Payroll is the process of employers paying their employees for work they’ve completed. That process, as a whole, encompasses many things—from calculating gross and net wages to making payments to tax agencies (including the Internal Revenue Service) and vendors that provide employee benefits. In some cases, such as when a court garnishment order is received, it even includes withholding money to pay an employee’s creditors.
Handling payroll the right way is important. Employers should be diligent to ensure that their employees receive the funds they’re legally entitled to in a timely manner. Many labor laws, such as overtime pay and minimum wage, also affect payroll.
- Payroll is the process of paying your employees for work they’ve already done, handling taxes and deductions, and keeping accurate records.
- Payroll mistakes can lead to costly fines, employee lawsuits, and lowered productivity.
- As a business owner, transparent insight into your company’s payroll process is imperative.
Why Payroll Is Important
Payroll is a critical component of any business. It’s not just about paying your employees on time, though that is extremely important. It’s also about proper and accurate tax filings, government reporting, and annual business and employee wage reports.
Payroll directly impacts your employees’ morale and trust in the company. Timely and accurate payment reassures your team the company values their work and contributes to their overall job satisfaction. A well-managed payroll system can help retain top talent, as employees are more likely to leave if they experience consistent issues with their pay.
Businesses are legally obliged to withhold certain taxes from employee wages and remit them to the appropriate government agencies, making compliance crucial. Failure to do so can result in hefty fines and penalties.
Payroll also plays an important role in your company’s financial management. It’s often one of the largest expenses for a business, so accurate payroll records are essential for budgeting and financial planning. They also provide important data for financial reports and audits.
What Happens When You Run Payroll?
While many people may define payroll as “just” paying your workers, processing payroll really consists of much more. Here are some of the basic things you’ll need to do when running payroll:
- Determining your employees’ gross wages, either a flat rate if they’re salaried or by multiplying hourly wages by hours worked; don’t forget about overtime for your nonexempt employees
- Withholding all required payroll taxes (federal, state, and local) and remitting taxes to the appropriate agencies on time
- Withholding all employee benefit premiums—medical, 401(k), life insurance, etc.—and ensuring that payments are made to the appropriate vendors
- Issuing payments to employees on time via their preferred method of payment (adhering to state laws) and providing them with pay statements for both their records and yours
And that’s just to make sure that your team is paid properly each pay period. You’ll also need to ensure that you stay on top of maintaining your payroll information and complying with all filing requirements.
Some components of payroll are different depending on the type of work you do. For example, if you’re working on a federal contract, you may be responsible for submitting weekly certified payroll documents with details of all hours worked and amounts paid to the agency that’s funding your project.
What You’ll Need to Run Payroll
Payroll is a process that requires many documents, tools, and resources to handle appropriately. Some of the things employers will need while running payroll include:
- Employer Identification Number (EIN)
- Business bank account (not required, but definitely best practice)
- Payroll legal compliance resources (federal, state, and local)
- Tips for effectively managing payroll
- Knowledge of how to calculate payroll and/or a calculator tool
- Time sheets and a time card calculator (if employing hourly workers)
- Payroll deduction amounts (such as taxes, benefits contributions, and wage garnishments)
- Payroll forms
All-in-one payroll software, like Gusto, is also a great tool to have. It automates your process and takes the liability off the business owner. Learn more in our Gusto review.
If you’re not quite ready for advanced payroll software, you may want to check out our article on the best free payroll software.
How Is Payroll Different From HR or Accounting?
Since payroll, human resources (HR), and accounting are often very closely related when discussing running a small business, it can be confusing to know the difference. Here are some of the most important components that can help you better understand what each of them encompasses:
Paycheck and tax calculations
Employment and labor laws
Balancing cash movement in the bank account to the general ledger (books)
Process of withholding money for employee benefits
Implementing HR policies like offering insurance benefits when reaching 50 full-time equivalent employees
Classifying money withheld from employee paychecks as liabilities until payment is made to benefit providers and tax agencies
Calculating holiday pay according to company policy
Creating and managing holiday pay policy
Correcting payroll errors on the books
Accurately paying employees for their PTO
Setting up and implementing a PTO policy
Keeping a log of outstanding PTO as a liability on the books (in states like California where PTO must be paid out upon termination)
Payroll vs HR
Payroll is more focused on the calculations and process of paying your employees, whereas HR covers policies and labor laws affecting different aspects of payroll. The main focus of HR is to manage employees, including functions such as employee onboarding, interviewing candidates, and employee conflict resolution.
