Managing Small Business Payroll: Complete Guide

Whether you have one employee or 100, ensuring everyone is paid correctly and on time, while complying with state and federal regulations and tax laws, can be a lot for small business owners to manage.

Whether you do it yourself, use leading payroll management tools, hire a payroll provider, or use payroll services specifically for small businesses, you should understand exactly what needs to be done.

My goal with this article is to give you everything you need to know to effectively manage payroll in your small business.

What Is Managing Payroll?

Payroll management is an essential business function that involves managing the payment of salaries to employees at the end of the pay period. This process includes several key tasks:

• Employee information management: Keeping accurate records of each employee's personal and employment information, such as name, address, social security number, and details of the job position.
• Time tracking: Recording the time worked by each employee. This can be done through time tracking software to track hours worked, overtime, and leave time.
• Calculating pay: Determining the correct amount to pay for each employee. This involves calculating total compensation including gross wages (based on hourly rates or salaries), adding any bonuses or commissions, and accounting for overtime payments.
• Deducting payroll taxes and other withholdings: Calculating and deducting federal, state, and local taxes, as well as other deductions like social security, Medicare, retirement plan contributions, health insurance premiums, and any other garnishments or deductions.
• Issuing payments: Paying employees either through direct deposit to their bank accounts, paper checks, or pay cards.
• Reporting and record-keeping: Maintaining records of payroll transactions and ensuring compliance with employment and tax laws. This includes reporting to government agencies and providing employees with payroll-related documents such as pay stubs and year-end tax forms (e.g., W-2 forms in the United States).
• Compliance with laws and regulations: Ensuring that the payroll process complies with all relevant laws and regulations, including tax laws, minimum wage requirements, overtime rules, and record-keeping laws.

Payroll processing can be handled in-house by you or your accounting or human resources department or it can be outsourced to specialized payroll service providers. This guide outlines how to run payroll and you can scale it up or down to match your needs from there.

When handling in-house, the purpose of payroll software is to automate many aspects of the payroll process and help ensure accuracy and compliance.

Typical Payroll Cycles

Common payroll cycles refer to the frequency an organization calculates and distributes wages to its employees. 

The choice of payroll cycle can impact your cash flow and the employees' budgeting. 

Here are the most common types:

1. Weekly payroll: Employees are paid once a week, often on a specific day like Friday. This results in 52 pay periods per year.
2. Bi-weekly payroll: In this cycle, employees are paid every two weeks, typically resulting in 26 pay periods per year.
3. Semi-monthly payroll: Employees are paid twice a month, usually on the 1st and 15th or the 15th and last day of the month. This results in 24 pay periods per year. 
4. Monthly payroll: This cycle involves paying employees once a month, resulting in 12 pay periods per year.

The choice of payroll cycle can depend on various factors, including the nature of the workforce (salaried vs. hourly employees), administrative capacity, cash flow considerations, and employee preferences.

Additionally, some regions or countries may have legal requirements or customary practices that influence the choice of payroll cycle.

What’s Needed To Process Payroll

OK, we’re getting into the nuts and bolts now. Small businesses should consider using free HR platforms for managing payroll while keeping overhead costs low.

To run an accurate, compliant payroll process, you’re also going to need:

• An employer identification number (EIN) and state/local tax IDs.
• Employee information: Accurate and up-to-date records of all employees, including their full names, addresses, social security numbers or equivalent identification, employment start dates, and other relevant personal details.
• Employment contracts: Detailed records of employment terms, including salary or hourly rates, overtime rates, bonus or commission structures, and any other compensation agreements.
• Timekeeping system: For hourly employees, a reliable system to track hours worked, including regular hours, overtime, and any leave taken, such as vacation or sick leave.
• Payroll schedule: A clear payroll schedule (weekly, bi-weekly, semi-monthly, or monthly) that complies with local labor laws.
• Tax information: Understanding local, state, and federal tax laws is essential. Integrating robust business tax software can ensure compliance and ease the burden of manual calculations. Don't forget, this includes federal income tax, Social Security, Medicare, and any state or local taxes.
• Benefits information: Details of any benefits provided to employees, such as health insurance, retirement plans, and other perks, and how these impact payroll calculations.
• Bank account information: For organizations offering direct deposit, current bank account information for each employee is necessary.

