The Essential Guide to Payroll

Updated: April 30, 2009

Payroll is one of the most complex and time-consuming chores of running a business. For new business owners, learning the ins and outs of payroll can be a daunting task. Here is some guidance to the responsibilities you must fulfill.

Who Is an Employee?

Before you begin paying people for work they have done for your company, you have to determine who is and is not an employee for tax purposes. Generally, if you direct the time, place and manner in which work is done, then the individual is an employee and not an independent contractor . Many states have their own specifications defining independent contractors. You should check with your state's labor department to understand these rules.

Independent contractors are not subject to tax withholding, and their employers do not have to pay Social Security , FICA (Federal Insurance Contributions Act) and other taxes on their behalves. However, if you pay an independent contractor $600 or more during the course of a year, you must file with the IRS (Internal Revenue Service) a Form 1099-MISC to report how much you paid.

Employees, however, are subject to tax withholding. Employers must therefore contribute Social Security and other taxes. Workers are also protected by minimum wage , unemployment insurance and other laws which employers must follow when calculating, paying and reporting compensation.

New Employees

Every new hire must complete a Form W-4 , the "Employee's Withholding Allowance Certificate," as soon as they begin work. This gives you the basic information you need for payroll administration, including the employee's name, address, Social Security number, marital status and tax exemptions. You will use this information to calculate income-tax withholding based on wages paid, tips, marital status and special withholding allowance. Complete instructions for calculating withholding taxes are contained in IRS Publication E , the "Employer's Tax Guide."

Calculating Net Pay

In general, net pay is calculated as follows:

  • Gross pay
  • Minus statutory payroll-tax deductions
  • Minus voluntary deductions
  • Equals net pay

Gross pay may be calculated by hourly wages or as a flat rate (salary ) for a period of time. You will have to classify employees as exempt (salaried) or non-exempt (hourly) for purposes of payroll. The federal and state governments have rules governing who is exempt and non-exempt. Non-exempt employees must be paid at overtime rates if they work more than a certain number of hours per week or day. Consult Publication E and your state laws for further guidance.

Statutory payroll taxes must be withheld from the employee's paycheck by law. Employers must deposit these withholdings with various tax agencies. Statutory payroll deductions include:

  • Federal income tax withholding
  • Social Security tax withholding
  • Medicare tax withholding
  • State income tax withholding
  • Various local tax withholdings

FICA and Unemployment Insurance Taxes

FICA includes Social Security and Medicare taxes. These taxes are paid jointly by the employer and employee. Both parties pay half of these taxes. There is a cap on the amount of wages subject to FICA taxes, which is generally raised every year. For 2008, the maximum is $102,000. Tax rates are 6.2 percent for Social Security and 1.45 percent for Medicare before the cap.

Another tax paid solely by employers is unemployment insurance. FUTA (Federal Unemployment Tax Act) is the federal unemployment insurance tax, and SUTA (State Unemployment Tax Act) is the corresponding state tax.

Voluntary Withholdings

Voluntary withholdings are deductions for which employees have agreed to pay. These items may include health- and life-insurance premiums, retirement-plan contributions, employee stock-purchase plans , meals, uniforms, union dues and other job-related expenses. Voluntary withholdings may be paid before or after taxes, depending on the benefit.

Paying Withholding Taxes and Other Deductions

It is extremely important to pay withholding and other taxes to the various federal, state and local tax agencies on time. The penalties and interest for failing to do so are exorbitant. It is also important to pay health-insurance premiums and other voluntary deductions to the appropriate entities. Failure to do so constitutes fraud .

Along with payment, employers are required to file various reports with federal, state and local organizations. Some of the federal reporting requirements include:

  • Annual federal unemployment tax return (Form 940 or 940EZ)
  • Employer's quarterly payroll tax return (Form 941 )
  • Annual return of withheld federal income tax (Form 945 )
  • Wage and tax statements (Form W-2 )

Record Keeping Requirements

Keep all records of employees' pay and withholdings for at least four years. This will help you if complications arise with taxes and other financial information. Kept records should include:

  • Your EIN (Employer Identification Number)
  • Amounts and dates of all wage, annuity and pension payments
  • Amounts of tips reported
  • Names, addresses, Social Security numbers and occupations of employees and contractors
  • Dates of employees' and contractors' employment
  • Periods for which employees and other recipients were paid while absent due to sickness or injury, and the amount and weekly rate of payments you or third-party payers made to them
  • Copies of employees' and recipients' W-4 income-tax withholding allowance certificates
  • Dates and amounts of tax deposits you made
  • Copies of returns filed
  • Records of fringe benefits provided, including substantiation required under IRS code section 274 and related regulations

Payroll Software

As you can see, there are many potential deductions from an employee's paycheck, and a great deal of necessary record keeping. A good payroll-software program is nearly essential to keep track of pay, deductions, contributions and payments made to various tax entities. But there is much more that payroll software can do for you.

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