Starting a business brings on a whole new set of challenges, from making your first sale to looking for ways to expand. When the time finally comes to add an employee or two to your team, you want to be sure you are following the proper steps. Setting up payroll for small businesses overwhelms many business owners and small business managers, which is why we’ve created a step-by-step guide to help you along this new journey.
Along the way, you might encounter terms you don’t know, such as independent contractors and state withholding numbers. We get it. Adding your first few employees opens the door to new obstacles that will take time to overcome. However, following the steps laid out in this guide is a great starting point to help you tackle this new challenge.
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Below, you will find the steps needed to understand how to set up payroll for small business owners laid out in chronological order. Some steps will take longer to complete than others, but all are necessary to get to the final point of processing your first payroll. Luckily, these steps will generally only need to be completed once. Keep in mind that there will be mishaps along the way, but some of the best learning methods are through trial and error.
Step 1: Apply for an EIN
Depending on your business structure, you may already have this step completed. Your Employer Identification Number, or EIN, is a series of numbers that the IRS and other regulatory agencies use to identify your business. Sole Proprietorships and Single-Member LLCs usually don’t apply for a separate EIN when the business is created because of the way the income is taxed.
If you already retain this number, great! If not, you will need to go to the IRS website and apply for an EIN online. In order to complete the application, you will be required to describe your business type, name, and owner information. Online submission for an EIN results in an immediate issuance, while mail applications can take up to 4 weeks, making it important to plan ahead.
Step 2: Obtain a Local and State Business ID
Similar to the EIN application process, you will have to submit applications for a state withholding number. The SBA recommends researching online or contacting your local government agency to determine your ID needs. As redundant as the application for a state business ID may seem, it is necessary to avoid any errors in your payroll tax withholdings and year-end tax forms.
Moreover, your state business ID number will be used to file business tax returns, sales tax forms, and required payroll forms. The issuance of the state ID can take a while, especially with agencies being backed up from the pandemic. Planning is critical to get these first two steps knocked out and on your way to successfully learning how to pay employees.
Step 3: Gather Employee Information
Once you have all of your identification numbers applied for, it’s time for the next step in setting up payroll for your small business. Gathering the necessary employee information is critical for accurate payroll processing and tax form remittances. For each employee or contractor, you will need to keep the following in your employee files:
- Full legal name
- Employment start date
- Identifying number (Social Security number for employees and EIN for independent contractors)
- Current address
- Date of birth
- Hired rate
- Form I-9
- Tax withholding rates (Form W-4 for employees or Form W-9 for independent contractors)
This information should be on file before you run your first payroll. If you pay out an employee and they quit before you obtain the required information, you could face fines and penalties from the IRS and state agencies for inaccurate reporting.
A majority of the above information is required to be remitted to regulatory agencies for unemployment and legal verification purposes. To be sure you have the necessary information on hand, create a list of onboarding documents for each new hire to complete. Better yet, use a compliance checklist to stay on track throughout the small business hiring process. What employee information is needed for payroll will depend on if the individual is an independent contractor or employee.
The U.S. Equal Employment Opportunity Commission requires that all employment records and personal information needs to be kept at a minimum for one year from the termination date. Keeping an abundance of paper opens the door to security issues and data loss, which is why many small businesses choose to invest in employee record management software.
Step 4: Classify Your Employees
The payroll set up for employees and independent contractors differs. Employees have payroll taxes withheld while independent contractors are in charge of remitting their own taxes. Misclassification can result in back payroll taxes being owed.
The IRS lays out three Common Law Rules that can help determine employment status. These sets of questions should be gone through when you are obtaining employee information to ensure correct classification in your accounting system.
- Behavioral – Who controls the specifications surrounding the employment? If you control the job duties and schedule, you have an employee. However, when there is no control, the individual is an independent contractor.
- Financial – Who controls the pay, including expenses for tools and supplies? When an individual provides their own tools and supplies, they are an independent contractor. On the other hand, if you reimburse the individual for these expenses, they will need to be paid as an employee.
- Type of Relationship – Was a written contract detailing employee benefits created? Additionally, will the work continue for an indefinite period, or is the individual being paid for a certain job? Offering employee benefits indicates you have an employee. Furthermore, being hired for a specific job with no guarantee of future work highlights an independent contractor.
Comprehending how to pay employees in a small business can seem confusing, which is why the IRS can help decide for you through Form SS-8. This form can be remitted to an IRS specialist, who reviews the circumstances of the situation to ensure you are properly setting up payroll.
In addition to differentiating between employees and independent contractors, you will have to understand when you have exempt and nonexempt employees. The Fair Labor Standards Act establishes certain criteria for classes of workers, such as minors, making it important to put safeguards in place.
Step 5: Decide on a Pay Schedule
Step 5 in understanding how to set up payroll is deciding on a pay schedule. Setting up payroll for small businesses comes with added flexibility on the pay schedules you can choose from. Common pay schedules include weekly, bi-weekly, semi-monthly, and monthly. A breakdown of what each pay schedule entails includes:
- Weekly – Your employees get paid each week, resulting in 52 payrolls a year.
- Bi-Weekly – Your employees get paid every other week, resulting in 26 payrolls a year.
- Semi-Monthly – Your employees get paid twice a month, resulting in 24 payrolls a year.
- Monthly – Your employees get paid once a month, resulting in 12 payrolls a year.
Although minimizing the number of payrolls sounds great, the cash requirements for a monthly payroll can be significant. Analyzing the following factors can help you decide on what pay schedule is right for your small business:
- Are you subject to any state requirements? Some states limit when and how you are able to run payroll, making it important to check before you set up your payroll system.