Small businesses can benefit from a payroll automation solution that handles complex tasks with minimal oversight, as you may not yet have a full accounting/payroll/bookkeeping staff yet.

How To Process Payroll

The role of HR in small-to-medium enterprise and large enterprises includes managing payroll systems that balance compliance with cost-efficiency.

Imagining that you’re starting from scratch, here’s how to set up and run an efficient, compliant payroll process.

Step 1: Pick your tools

• Most folks use some sort of small business payroll software solution for this process. Pick something that fits your needs and budget, plus is easy to use if you don't have a dedicated accountant yet.

Step 2: Gain your EIN and state/local tax IDs

• Follow this guide from the IRS to do so.

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Step 3: Establish your payroll policy

Even if you're doing payroll for a business with one employee, it's best to have a clear payroll policy.

• Define payroll schedule: Define payroll schedule: Decide on a regular payroll cycle (weekly, bi-weekly, semi-monthly, or monthly) and set up necessary tools, including financial management software, to streamline the process.
• Set up payroll policies: Establish clear policies for overtime, leave, benefits, deductions, and other payroll-related aspects.

Step 4: Collect and verify employee information

• Check employee data: Check you have accurate employee information including:
  • Tax forms (W-4, W-9, I-9)
  • Identification numbers (like Social Security numbers)
  • Deductions: benefits such as health insurance and retirement plans
  • Bank account details
  • Employment contracts with correct salary or hourly rates.

Step 5: Track time and attendance

• Tally work hours: For hourly employees, track the number of hours worked, including regular hours and overtime.
• Manage leave and absences: Take note of any vacation, sick leave, or other absences as it pertains to worker pay.

Step 6: Calculate gross pay

• Determine gross pay for hourly employees: Multiply the number of regular hours worked by the hourly rate, and add any overtime pay.
• Calculate gross pay for salaried employees: Divide annual salary by the number of pay periods to get the gross pay for each cycle.

Step 7: Calculate deductions

• Withhold taxes: Calculate and withhold federal, state, and local taxes based on employee tax information.
• Deduct benefits and other contributions: Deduct contributions for benefits like health insurance, retirement plans, etc.
• Account for other deductions: Include any other garnishments or deductions legally required or agreed upon.

Step 8: Determine net pay

• Subtract deductions from gross pay: The result after all deductions is the net pay for each employee.

Step 9: Process payments

• Issue payments: Pay employees via the chosen method (direct deposit, check, cash, etc.).
• Provide pay stubs: Distribute pay stubs to employees, detailing gross pay, deductions, and net pay.

Step 10: Record and report payroll

• Maintain records: Keep detailed records of each payroll cycle for internal and legal purposes.
• Report to government agencies: File required reports with tax authorities and other government agencies.

Step 11: Prepare for year-end processing

• Year-end reports: Prepare and distribute year-end tax documents to employees (like W-2s in the U.S.).
• Reconcile yearly data: Ensure all payroll data for the year is accurate and complete.

Step 12: Review and update payroll information

• Regular audits: Periodically audit the payroll process for accuracy and compliance.
• Update policies and records: Make adjustments as needed for changes in tax laws, employee information, or company policies.

Payroll Management Best Practices

Follow these best practices to help ensure you run an efficient and accurate process.

