exempt if they meet all three of the following requirements:

  • They earn a salary
  • They earn at least $24,600 a year ($455 per week)
  • They’re high up in the company and their job responsibilities directly affect the company’s operations

You’ll also need to check in with your particular state restrictions, as they can sometimes be even more stringent.

Employers often assume that their employees are exempt because they earn a salary, but that’s not always the case. Make sure you’re clear on your employee’s status, because you could be on the hook to pay overtime wages—and that could be a big expense if you haven’t accounted for it.

Miscalculating overtime pay

Overtime wages are different than regular wages. Typically, you must pay your employees 1.5 times their regular pay rate (time and a half) for anything more than 40 hours a week, but the rules can vary from state to state, and even city to city, so make sure you double check. If you fail to pay the correct overtime rate, you are responsible for back wages, and you could incur penalties and interest.

Miscalculating taxable income

If you’re paying out unused vacation pay or overtime hours, it can be easy to forget the vital step of factoring in applicable payroll taxes. Vacation, sick pay and overtime are all taxable. To remit the correct payroll taxes, you need to calculate it based on all taxable income—even the extras—factoring in any minimum or maximum caps that apply.

Missing the deadline

Deadlines can vary on the state and federal level. Make yourself aware of them, and always file on time, because you’ll have to pay penalties between two and ten percent depending on how late you are.

Paying the wrong tax rates

Tax rates are reassessed every year. If you pay the wrong rate, you won’t just be liable for the missing tax—you’ll also have to pay interest, and a fine. Stay on top of the current tax rates by checking Publication 15 (Circular E) — The Employer’s Tax Guide.

Paying the wrong state taxes

If your employee lives in a different state from the one they work in, you might be paying the wrong state taxes. You should be paying according to the state they live in, not the one they work in (if different).

Paying your employees

After you’ve figured out your tax obligations, you have to pay your employees. What you actually end up paying them is their net pay—the amount that’s left over after deductions such as:

  • Tax withholdings
  • Employer contributions, such as 401(k)
  • Employee contributions, such as a health insurance policy;

You should pay your employees according to an agreed-upon schedule. The actual pay period will depend on what works best for your business, but you should keep it consistent. How you pay them will vary: some employers still rely on paper cheques, but for efficiency on all sides, direct deposit is commonly the best practice. If an employee doesn’t have a bank account, some employers may pay their wages directly to a prepaid card—the employee can use the card to make purchases directly or to pull cash from an ATM.

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Can I make this easier?

If this is all sounding a bit complicated, you’ll be relieved to know there are easier options than the DIY route. We recommend Gusto, a software application that guides you through the payroll process. Even better, it automatically files and pays your payroll taxes, so you don’t have to worry. Gusto is to payroll as Bench is to bookkeeping, and thanks to its user-friendly interface and automation features, it also received an Editor’s Choice recommendation from PCMag.com. By outsourcing your payroll, you can be free to focus on what your business does best, and enjoy the peace of mind that comes with accurate tax filings.

Further reading: The Top 5 Payroll Solutions for Small Businesses


This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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