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Paying employees is a fast and fairly simple process with electronic payment systems. However, the prep work done prior to payday, which often determines if employees are paid the right amount, is more time-consuming.
Whether you have a small business with a few employees or a larger company with many workers, you want to ensure your employees are paid correctly, that you meet your obligations related to payroll taxes and that you maintain legally required paperwork.
Set up a payroll process
There are several key decisions you need to make before the first payroll run can be set into motion. To start, you'll need to decide on:
Payroll systems: Options may include running the payroll manually, purchasing payroll software, and using a bookkeeper or payroll service.
Pay schedules: Monthly, semimonthly, biweekly and weekly are common options. Adjustments to the pay schedule may need to be made for bank holidays.
Pay options: Direct deposit, check and debit card are the most common options.
Once these decisions are made, you'll also have to set up:
Withholding: Taxes (federal, state and local), Social Security and Medicare.
Deductions: Health benefits, insurance, retirement, etc.
Tax filings and payments: Specific forms, filings and payments that need to be managed by the employer.
Some payroll software products help you set up withholding by allowing employees to fill out W-4 forms and make benefits elections through self-service portals. Most also handle tax filings and payments on your behalf.
In some cases, you might also have to handle wage garnishment orders for employees. With some payroll products, garnishment management services come included in the basic plans; in other cases, you need to purchase a higher-tier plan for those services.
Whether done manually, with payroll software or by a payroll service, the following steps are used to determine the amount employees are paid.
1. Gross pay calculation
Gross pay is the total amount an employee earns before taxes and deductions are taken out of their paycheck. It's used to determine the amounts of taxes that are withheld from an employee's pay and is calculated based on an employee's classification:
Hourly employee: Gross pay is determined by the hours worked multiplied by the employee’s hourly pay rate.
Salaried employee: Gross pay is determined by dividing the employee’s annual salary by the pay periods per year.
Overtime pay and commissions could also be included in the gross pay for hourly and salaried employees. It depends on the pay structure of the business and state labor laws.
Many small businesses hire independent contractors to do work for them. But contractors aren't employees. While they may be paid at the same time as employees, the gross pay a contractor receives is a business expense and tax payments are their responsibility.
2. Tax withholding and deductions determination
Based on pre- or post-tax guidelines, the following taxes and deductions will typically be calculated for each employee:
Income taxes: Federal, state and possibly local.
FICA taxes: OASDI (Social Security) and Medicare.
Deductions: Employee-paid amounts for health care, dental, vision, retirement plans, etc.
Garnishments: Court-ordered withholding for child support, tax levy, spousal support, etc.
After the above amounts have been determined, they will be deducted from the employee's gross pay to arrive at their net pay amount.
3. Net pay delivery to employees
The net pay of each employee will be delivered to them each payday. How that is accomplished will depend on available company options and employee preference. Here are three typical options:
Direct deposit: Transfer from the employer’s bank account to the employee’s bank account.
Check: Paper check that the employee can cash or deposit into a bank account.
Debit card: Transfer from the employer’s bank account to the employee’s debit card.
In a 2020 survey from the American Payroll Association, about 94% of respondents said they receive their paychecks through direct deposit. In some states, employers can make direct deposit mandatory; in other states, businesses need to offer alternatives.
4. Tax filings and benefits payments
The employer is responsible for forwarding the taxes withheld from their employees to the appropriate taxing agency. They are also required to pay additional employer contributions for Social Security and Medicare that match the amount paid by the employee. The payment schedule for payroll taxes is typically set by the individual taxing agency.
If deductions were made for employee health, insurance and retirement plans, the premiums, along with any employer contributions, should be sent to the appropriate carrier. These payments can be made directly by the employer or automatically through payroll software or a payroll service.
Keep payroll records
Payroll records is a broad term that refers to documents associated with the payroll process. The employer needs to keep any documents used to determine an employee’s pay. For example, W-4 and W-2 forms, direct deposit authorizations, timecards, salary sheets, commission plans, employee benefits forms and pay stubs would all be considered payroll documents.
Generally, employers are required to keep most payroll records for a minimum of three years per the Fair Labor Standards Act. However, the Internal Revenue Service advises small businesses to keep tax records for at least four years. As a best practice, employers may want to maintain payroll and tax records for a longer period of time or consult a professional before destroying documents.
Mistakes to avoid
At some point, an error might be made when paying employees. Minor errors can be fixed with the next payroll run, but large mistakes can often take a significant amount of time and effort to correct and can result in an unexpected expense for the employer. Here's what to avoid.
Misclassifying employees and independent contractors
The IRS has rules for classifying workers. These rules relate to how much control the worker has over their work, their pay and their relationship with the business. Because employees and independent contractors are paid differently, incorrectly classifying them can have tax consequences and result in fines and penalties assessed against the employer.
Not paying payroll taxes when due
Employers must make payroll tax payments to the IRS on a monthly or semiweekly schedule. The frequency of payments is determined by the total tax liability of the business. If the employer doesn’t make the deposits on time, it could face penalties up to 15% of the amount due. The employer will also face similar penalties if required state payroll taxes are not paid on the scheduled date.
Not staying current on payroll laws
Employers are responsible for staying current on federal and state payroll laws, and they can face fines and penalties for not paying their employees correctly. Subscribing to newsletters, joining related business associations and attending seminars are a few ways employers can stay informed. They may also take it a step further and contract with a payroll service, professional employer organization, accountant or attorney who can advise them on changes related to payroll laws.
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