• Stay updated on regulations: Regularly update your knowledge of local, state, and federal tax laws and employment regulations. This includes understanding changes in tax rates, minimum wage laws, overtime rules, and benefits regulations. Resources like the US government’s compliance assistance will help here.
• Maintain accurate employee records: Keep accurate and up-to-date records of all employees, including their details, tax information, benefits, and any changes in their employment status or pay rate.
• Regular audits and reconciliation: Periodically audit your payroll process to ensure accuracy and reconcile payroll records with bank statements and general ledger accounts regularly.
• Open communication with managers. Communicate your payroll process with any managers highlighting what’s required of them and when.
• Clear communication with employees: Maintain open lines of communication regarding payroll policies and changes, provide clear, detailed pay stubs, and be available to answer employee queries about their pay.
• Timely and accurate tax filings: Ensure that all payroll-related tax filings are accurate and submitted on time. This includes withholding the correct tax amounts and timely remittance to tax authorities.
• Data security and privacy: Implement strong security measures to protect sensitive payroll data. This includes safeguarding digital records and ensuring privacy in handling employee information.
• Make efficient use of technology:
  • Invest in payroll software that can automate calculations, manage data, and stay updated with the latest tax rates and regulatory changes. To help, here are some key payroll software features.
  • Use a reliable system for tracking employee hours, especially for hourly workers. Ensure that the system accurately captures regular hours, overtime, and leave.
  • When handling payroll in a small business, consider a free-to-use payroll system to keep things simple and cost-effective.
• Prepare for year-end processing early: Start the year-end payroll process well in advance. This includes verifying employee information, updating payroll records, and preparing for tax document distribution.
• Seek professional advice: When in doubt, consult with payroll experts or legal advisors, especially for complex issues or major changes in payroll laws and practices.
• Document payroll procedures: Maintain a written record of all payroll procedures. This helps in maintaining consistency and serves as a training tool for new staff.
• Plan for contingencies: Have a backup plan for payroll processing in case of emergencies or unexpected disruptions (like technological issues or natural disasters).
• Seek employee input. As Malcolm Ferrante, senior accountant at CBS Group, highlights “Seeking employee input can also shed light on pain points and highlight opportunities for improvement.”
• Double and triple-check EVERYTHING before submitting.

Payroll Taxes

For your payroll process to remain compliant, you have to deduct the appropriate payroll taxes from the employee’s paycheck:

• Social security: Known collectively as FICA taxes, both you and your employees contribute to these. The Social Security tax is 6.2%, paid by both the employee and the employer, for a total of 12.4%. 
• Medicare taxes: The tax for Medicare is 1.45% for the employer and 1.45% for the employee, for a total Medicare tax of 2.9%.
• State and local taxes: Some states and local authorities might impose additional taxes.

Here’s a more comprehensive breakdown of payroll taxes.

Payroll Regulations

A mix of federal and state laws govern the payroll process. Here’s what to look out for:

• Minimum wage: The Wages and the Fair Labor Standards Act (FLSA) sets the minimum wage as $7.25 per hour although some state minimum wages are higher.
• Overtime pay: Unless exempt, the FLSA states that any hours worked over 40 hours must be paid to employees as overtime pay.
• Pay frequency: Monthly payday requirements “must be consistent” at a federal level, but state laws vary
• Payment methods: While no federal law exists, some states have laws determining which payment method(s) you can use e.g. direct deposit or pay cards. To help, use this resource of wage payment laws.
• Payroll taxes: Must calculate all payroll taxes correctly and pay them on time
• Tax forms: Must file payroll tax forms on time
• Recordkeeping requirements: The FSLA requires employers to keep payroll records for non-exempt employees for at least three years.
• Paid sick leave: Federal law doesn’t require sick leave but, at the time of writing, there are 14 states with their own paid sick time laws.
• Paid family leave: While no federal law exists, at the time of writing, 13 states have mandatory paid family leave systems.

