Starting a business can be overwhelming. Whether you begin as a solo venture or you have a team from the first day, you’ll eventually face the task of creating a payroll system and withholding taxes on employees. Although the entire process can be complicated, luckily there are plenty of tech tools available to help you out.
When Is Payroll Necessary?
Hiring employees is a big decision. Not only are you committing to a salary, but you’ll also likely be paying benefits. For a time, some businesses can get away with bringing on independent contractors to perform some tasks, but the IRS has strict rules regarding this. Your independent contractors will need to work on their own terms, setting their own hours and using their own equipment. If you need someone to come to your location and work fixed hours each week, you’ll likely need to classify that person as an employee.
The best thing about independent contractors is that they handle their own taxes. You simply pay them an agreed-upon amount and let them handle the rest. With employees, you’ll need to withhold taxes from each paycheck and provide a Form W-2 once the tax year is up, detailing how much you paid them and the amount of taxes that were withheld. You may still need to provide a Form 1099 detailing wages paid to an independent contractor, but you’ll skip the part where you withhold taxes throughout the year.
How Do You Prepare a Payroll?
Whether you’re hiring employees or independent contractors, you’ll need to apply for an Employer Identification number from the IRS. The process takes only a few minutes and can be done completely online. This number will allow you to file taxes both federally and locally on any employees you’ve hired. It will also give you the number you need to report to independent contractors at tax time. In some locations, you’ll also need to get an identification number from state or local authorities. Check with your local government to determine what’s necessary.
Your payroll setup begins during the hiring process. You’ll put the employee’s salary and benefits agreement in writing so that there are no discrepancies later. You’ll also include a Form W-4 with each worker’s onboarding paperwork and require that it be filled out before work can begin. Each employee will also need to complete a Form I-9 verifying that he is authorized to work in the U.S., whether he’s a citizen or noncitizen. Employees will also be required to submit documentation proving residency, including but not limited to a passport, driver’s license or Social Security card.
Putting Payroll in Place
Once you have your employee documentation on file, it’s time to get your payroll started. You have three options for this:
- Contract with a third-party provider
- Use payroll software
- Use manual processes
A third-party provider like ADP or Paychex does everything for your business from remitting taxes to depositing the funds. You’ll pay a fee for this type of service, but you’ll also have the peace of mind of knowing everything’s being handled in a compliant manner. You won't have to worry about keeping up with tax laws or tracking down a technical glitch that causes an employee not to get paid on time. Many of these services can also set you up with benefits solutions.
If you do it in-house, payroll software is the easiest way to go. You’ll pay a fee for the software, but many popular solutions will automate the submission of income tax withholdings and even help you file your taxes once the year is over. If you choose to go the completely manual route, though, be prepared to do all of the calculations and remittals by hand. This can save you money and give you more control over your payment processes, but it can also put you at risk of a costly error, in addition to the extra time it takes.
Remitting Federal Payroll Taxes
Once you’ve hired your first employee, you’re responsible for withholding taxes from each paycheck. Those withholdings are based on the Form W-4 the employee completed at hiring. You’ll start by working with the IRS to set your business up to deposit employment taxes. You’ll have to determine whether you need to pay monthly or semiweekly. This is based on the amount of taxes paid in your “lookback period,” which relates to the amount you paid in taxes in the previous year. If you’re new, you won’t have a lookback period, so you’ll be a monthly payer for the first tax year. No matter what method you’re set up on, though, if you accumulate $100,000 or more in taxes on any day during your deposit period, you must deposit that tax by the next business day. This is known as the $100,000 Next-Day Deposit Rule.
If you’re using a third-party provider or software package, your withholdings will likely be handled for you. If they aren't, or if you’re going the manual route, you’ll need to pay all employment taxes by each deadline using the Electronic Federal Tax Payment System. You can schedule payments in advance, but you’ll need to make each payment by 8 p.m. Eastern time at least one calendar day before the deadline. Unfortunately, the Electronic Federal Tax Payment System is solely a payment system. You’ll need to do all calculations based on the employee’s W-4, which includes the number of allowances being taken.
Remitting State Payroll Taxes
Each state has its own policies regarding income tax collections, but in every state with an income tax, you’ll be required to withhold taxes from each check. At tax time, each employee will file a state income tax to cover any overpayments or underpayments throughout the year. In South Carolina, for example, you’ll be required to withhold taxes from each paycheck, then submit those taxes monthly unless the total withholding amount is less than $500 each quarter, at which point you’ll pay quarterly.