HR professionals will also create employee handbooks, establish workplace policies, train new staff members, and work to ensure that existing staff is engaged.
Overall, HR is the process of managing employees (which includes salary amounts and PTO policies), while payroll is the process of actually paying those employees for work completed.
Payroll vs Accounting
Although payroll amounts need to align with accounting records and are vital to ensure the accuracy of financial statements, payroll processing and accounting are two very different roles. Accounting is defined as the process of keeping financial records and then analyzing, verifying, and reporting the results. A big component of accounting is creating and managing financial statements (balance sheets, income statements, etc.).
Keeping these financial records is the overall purpose of accounting, while payroll is the process of issuing payments from the company account to pay employees.
Payroll for Contractors vs Employees
Many people associate payroll with the process of issuing payments to W-2 employees only. However, it can also include contract (or 1099) workers.
The primary difference between paying W-2 employees vs 1099 contractors is that you don’t need to withhold payroll taxes for contractors. You pay them what they earn—ideally, after you’ve received an invoice from them—and give them a 1099 form at the end of the year detailing their earnings; they then handle paying their own tax bills.
What Is Payroll for Contractors?
Independent contractors are people you hire to perform work for you, usually on a case-by-case or project basis. They’re not employees. You pay them at an agreed-upon rate and shouldn’t withhold money for taxes or insurance. Contractors are responsible for paying their own payroll taxes, and employee benefits don’t apply to them.
What Is Payroll for Employees?
Learning how to manage payroll for employees requires more work than contractor payroll. You are responsible for withholding and paying their payroll taxes. Instead of paying them the total money they earned, you must deduct Social Security, Medicare, income taxes, garnishments, and so on.
If you offer benefits, like insurance or 401(k), you must also withhold funds to pay for them. This requires a lot of tracking and calculating to ensure you are paying the correct amounts to your employees and tax agencies. Your payroll expenses are usually higher when it comes to employees vs contractors because you have to pay a percentage of the money your employees earn out of your own funds as employer payroll taxes.
Tips to Run Payroll Smoothly & Successfully
Here’s some practical advice on how to keep your payroll process smooth and successful every time.
1. Choose the Right Payroll System
Investigate multiple payroll systems before making a decision. Look for features like automatic tax calculations, direct deposit capabilities, and integrations with your current accounting software. If you have remote or freelance workers, ensure the system can handle varying tax rates and employment laws.
2. Understand Wage and Hour Laws
Thoroughly research federal, state, and local wage and hour laws. For instance, some states require overtime pay after eight hours worked in a day, not just 40 in a week. Use resources like the Department of Labor’s website or a local employment attorney to ensure you’re up-to-date on all regulations.
3. Stay on Top of Tax Obligations
Create a calendar of all tax deadlines—both monthly and quarterly—and set reminders for a few days before each is due. Be aware of how bonuses, benefits, and other special circumstances affect tax withholding. Use IRS Publication 15 as a guide.
4. Keep Accurate Records
Set up a digital filing system for employee records and keep it meticulously organized. This should include W-4s, timecards, pay stubs, and any written agreements about pay or benefits. It should also include invoices and independent contractor agreements with your freelancers and 1099 workers. Invest in cloud storage to ensure these records are safe from physical damage or loss.
5. Regularly Review Your Payroll Process
Each quarter, take the time to audit your payroll process. Check for common errors like incorrect tax withholdings or miscalculated overtime. Look for patterns in mistakes to identify if there’s a flaw in your process or system.
6. Plan for the Unexpected
Create a detailed plan for potential payroll complications. For instance, if your payroll software crashes, have a manual calculation method ready. If there’s an error on an employee’s paycheck, know in advance how you’ll rectify it to maintain trust and compliance.
