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Business

How to Run Payroll (Systematize Your Process)

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Hiring employees is a major step in the evolution of your small business. Suddenly, instead of having to do everything yourself, you’re able to delegate tasks and focus on the important things. With more people contributing, your company’s growth can take off.

But with the hiring of employees comes a lot of extra administrative headache as well, and a large part of that is figuring out how to run payroll. Not only do you have to work out how much to pay each person and make the transfer, but you also have to figure out payroll taxes. In a 2015 survey of U.S. small businesses by the National Small Business Association, payroll taxes ranked number 1 of all taxes in both financial and administrative burden.

Getting it wrong can be costly, too. In 2015, the IRS imposed 6.25 million penalties worth over $4.25 billion related to employment taxes.

So in this tutorial, you’ll learn how to set up your systems and process payroll for a small business with multiple employees. Whether you’ve just hired your first employees or whether you’ve been running payroll for a while and want to improve your process, this tutorial has you covered. You’ll learn about the different options you have, the steps you need to go through, and the mechanics of how to withhold tax and make payments to your employees.

Note that some of the details, such as the taxes and other items to be deducted, will vary in different parts of the world and for different types of companies and employees. 

In this tutorial I’ll go through the general steps of setting up a payroll system, but remember that the details may be different in your specific situation, so be sure to get a guide from your local government that explains what you need to do. In the U.S., for example, IRS Publication 15 is a useful guide to employers’ federal tax responsibilities (although states and cities also have their own tax rules to take into account).

1. Introduction to Payroll for Small Business

Let’s start by looking briefly at what a payroll system is and how it works.

Basically, a payroll system has two main functions: to ensure that the employees get paid the correct amount, and to ensure that the government gets paid the right amount of tax.

These days, many companies run their payroll systems using specialized software or online apps (which we’ll look at in the next section). But the form it takes is not important: as long as you do everything accurately, you could also run payroll using your own manual records.

So the basic components of a payroll system are:

  • accurate employee records
  • calculation of the right wages
  • calculation of withholding taxes and other government deductions
  • paying employees, either by printing cheques or making transfers
  • paying employment taxes to the government
  • keeping any necessary records

These are the basics, but depending on your employees’ situations, you may also need to account for overtime, bonuses, deductions towards a pension scheme, and more.

2. Options for Running Payroll

Paying employees sounds as if it should be an easy thing to do, but when you start having to take account of tax and other considerations, it can become quite complicated, with significant room for error. So many companies choose either to outsource payroll processing or to use specialized software or services.

Here are the main options for how to process payroll, with their pros and cons:

Hire Professionals

According to the National Small Business Association, 41% of U.S. small businesses outsource their payroll services to an external company. And the majority of businesses with more than five employees outsource.

The advantage of getting another company to do your payroll is that you no longer have the headache, and that they’re likely to get it right, since it’s their main business.

The main disadvantage is that it can be costly. That same NSBA survey found that one-third of small firms spend more than $6,000 per year on the administration of payroll and payroll taxes. That’s quite a big investment for a small company.

Of course, better deals are out there, so you may not have to spend so much. Get quotes from a few companies to see what it will cost. A couple of the biggest companies in this field are ADP and Paychex. Some of the companies mentioned in the next section also offer full-service options.

Use Payroll Software or Online Apps

Another popular option, particularly for smaller businesses, is to run payroll themselves, but using specialized software or online apps to guide them through the process and perform the calculations for them.

ADP and Paychex also offer this kind of solution, and so do many other companies, like Intuit, Gusto, and Patriot Software.

The advantage of this approach is that it’s often cheaper than hiring a full-service payroll provider, but you still get a reliable service—as long as you feed in the right information, the software will make the necessary calculations and make the process easier for you.

The downside is that you don’t get as much as you would from a full-service provider, so you’re responsible for using the software correctly. And it still costs more than option 3, which is...

Do It Yourself

If you’re confident in your own financial and technical abilities and your understanding of your country’s tax code, or if you have someone on staff who can do it for you, then you may want to run payroll entirely in-house. You can calculate wages and taxes yourself, print off paychecks, and process the payments to your employees.

The advantage of this approach is that you don’t have to pay any other providers, and everything is under your control.

The obvious disadvantage is that it can be quite complicated, and doing it without outside help may result in costly errors. Also don’t forget that your own time has a cost attached to it. If you’re spending lots of time and energy on running payroll, that’s diverting time and energy away from other, more productive things you could be doing.

We’ll go through some of the steps in the rest of this tutorial, and there are online calculators and other tools that can help you, but it can still be pretty tough to run your own payroll system, so at least consider some of the online or full-service providers.

3. Preliminary Steps

Once you’ve decided on your approach, the first step in the payroll process is to gather the necessary information on each of your employees.

At a minimum, that consists of:

  • employee's full name, address, and tax ID number
  • employee’s tax allowances and other details
  • pay rate and time period (e.g. $15 an hour, $50,000 a year, etc.)
  • details of time worked in this pay period
  • details of any overtime, bonuses, or other adjustments to pay

Most of this is quite straightforward, but I’ll just explain a bit about the second point, on tax allowances. This depends on your tax system, but in the U.S., for example, employees can claim different allowances to reduce their tax depending on whether they’re married, how many children they have, and so on. You need to know this information so that you can withhold the correct amount of tax. You can gather it by having the employee fill out a W-4 form.