Like the IRS, most states have set up an electronic payment remittance, although you may also have the option of submitting a check. The withholding tables are subject to change each year, so you’ll need to make sure you have the most up-to-date information. If you’re using payroll software, these updates should be among the services provided but otherwise, you’ll have to keep up with the changes on your own.
Managing Independent Contractors
If a worker is classified as an independent contractor, you’ll still have IRS obligations, although they’re simpler than with employees. To start, you won’t even have to worry about filing with the IRS unless you pay someone $600 or more. Some employers choose to wait until a contractor reaches that $600 to ask him to complete a Form W-9, which provides the information necessary to report payments to the IRS, including contact information and Social Security numbers.
At the end of the tax year, you’ll issue a 1099 form for every contractor who performed $600 or more in work for you. It’s important to note that these requirements apply specifically to business payments. If you pay a nanny or landscaper for services performed for your home and family, you won’t need to require a Form W-9 or 1099 for those workers, unless the person qualifies as a household employee. Those contractors will need to file taxes for the money they make, but you aren’t obligated to report the income to the IRS.
Can Employees Be Paid in Cash?
In some situations, employers may prefer to pay workers in cash, especially if the person is only performing a quick one-off job. But even if you pay in cash, the IRS requires you to report it. In many cases, accountants will discourage you from paying this way, since it makes it difficult to ensure you’re accurately deducting payroll taxes. It also means you’ll have to take extra steps to document the payments since an auditor will want to see a paper trail of every payment you made. You’ll also need thorough documentation in case the worker files a workers’ compensation claim or requests unemployment benefits.
What if you choose to pay an employee without reporting it? This is 100 percent illegal, known as “paying under the table.” If the illegal activity is discovered, you’ll have to pay the taxes with interest, as well as penalties for tax evasion. For businesses, that penalty can be as high as $250,000, and corporations can pay as much as $500,000. In addition, you can face up to five years in prison.
Paying Hourly Employees
As if payroll weren’t complex enough, some employers face the challenge of paying hourly workers. This is especially true for retailers and service-based businesses. With hourly workers, you’ll need a way to track the hours your employees put in each week and then easily translate the information to paychecks, withheld taxes and end-of-year filing. If you plan to employ hourly workers, make sure your payroll software is set up to easily handle that, including giving them an easy way to clock in and clock out with the information being sent to your payroll system. There are timeclock apps you can use to automate the process, and most payroll solutions integrate with at least one or two of them.
Another instance where time tracking is important is when you’re paying contractors by the hour. You’ll want to make sure you’re getting the work you’re being billed for, especially if these workers are off-site. One way is to require your contractors to clock in at the start of each shift and clock out at the end, but this doesn’t guarantee the person is working the entire time. If the freelancer works at a computer, you can install tracking software that will monitor for activity and even capture screenshots at intervals. The software only remains active when the contractor activates it at the start of each work session, so she won’t have to worry about her computer being monitored during the hours she isn’t working.
Other Payroll Tax Forms
Submitting withholdings from each paycheck is only the start of the employer’s requirements. There are forms the employer will need to file for each employee on a scheduled basis. One is Form W-3, which serves as a summary of all of the W-2 forms you send out for the tax year. You don’t send employees a copy of W-3, but you do send a copy along with your W-2s when you file your business taxes with the IRS.
You’ll also need to submit Form 940, which reports the federal unemployment taxes you paid. Like your W-2 and W-3 forms, you’ll only need to submit a 940 form once per year. You’ll also submit Form 941, which provides an accounting of the employment taxes you withheld and submitted each quarter of the tax year. These forms are in addition to the forms you file to report the income and expenses your business incurred during the year, as well as the forms you’re required to file with your state revenue agency.
- IRS: Understanding Employee vs. Contractor Designation
- IRS: Apply for an Employer Identification Number (EIN) Online
- Fit Small Business: ADP vs. Paychex vs. Gusto: Who’s the Best Payroll Provider for 2018
- Capterra: Payroll Software
- Patriot Software: How to Do Payroll Yourself
- IRS: About Publication 15, Circular E, Employer's Tax Guide
- EFTPS: Welcome to EFTPS®
- SC Dept of Revenue: Withholding
- IRS: Form 1099 MISC & Independent Contractors
- SurePayroll: Is It Illegal to Pay Employees Cash?
- Ricotta & Marks, PC: IS THERE A PENALTY FOR PAYING EMPLOYEES UNDER THE TABLE?
- ADP: Time & Labor Management Solutions
- Patriot Software: 7 IRS Payroll Forms for Small Business
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.