If you’re looking for comprehensive tips for managing your overall payroll process, check out our 27 tips for managing payroll to help you.
Payroll Mistakes & Legal Considerations
Payroll is vital for employees. It’s their way of paying for their life needs and wants. If you mess up, you not only affect your employees, but you risk fines and legal action.
1. Misclassification of Workers
Misclassifying workers, often by labeling employees as independent contractors, is a common error with serious implications. This mistake can lead to underpaid taxes, as you’re required to withhold and pay employment taxes for employees, but not for independent contractors.
2. Inaccurate Time Tracking
Inaccurate recording of hours worked can result in both overpayment and underpayment. This not only affects your finances but could also lead to legal issues, such as wage and hour disputes or violations of overtime laws.
3. Late Tax Filings
Failing to adhere to tax deadlines can result in substantial penalties from the IRS and state tax agencies. These penalties can accumulate quickly, adding unnecessary costs to your business.
4. Wage and Hour Disputes
Inaccurate payroll can lead to wage and hour disputes, which can escalate into costly lawsuits. These disputes often arise from unpaid overtime, incorrect pay rates, or unauthorized deductions.
Types of Payroll Systems
There are many ways to go about payroll. Some, however, are more efficient than others, requiring less worry and stress on your part. Here’s a quick discussion of three of the most common approaches to payroll for small businesses.
Manual & In-house Payroll
A manual or in-house payroll system involves calculating and distributing paychecks within your business without the aid of specialized software. This includes tracking employee hours, calculating wages, withholding taxes, and issuing checks.
The payroll department keeps track of employee hours, either through timesheets or a time clock. They then calculate each employee’s gross pay, subtract necessary deductions like taxes and benefits, and issue a net paycheck. All of this happens manually or within a spreadsheet, making it ripe for errors.
|Cost-effective: There's no need to pay for expensive software or service fees.||Time-consuming: Manual payroll is labor intensive and can distract from other important business tasks.|
|Full control: You maintain complete control over your payroll process, which can be beneficial if you have unique payroll needs.||Prone to errors: Without automated checks and balances, it's easy to make mistakes in calculations.|
|Regulatory challenges: You're responsible for keeping up with tax laws and filing all necessary paperwork, which can be complex and ever-changing.|
Outsourced Payroll Service
An outsourced payroll service is a third-party company that handles all aspects of payroll on your behalf. You provide the service with information about your employees’ hours, salaries, and deductions. The payroll service then calculates pay and distributes checks, but may not handle tax filings on your behalf. They may calculate taxes for you but you’re still responsible for your tax registrations and filings.
|Time-saving: Outsourcing payroll frees up time for you to focus on other business operations.||Cost: Outsourcing can be expensive, especially for small businesses with tight budgets.|
|Expertise: Payroll services are experts in tax laws and regulatory requirements, reducing the risk of errors or legal issues.||Less control: You're entrusting a crucial business operation to an outside party, which can be nerve-wracking.|
|Scalability: As your business grows, a payroll service can easily adapt to handle more employees.|
Payroll software is a digital solution that automates the payroll process. These systems can handle time tracking, wage calculations, tax filings, and direct deposits.
You input your employees’ information and the software calculates pay, deducts taxes and other deductions, and generates paychecks or direct deposits. Many software solutions also file taxes on your behalf.
|Efficiency: Payroll software speeds up the payroll process and reduces the chance of human error.||Cost: Generally the most costly because it's the most comprehensive option. However, many consider it a worthwhile investment due to the time and resources saved.|
|Compliance: Most software stays updated with current tax laws, ensuring compliance.||Learning curve: There may be a learning curve to understand how to use the software effectively.|
|Accessibility:Cloud-based software allows you to access payroll from anywhere, making it convenient and flexible.|
Payroll can be a pretty confusing topic depending on the rules and regulations that apply to your business, but it’s essentially the process of paying your workers. It affects other areas of a business, from human resource management and labor laws to payroll accounting and taxes.
The more employees you have, the more oversight you’re subjected to, so you may want to consider payroll software when you reach a certain number of employees.