If you have at least one employee or if you are a self-employed owner of an S Corporation, setting up your payroll system can help you streamline your ability to stay on top of your legal and regulatory responsibilities as an employer. It can also help you save time and protect you from incurring costly Internal Revenue Service (IRS) penalties.
Before setting up your payroll system, make sure you have secured an Employment Identification Number (EIN), aka Employer Tax ID, from the IRS. The EIN is necessary for reporting taxes and other documents to the IRS. Also, check and secure if your state is one of those states that also requires State/Local IDs in order to process taxes.
Here are 8 steps to help you set up a payroll system for your small business:
- Know the difference between independent contractor and employee: Whether the person working for you is considered an employee or an independent contractor determines how you withhold federal and state income taxes, withhold and pay Social Security and Medicare taxes, and pay federal and state unemployment taxes.
- Take care of employee paperwork: New employees must fill out Federal Income Tax Withholding Form W-4, and its state equivalent if your state requires it, and return it to you in order for you to then start withholding the correct federal and state income taxes from their pay.
- Determine pay period: Setting up a pay-period (monthly or bi-monthly) is sometimes determined by the state law with the 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.
- Document employee compensation terms: As you set up payroll, consider other payroll related items such as how you track employee hours, if you pay overtime, how you handle paid time off, etc. Don’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 paychecks and paid to the appropriate organizations.
- Choose a payroll system: Payroll administration requires a great deal of attention to detail and accuracy. Typically, you have two options for managing your payroll – in-house, or outsourced to a local accounting firm or online payroll service provider. Regardless of the option you choose, you — as the employer — are responsible for reporting and paying off all payroll taxes.
- Run a payroll: Depending on which payroll system you choose, in-house or outsourced, you will either enter payroll information in a payroll software yourself, or give it to your accountant.
- Keep records: Federal and some state laws require that employers keep certain records for specified periods of time. For example, W-4 forms must be kept on file for 3 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.
- 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. Check the IRS’s Employer’s Tax Guide for all federal tax filing requirements and the Employer’s Tax Guide for your state for their specific tax filing requirements.