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How Does Payroll Work? A Guide for Small Businesses

Payroll is essential to ensure all employees are compensated. But how does payroll work? Read on to learn about different options and solutions.

Just over 6 million small businesses have at least one employee. Business owners with employees have much more responsibility than they expected.

They feel responsible for making sure there’s always enough money to pay the employees. There are also additional taxes and overhead costs to have an employee.

One of the biggest headaches is processing payroll. If you’ve had employees for a while or thinking about hiring one, you’ll need to know how to do payroll.

How does payroll work? Keep reading to find out everything you need to know about payroll and how it works.

Necessary Paperwork When Hiring Employees

Your first priority when you hire new employees is to have them fill out the required paperwork. You’ll need to keep a copy of their job application on file in case there are questions about your hiring practices.

You also need to have an I-9 form on file, which shows that the employee is legally entitled to work in the U.S.

For tax purposes, you’ll need to have employees fill out a W-4 form. This is an employee’s way to tell you how much federal income tax you should withhold from their paychecks.

The tax code isn’t easy to follow. They need to know their filing status, dependents, and potential tax credits and deductions. If an employee wants to check how much they should have withheld, have them use the IRS tax withholding calculator.

If an employee has little income tax withheld to get more in their paycheck, they’ll pay for it later in a high tax bill in April. If they pay too much, the give the government money that they’ll get back in a tax return.

Calculating Withholdings

You’ll have to determine what exactly gets withheld from an employee’s paycheck. You need to figure out federal withholdings, state and local taxes, FICA, and any other benefits they may have withheld from their checks.

For FICA, you’ll withhold 1.45% for Medicare and 6.2% for Social Security. You’ll match these amounts when you pay your payroll taxes.

State and local withholdings will depend on your state’s laws. Some states have a flat tax, while others have no income tax at all. You want to check with your tax preparer to find out what to withhold.

Federal taxes will depend on the information on the W-4 form. You can refer to the IRS withholding tables to determine how much income tax needs to be withheld.

Distributing Paychecks and Pay Stubs

Employees prefer to have direct deposit set up in their system. You still want to have a copy of a voided check and pay stub to give to your employees.

In fact, it may be required by law to hand out pay stubs. There’s not a federal law that gives guidance on the matter, so it’s the states that have to decide.

Most states require that you at least have to give your employees access to their pay stub, either by print or electronically. You have to check the labor laws in your state to find out more.

Making Payroll Easier

Payroll can take many hours each pay period. Plus, when you use spreadsheets or pen and paper, the likelihood of errors will increase. You can make things easier on yourself by creating a system for your payroll process.

You can invest in software or a paycheck template that can simplify your workload. These tools will help you minimize your errors as well.

One other thing that can take up time is when employees make mistakes on their timesheets. You don’t want to have to go back and redo your work. You should have a written policy in place that says when all timesheets are due, when errors need to be corrected by, and remedies for mistakes made.

For example, your policy can state that employees must turn in all correct timesheets by noon the day before you process payroll. If an employee didn’t clock back in after lunch one day and didn’t report it on time, the correction will be reflected in the next paycheck.

Maintain Payroll Records

You have to keep good payroll records in case any questions come up about payroll taxes or underpaying your employees. The statute of limitations for employees to dispute amounts paid is two years.

The IRS recommends that you keep your business records for about 7 years in case of an audit.

Pay All Payroll Taxes on Time

You’ll have a deposit schedule set up with the IRS as to when you’ll make your payroll tax payments. For some businesses with a lot of employees, that can be when you pay your employees.

Other businesses may pay monthly or quarterly. You have to know when your payroll taxes are due and pay them on time.

You could get hit with an FTD, or Failure to Deposit penalty. This can be a 2% penalty on the amount unpaid if you pay just a day late. If you wait 10 days to pay, your penalty will rise to 15% of the unpaid tax.

There are some accounting and payroll systems that will automatically pay payroll taxes. If you use these or not, you have to set up reminders in your calendar to make sure the funds are there.

How Does Payroll Work?

Payroll is so much more than making a direct deposit into your employees’ bank account. While that’s the important part to maintain good employee relationships, you have a lot more responsibility on your shoulders.

How does payroll work? It works by understanding how much you need to withhold from your employees’ paychecks. You also need to know how much you need to pay in payroll taxes and pay them on time.

Want to know more about managing business operations? Check out the How To section of this site to learn more.

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