How to Set Up Payroll for Small Business in 7 Steps

You need an Employer Identification Number, a handbook and a payroll schedule, among other things.
Amrita Jayakumar
By Amrita Jayakumar 
Edited by Rick VanderKnyff

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Setting up a payroll system for your small business may seem like a daunting task, but it can be broken down into small steps.

Before you can hire an employee, you need to have some things in place, such as an Employer Identification Number, or EIN, and an employee handbook. Once you have these bases covered, you can set up a payroll system. Ideally, you should consult with an accountant or a labor attorney to make sure you’ve set up payroll according to your industry requirements and state laws.

Here's how to set up payroll for your small business in seven steps:

1. Get an employer identification number

Also called an EIN or federal EIN, this is a number issued by the IRS for tax administration purposes. The EIN will be used in your business filings to identify your company. Getting an EIN is free and quick — you can apply for it on the IRS website and get one immediately.

2. Find out your state’s business requirements

In addition to a federal EIN, you may have to register your business in your state and get a state ID number. This number will be used when you pay state taxes for income and employment (nine states have no state income tax). You can check whether you need a state ID number by using the Small Business Administration’s state-by-state resource. At the same time, check with an accountant or attorney about whether you need to apply for state withholding and unemployment insurance accounts.

3. Understand the difference between independent contractors and employees

As a business owner, you need to determine if the people you’re hiring should be treated as contractors or employees so you can file the correct paperwork and withhold taxes for any employees. The IRS has a guide to help you classify workers as independent contractors or employees. If you’re unsure which category is appropriate, you can file a form and ask the IRS to make the decision for you.

4. Determine the payroll schedule

You can choose to pay your employees on a weekly, biweekly, semimonthly or monthly basis depending on your business’s cash flow. The most common pay frequency is biweekly. States also have requirements about the minimum pay frequency for employees, which you can confirm with your attorney or by visiting your state’s department of labor website.

5. Create an employee handbook and time-off policies

An employee handbook is a compilation of your company’s policies and processes. It also includes the rules employees should follow and their legal rights.

Your handbook will be unique to your business, but there are free and paid online resources available to help you shape it. You can check the websites of organizations like Score, the National Association for the Self-Employed and the National Federation of Independent Business for guidance on what to include in your handbook.

One of the policies you’ll want to design is how your business manages paid time off, overtime and other types of non-mandatory leave.

6. Choose a payroll system and decide who will manage payroll

This is the big step: As a business owner, it’s up to you to decide if you’re going to run payroll with the help of payroll software or hire a payroll service company to do it for you. Many payroll software options let you automate payroll entries, file quarterly tax forms and stay compliant with federal and state laws. Payroll services are third parties that handle payroll from start to finish.

If you go with payroll software, you should also think about who will manage the payroll process going forward. If your business is small and you plan to have only a handful of employees, you can probably run payroll yourself. But if you think your company is going to grow quickly or you just won’t have the time, it might be worth hiring a payroll specialist to run it for you.

7. Ensure new employees or contractors complete the required paperwork

You're now ready to hire your very first employee. There are two forms every new employee has to complete:

  • W-4: The employee withholding certificate gives you the information you need to withhold the correct tax amounts from the employee’s paycheck. Form W-9 is used for independent contractors, but you don't need to withhold taxes for them.

  • I-9: This form verifies that the employee is eligible to work in the United States.

As an employer, you also need to verify the employee’s Social Security number and name, which you can do on the Social Security Administration’s website. You also have to file a new hire report to your state within 20 days.