4. Calculate Wages

If you’re using payroll software, it should calculate the wages for you, but it’s still good to know how to do it, so that you can understand and verify the results.

Fortunately, calculating gross wages (i.e. the total amount before tax) is quite straightforward.

If your employee is paid an annual salary, you just divide the salary by the total number of pay periods in the year. For example, if your employee earns $30,000 a year, her monthly pay would be $30,000 / 12 = $2,500. If you paid her weekly, you’d simply divide by 52 instead of 12.

If you pay by the hour, you just multiply the number of hours worked by the pay rate. Let’s say the employee earns $30 an hour, and an overtime rate of $45 an hour. In the past week, she worked 40 regular hours and 10 overtime hours. Her gross pay would be:

  • Regular hours: $30 * 40 = $1,200
  • Overtime = $45 * 10 = $450
  • Total = $1,200 + $450 = $1,650

Also be sure to add in any bonuses or other one-off items. So far it’s quite simple, but things get more complicated when the taxman gets involved...

5. Withhold Tax

Your employees have to pay tax on their wages, and in most countries they’ll also have to contribute a portion of their wages to fund some kind of social security scheme. It’s your job to take that money out of their paychecks and send it to the appropriate authorities.

On top of that, you as an employer may have to pay tax based on the number of workers you have or, more often, the amount of money they earn.

So your responsibility as an employer is to ensure that your payroll system withholds the right amount of tax and social security from the employees, and also that you as an employer pay the right amount of payroll tax.

The details vary widely by country, but here’s an example of how it would work in the UK:

Let’s say your employee, Tina, has an annual salary of £60,000.

In the UK, as in many other countries, employees get a tax-free allowance every year. A person can earn £11,000 before they pay any tax. So Tina will only pay tax on £49,000 of her annual income.

After that, income is taxed at different rates as it increases. In the UK, the bands are:

  • Up to £32,000: 20%
  • From £32,001 to £150,000: 40%
  • Over £150,001: 45%

So the tax on Tina’s salary will look like this:

  • £32,000 * 20% = £6,400
  • £17,000 * 40% = £6,800
  • Total annual tax = £13,200

Each month, then, her salary would look like this:

  • Gross pay = £60,000 / 12 = £5,000
  • Tax = £13,200 / 12 = £1,100
  • Net pay = £5,000 - £1,100 = £3,900

Note that you’d also need to perform a similar calculation to work out how much to withhold for National Insurance. And, on top of that, you’ll need to make National Insurance contributions yourself, as an employer, based on a percentage of Tina’s monthly pay above a certain threshold.

In some cases, you may need to make other adjustments to your employee’s pay, such as contributions to a retirement plan, health insurance premiums, or any vacation or sick pay.

Be clear about whether to make these adjustments before or after withholding tax. For example, in many countries, retirement plan contributions are often deducted before tax is calculated, effectively reducing the employee’s taxable income and providing an incentive for retirement saving.

6. Pay Your Employees

Once you’ve worked out how much to pay and how much to withhold, it’s time for the fun part: actually sending your employees their hard-earned money!

Traditionally, this was usually done by cheque, but electronic bank transfers are increasingly popular. The National Federation of Independent Business states that nearly 60% of employees in the U.S. are paid by direct deposit into their bank accounts.

How it works is quite simple: you just get your employee’s bank account details and make a transfer to their account, either by using your bank’s online banking software or by using your payroll software, which often includes this feature (for example, here’s Intuit’s direct deposit offering).

It’s cheaper and quicker than printing and sending cheques, and there’s less risk of cheques getting lost or stolen. Note that, even if you make the payment electronically, you’ll still need to provide a statement to each employee showing the details of their pay for that period and any taxes withheld.

7. Make Tax Reports

You also need to make reports to the tax authorities and send them any funds you’ve withheld from employees.

In the UK, for example, you’d send that £1,100 you withheld from Tina’s pay, plus the necessary National Insurance contributions, to Her Majesty's Revenue and Customs by the 22nd of the month. Failure to pay on time leads to an eye-watering 3% daily interest plus other penalties.

You also need to send reports each month on how much you paid your employees and how much you deducted from their pay. And you’ll have to report to HMRC whenever you hire a new employee or when that employee’s circumstances change.

Then you’ll need to make an annual report to HMRC at the end of each tax year, as well as sending a “P60” statement to all of your employees summarizing their total pay and deductions for the year.

Other countries have their own requirements, but it’s likely to be a fairly similar process. The basic idea is that you report regularly to the tax authorities and make prompt payments of all the money you’ve withheld from employees’ paychecks, plus any money you owe yourself.

Each country’s tax authority will also have rules on which payroll records you need to keep and for how long, so make sure you’re keeping everything you need.

Conclusion

So now you know how to set up and run a payroll system for your small business. As you’ve seen, while calculating basic pay is quite simple, making deductions for tax, social security and other items can make the process quite complicated.

A good payroll service provider or software system will take away a lot of the headache from you, so the investment may well be worth it, especially as your business grows and hires more people.

Now that you’ve got a solid grasp of payroll, it’s time to read about the more fun aspects of hiring employees for your business:

Graphic Credit

Payroll icon designed by Yamini Ahluwalia from the Noun Project.

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