Required Payroll Documents

Here’s a list of the documents you need for processing payroll:

• Form 940: An annual federal tax form that employers must file if they’ve paid wages of $1,500 or more in a calendar quarter. It's used to report the employer's annual Federal Unemployment Tax Act (FUTA) tax liability.
• Form 941L: A form that employers must file quarterly to indicate how much they withheld in payroll taxes across all their employees per quarter. It's necessary for most small businesses that withhold federal income taxes and FICA taxes from their employees' paychecks.
• Form 944: A form that businesses must file if their annual liability for Social Security tax, Medicare Tax, and federal income tax is $1,000 or less.
• Form W-4: Also known as the Employee's Withholding Certificate, this form is filled out by employees upon being hired to let their employers know how much tax the employers should withhold from their paychecks.
• Form 1095-C: An employer-provided health insurance offer and coverage form that applicable large employers must file. It includes information about the health coverage for the employee, including the cost and covered months.
• Form 1096: A form used by the payers to summarize 1099-INT Forms being filed with the IRS. It's only required when 1099-INT Forms are filed by paper.
• Form 1099: A tax document that details any earnings received outside of the salary paid by an employer. It's required for self-employed people or those who run a side hustle. 

The Impact Of Effective Payroll Management On Business Objectives

Effective payroll management isn't just another administrative task. It's a critical component in aligning with broader business goals for five key reasons:

1. Financial Stability and Budget Management: Accurate and efficient payroll management ensures that a significant portion of the company's expenses (employee salaries and benefits) are correctly budgeted and managed. This financial stability is crucial for long-term planning and investment, directly impacting the company's ability to achieve its strategic objectives.
2. Employee Satisfaction and Retention: Timely and accurate payroll processing contributes significantly to employee satisfaction. Satisfied employees are more engaged, productive, and loyal, which is essential for achieving business goals related to workforce stability, quality of work, and company reputation.
3. Regulatory Compliance: Proper payroll management ensures compliance with tax laws and labor regulations. This compliance is vital for avoiding legal penalties and maintaining a positive company image, which in turn supports broader business objectives like market credibility and operational continuity.
4. Resource Allocation: By streamlining payroll processes, resources (both time and money) can be more effectively allocated to other strategic areas of the business, such as growth initiatives, innovation, and market expansion.
5. Data-Driven Decisions: Efficient payroll systems often provide valuable data on labor costs and trends, which can inform strategic decision-making in areas like staffing, budgeting, and compensation strategies, aligning closely with the company's overall business objectives.

Managing Payroll In-House Vs Outsourcing

Rather than trying to handle everything in-house, some organizations choose to outsource payroll to an external payroll service.

This is particularly the case with organizations with employees in different jurisdictions.

The meaning of payroll service is any outsourced solution provided by external companies that specialize in handling all aspects of payroll processing for other businesses.

These services take on the responsibility of managing employee payments, including calculating wages, deducting taxes, and ensuring compliance with legal and tax requirements.

The goal of payroll services is to streamline payroll operations, reduce the administrative burden on internal staff, and mitigate compliance risks associated with payroll management.

These services are particularly useful for managing global payroll.

What payroll services can assist with:

• Wage calculation: Payroll services compute employees' earnings based on their work hours, salary agreements, and other compensatory elements like bonuses and overtime.
• Tax deductions and filings: These services handle all required tax withholdings from employee paychecks and ensure that these are correctly deposited with the appropriate government agencies. They also manage the filing of payroll-related tax documents, such as W-2s and 1099s.
• Regulatory compliance: They stay updated on changes in employment law and tax regulations to ensure that the business complies with all applicable laws, thus reducing the risk of penalties and legal issues.
• Direct deposits and payment management: Payroll services facilitate the direct deposit of salaries into employee bank accounts, and some also offer options for pay cards for employees who do not have bank accounts.
• Employee self-service platforms: Many payroll services provide online portals through which employees can access their pay stubs, tax forms, and personal payroll history.
• Reporting: They provide detailed reports on payroll expenses, tax withholdings, and other financial data, which are essential for financial planning and analysis.