- What is best for you? As an employer, you will need to choose a payroll setup that is convenient for you. Running payroll each week can be time-intensive while running payroll once a month can be cash-intensive. Look at your cash flow cycle to determine when money regularly comes in. If you have a large number of customers who pay on the first of the month, it may be beneficial to set up payroll for the second week of the month.
- What is best for your employees? Your employees impact which pay schedule you choose. Waiting until month end to get paid can make cash flow difficult for your employees. Gauge your employees’ needs before implementing a pay schedule.
Step 6: Choose a Payroll System for your Small Business
The next step in setting up payroll for small businesses is to choose a payroll system. Does keeping track of employee hours on paper or through a payroll system make more sense for your business? How much time can you set aside each week for payroll? These are questions you will need to ask yourself to uncover how to pay employees.
Many small business owners decide to enlist the help of a payroll system that provides them with comprehensive access to payroll features. A payroll system reduces errors, speeds up processing times, and remains cost-effective. When it comes time to choose the best payroll software company, there are specific questions you should analyze including:
- How easy is it to use the payroll system? Processing payroll should not be complex. In fact, a robust payroll system should take a majority of the calculation burden off your plate. Access to mobile devices, clearly labeled features, and an inclusive menu are aspects to consider.
- Is it cost-effective for my business? Your payroll software should be cost-effective for your business. Some platforms charge a flat fee, while others charge based on your employee number.
- Does it include all the features I need? Automatic updates, deduction calculation, employee information retention, and cloud access are all features that should be considered.
- Can it scale with my business? The goal of most business owners is to grow their business by adding new employees. Payroll software should give you the opportunity to add on new employees as needed.
Step 7: Process Your First Payroll
The final step involved in setting up payroll for small businesses is processing the payroll. First, you will need to gather your employee hours. You will need to differentiate between different types of pay, including overtime and PTO, to correctly calculate employee hours worked.
Once you gather the hours worked, you will enter them into your payroll system or manually calculate the pay. Payroll taxes will need to be withheld from your employee’s pay depending on their withholding levels and applicable wage and hour laws. Be sure you read up on federal employment laws as well.
Understanding how to pay employees in a small business for the first time won’t be an easy task. Plan on taking extra time on your first payroll and don’t be discouraged if you find errors. Most errors can be resolved on the next payroll.
Once you clicked submit on your first payroll, you aren’t off the hook yet. You will need to pay any federal, state, and local taxes to the corresponding agencies.
Create an Employee Handbook
As you begin working out the little details in your payroll process, be sure to document everything in an employee handbook. Creating an employee handbook reduces questions and errors between you and your employees. Additionally, it gives you a guide to fall back on when disagreements arise. General policies and procedures, a code of conduct, compensation, and benefits should all be included. Consider using an employee handbook template to get started.
Provide Your Employees with Payslip Access
Most employees neglect to look at the breakdown of their pay, leaving errors to go undetected for weeks or even months. By providing your employees with a payslip, they are more likely to analyze their pay and catch errors quicker. Most payroll systems offer employees the ability to view their payslips; however, downloadable payslips are also an option. Even if your employees don’t look at the payslip, you should still be providing one.
Process Payroll on Time
Prioritize being on time with each payroll. Late payroll can impact your employee’s happiness, ultimately driving them to find different jobs. Moreover, timely payroll reduces the risk of underpaying or overpaying employees. Set reminders on your phone or calendar 2-3 days before the payroll is due. Keep in mind that direct deposits have a 2-day lead time, meaning you need payroll entered and submitted by Wednesday to meet a Friday pay date.
Take Your Time Filling Out Forms
Setting up payroll for small businesses comes with added responsibilities to remit required forms to the IRS and state agencies. Take your time filling out payroll forms and be sure to check everything over before you submit it. This reduces the risk of incorrect filings and any corresponding penalties.
Payroll for Small Business FAQs
How hard is setting up payroll for small business?
The ins and outs of how to set up payroll are manageable when you break it down step by step. Take it one step at a time and reach out to an expert when you get confused. Furthermore, most federal and state agencies are willing to assist you through the process of applying for identification numbers, while your payroll system provider can help you with other tasks. The process is bound to get a little tricky the first time around, so don’t feel discouraged!
How to put someone on payroll?
Putting someone on payroll can be done by obtaining the necessary employee information and setting them up in your payroll system. If this is your first employee, you will need to go through Steps 1 through 7 listed above. On the other hand, when you are adding an additional employee to the payroll, the procedures will not vary drastically from your regular processes.
How to set up payroll for one employee?
Setting up payroll for small businesses means you may only have one employee. All of the above steps will still apply; however, each payroll period will be on a smaller scale. It is not uncommon for small businesses to only add one employee as they are still in the process of growing. Finding a payroll provider that can grow with you will be key as one employee turns into two.
How to account for PTO in payroll?
Effectively managing PTO calls on the need to have plenty of tools and resources to utilize. The PTO hours your employees retain should be laid out in the employee handbook and kept track of through PTO requests and other documentation. Most importantly, be sure you separate PTO hours from regular hours when you pay your employees since payroll systems often include tracking features.
Setting up payroll for your small business doesn’t have to be overwhelming. Instead, focus on this step-by-step guide to get you started, and don’t hesitate to reach out to an expert. One way you can ease part of the setup burden is to invest in a payroll system that completes a majority of the tasks for you. For more information, reach out to a team member at Factorial HR.