Payroll is the entire process of calculating and distributing payments to employees. That includes making withholdings and deductions, distributing funds and keeping records. In other contexts, it can also refer to a company’s list of employees who are paid or the total funds paid to them.

If your small business has employees, here’s what you need to know about running your payroll smoothly and staying in compliance with the law.

How can I handle my small-business payroll?

Small businesses have two major options for handling payroll processing:

  1. Payroll software: Several companies offer payroll software platforms that simplify the process of paying employees, keeping comprehensive records and avoiding errors while mostly managing payroll in-house. Most charge a monthly fee, but a few free options are also available.

  2. Payroll outsourcing: You could hire an outside service to handle your payroll. This is a more expensive option, but it takes virtually all the work of payroll processing out of your hands so you can devote more time to other aspects of your business.

While manually processing payroll is also an option, it’s not one that NerdWallet recommends. Taking a DIY approach may save you money initially, but this method is time-consuming, complex and increases your odds of errors.

What’s involved?

Outsourcing payroll or using a payroll software product sharply limits the calculations and administrative responsibilities you’ll take on, though you’ll still have to keep employee records updated, submit accurate data to your provider and approve payroll.

Gather personal and tax information: Have employees complete I-9 forms to verify they are eligible to work in the U.S. and W-4s for proper tax withholding. This can be done with paper forms, online or through employee self-service portals available on most payroll software products. You’re also responsible for verifying names, Social Security numbers, pay rates, hours worked (for hourly employees) and other deductions.

Make calculations: Payroll software products can help with this step, and payroll services generally handle it completely.

  • Calculate gross compensation: Multiply employee hours worked by their hourly wage (or for exempt employees, use their base salary for this step).

  • Calculate additional compensation: This may include overtime, tips, bonuses or commission.

  • Calculate and remit deductions: Withhold, report and pay required deductions, which may include:

    • Social Security, Medicare and unemployment as well as federal, state and local taxes. Most payroll services and software handle tax filing and payment on your behalf.

    • Benefits such as retirement plans, health insurance, health savings accounts and flexible savings accounts. If you purchased benefits through your payroll software provider, the provider might be able to remit these payments for you.

    • Garnishments for unpaid debt including alimony, child support bankruptcy, medical bills and personal debt. Some payroll services and software offer garnishment management services to help you stay in compliance with court orders and avoid penalties.

  • Calculate net pay: Add additional compensation and subtract deductions from the paycheck amount.

Approve direct deposits or distribute paychecks: After running payroll, it generally takes a few days for direct deposits or checks to land; some payroll software offers same-day or next-day deposit options.

What are the minimum requirements of payroll?

In addition to tax and garnishment withholding requirements, the Fair Labor Standards Act establishes some additional payroll standards:

  • Record-keeping: Employers must record employee hours and payment history, as well as display an official poster outlining FLSA requirements.

  • Minimum wage: Workers must receive no less than the federal minimum wage of $7.25 hourly. In states where both federal and state minimum wage laws apply, employees must receive no less than the higher of the two minimum wages.

  • Overtime: Qualified nonexempt employees are entitled to overtime pay for hours worked beyond 40 weekly. (Some states have additional laws requiring overtime paid for time exceeding eight hours in a day.)

  • Restrictions on child labor: A number of FLSA provisions protect minors by detailing conditions under which they may or may not be employed.

Your state may also have its own distinct child labor and minimum wage laws, as well as laws governing rest periods, meal periods, payday requirements and prevailing wage, the wage government contractors must offer their employees.

What happens if I make payroll errors?

Beyond compromising the trust of your valued staff, payroll errors may also bring heavy financial costs to your business or impact your cash flow. Here are just a few of the countless common payroll mistakes, the consequences and how to avoid each one.

Miscalculating pay

  • Consequences: Having to issue a payroll correction (could impact cash flow).

  • How to avoid it: Before running or approving payroll, check for discrepancies in pay rates or hours worked. If you have hourly employees, use a time-tracking app that makes accurate reporting easier.

Incorrect Social Security number or other identifying information

  • Consequences: IRS fines if a mismatch isn’t resolved.

  • How to avoid it: Double check your data entry and confirm information with employees.

Sloppy record-keeping

  • Consequences: Various IRS penalties and fines, depending on the violation.

  • How to avoid it: Keep employee records updated, well-organized and safely stored. State requirements vary, but the Small Business Administration recommends storing payroll records for six years.

Misclassifying independent contractors and employees

  • Consequences: Owing unpaid overtime, owing back FICA taxes, penalties, possible prison time.

  • How to avoid it: Familiarize yourself with IRS employee definitions and obtain proper tax forms or outsource the job of employee classification and other payroll tasks to professionals.

Missing employment tax deposit deadlines

  • Consequences: Significant IRS penalties that grow larger with time.

  • How to avoid it: If your payroll software or service is filing and paying taxes on your behalf, confirm it’s being done. If you’re paying taxes on your own, set up reminders for payroll tax payment due dates to make sure payments are made on time.

Not paying or miscalculating overtime

  • Consequences: Back overtime pay owed plus civil penalties of up to $1,000 per violation.

  • How to avoid it: Maintain careful, accurate timekeeping records and promptly pay all overtime due.

How can I pay employees?

You’ve got a few employee payment options to consider, each with its own advantages and disadvantages:

Direct deposit

  • Clear records.

  • Can’t be lost or stolen like paper checks.

  • No employee fees.

  • Not practical for employees without bank accounts.

  • May take time to set up initially.

  • Employers pay setup and transaction fees.

Additional considerations: Under federal law (Electronic Fund Transfer Act or EFTA), employers can require their employees to be paid through direct deposit as long as the employee can choose the bank through which it’s received. If you choose the bank for direct deposit, you need to offer another payment option. Additionally, some states have their own laws regarding employee consent for direct deposit or direct deposit regulations.

Physical checks

  • No bank account needed.

  • Good paper trail.

  • Can be lost or stolen.

  • Employees with no bank account may have to pay check-cashing fees.

  • It takes time to deliver checks.

Additional considerations: With this method of payment, the employer generally bears the expense of paper, printing and postage. If using the manual payroll method, writing employee checks is time-consuming and subject to errors.

Pay cards (prepaid debit cards)

  • No need to deposit or cash a check.

  • No bank account needed.

  • Same federal fraud and liability protections as bank debit cards.

  • Can be used directly to make purchases.

  • Easy and fast for employers to load funds onto pay cards.

  • Fees may apply for both employee and employer.

  • Cards may be lost or stolen.

  • Some service businesses may place a temporary freeze on pay cards, which is a problem if the card is the only way an employee can access funds.

Additional considerations: Employers can’t force employees to be paid via pay card. Individual states may also have pay card laws regarding issues including consent, withdrawal fees and viewing current balance.

What about cash?

Despite the fact that everyone tends to love cash, running a cash payroll isn’t recommended. Cash is easily lost or stolen, makes it difficult to keep accurate records and is inconvenient for employers to have to withdraw on a regular basis. Perhaps most importantly, a cash payroll could increase your risk of an IRS audit, something all businesses want to avoid.

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