Cost Analysis Of In-House Vs Outsourcing Payroll

Another factor for small businesses is of course cost. Here's a simplified table that compares the cost analysis between managing payroll in-house and outsourcing it.

Cost Factor	In-House Payroll	Outsourcing Payroll
Software	Payroll software costs; hardware costs if needed.	Included in the service fee of the provider.
Staffing	Salaries for payroll staff; benefits and training costs.	No direct staffing costs; handled by the provider.
Training	Ongoing training for software updates and legal compliance.	Typically not required as the provider manages updates and compliance.
Compliance	Costs associated with staying compliant with tax laws and regulations.	Compliance is typically managed by the provider, reducing direct costs.
Operational Time	Time spent by staff in processing payroll, generating reports, etc.	Time is saved as the provider handles most of the operational tasks.
Error Correction	Potential costs related to errors in payroll processing.	Reduced error rates due to specialized expertise; any errors are typically the provider's responsibility to correct.
Software Updates	Regular software update costs.	Included in the service fee; the provider ensures software is up-to-date.
Scalability	May require additional investment as the company grows.	Outsourcing is often more scalable with variable costs depending on company size and needs.
Security	Costs for securing payroll data and ensuring privacy.	Security is managed by the provider, though due diligence is required to ensure their standards meet your needs.
Miscellaneous Costs	Costs for printing, distributing payslips, etc.	Often reduced or eliminated as most processes are handled digitally by the provider.

In conclusion, the cost of payroll is generally higher when it's in-house but it offers more direct control. 

Outsourcing services can be more cost-effective in terms of operational time and resource management, but it requires trust in the chosen provider.

For a more accurate analysis, specific quotes and assessments should be obtained based on the needs of your business. I suggest using this table just as a guide.

Using Payroll Software

Payroll software makes managing the payroll process considerably easier. Features and benefits include:

• Pay calculator: The software must be able to process your employee’s pay, including automatically calculating wages, deductions, and taxes. This eliminates manual errors and saves time, making the process more efficient.
• Tax deductions: The system will calculate federal, state, and local taxes to be withheld, ensuring compliance with tax laws.
• Tax compliance forms: Compliance tax regulations require payroll software to prepare year-end tax forms for employees such as the W2 and T4 forms.
• Benefit deductions: The software often handles deductions for benefits such as health insurance, retirement contributions, and other employee benefits.
• Pay distribution: It can facilitate direct deposits to employees’ bank accounts, produce checks, and manage other forms of payment distribution such as unlimited payroll runs or pay-on-demand options.
• Compliance: Helps ensure compliance with employment laws and reporting requirements by generating necessary reports and forms, such as end-of-year tax forms.
• Time and attendance tracking: Many payroll systems also include timekeeping features that track employee hours, absences, and leave balances.
• Customizable payroll reports: The ability to customize your payroll reports to track payroll taxes, employee deductions, and other expenses can help with budgeting and financial forecasting.
• Self-service: Many payroll and HR apps have a self-service portal where employees can access digital copies of their pay stubs, see their contributions, and manage their retirement accounts.
• Analytics: Dashboards, graphs, and reports to analyze payroll data to gather insights about your staff. These analytics support your organization’s workforce planning efforts. 

For more details, check out our pick of the best payroll software.

Get (Pay)rolling Smoothly

Whether you're the head of HR at a small business or the owner of said business, the technicalities of payroll can feel like a lot to think about. But once you know your local tax regulations and get your forms and processes in order, things start to get a little easier.

Here are a few key takeaways:

• It's important to follow payroll best practices so your business meets the needs of its employees and the requirements of the government.
• When selecting payroll software, be sure to read reviews and note the pros and cons so you can make the best selection for your business.
• Whether you keep payroll in-house or outsource it, there are perks to both sides. This is a personal choice, made to suit the unique needs of your business.

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You can also check out our guide on outsourcing HR to discover what other HR functions could benefit from being outsourced.