Finances and Taxes

How Do I Set Up Payroll for the First Time?

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How Do I Set Up Payroll the First Time?

There’s something we’ve got to tell you: You rock. You’ve started your business, and now you’re at the point where you’re ready to hire a few new employees and set up payroll.

It’s a big milestone for you — and you’ve created a job for someone else. How cool is that?

As exciting as growing can be, it comes with a new set of challenges. Terms like “business structure” and “EIN” are entering your vocabulary, and you’re probably starting to encounter a few confusing emotions that are the polar opposites of the elation you’ve felt so far.

We get it; we’ve helped thousands of business owners through rites of passage like setting up payroll for the first time.

Here’s our best advice for meeting most of the regulatory requirements for running payroll while saving yourself time and protecting yourself from IRS penalties.

Step 1: Get an EIN

Before you can hire anyone, you need to get an EIN (Employer Identification Number) from the IRS. In case the terminology gets confusing, people also often refer to EINs as an “Employer Tax ID.”

You’ll use your EIN to report taxes and other info to the IRS and state agencies.

Apply for an EIN online and boom — your first task is in the bag.

Step 2: Get a local or state business ID (if necessary)

Some state and local governments require companies to have ID numbers for tax processing. Contact your local and state government officials to find out if you need an additional tax ID number.

We know it’s a little annoying, but once you’re done, you can proudly check that one off the list.

Step 3: Nail down your team’s info

Now that you’re becoming an employer, you’re going to be responsible for filing reports and taxes on behalf of your team. These are the details (and forms) you’ll need to keep on hand for each employee or contractor you hire:

  • Full name
  • Employment start or termination date
  • Tax filing number (Social Security number or EIN)
  • Date of birth
  • Current address
  • Compensation details: Make sure you take the step of putting details about compensation in writing to prevent disagreements from popping up.
  • Form I-9 to verify employees’ eligibility for employment in the US
  • A W-4 for employees (or a W-9 for independent contractors)

Keep in mind that gathering this info is just the first step. To stay compliant you’ll also need to do things like submit your employees’ I-9 form for verification.

Here’s the full list (and all the links you need) to stay compliant on your employee’s first day.

But we’re talking about setting up payroll here, so let’s keep the focus on what you need to do to get your employees paid (and keep them happy).

Step 4: Classify your employees

Before you even think about adding up the payroll numbers, you need to figure out who’s an independent contractor and who’s a full-time or part-time employee. Even if this seems obvious, there are legal definitions of each — and differences between the two — that impact how much you actually owe them and how you withhold their taxes. If it’s unclear, the IRS will help figure it out for you if you fill out Form SS-8.

Why is it so important to classify employees correctly? Well, if you accidentally classify an employee as an independent contractor, for example, you wouldn’t withhold income taxes for them or pay any payroll taxes. That means you could get stuck paying back payroll taxes as a result of your mistake.

Not to mention, you could have to amend your taxes and potentially pay interest or penalties. According to an Economic Policy Institute report, studies of multiple states have shown that 10 to 20 percent of employers misclassify their employees as independent contractors. Since employees typically cost companies 25 to 30 percent more than contractors do, you want to be sure you get it right.

Similarly, the FLSA makes distinctions between exempt and nonexempt employees—in other words, those who aren’t eligible for things like overtime and those who are.

Step 5: Choose a pay period

Payday’s going to be a day your employees cherish, but what day should it actually be? And how often should you have it?

There are three things you need to think about to choose the right payroll schedule:

  1. What’s required by your state? Check out this list of federal and state payroll resources to see if there are any constraints about when or how you can run payroll.
  2. When is it best for you? Payroll is the largest expense for a lot of small businesses. Will running payroll cause cash flow problems? Is there a period of time when it’s more convenient for you to run it? Before your employees pass Go and collect $200, set up your schedule in a way you’re comfortable with.
  3. What do your employees need? Don’t forget that payroll is all about taking care of your team. They basically give you their labor on credit, and it can be hard for them if they have to wait a month to get paid. Try to get a sense of their needs and what they prefer — especially if they’re likely to have cash-flow issues of their own.

Once you decide what your pay period will be, be sure to let your employees know so they can plan accordingly.

Step 6: Pick a payroll system

Will you use a pad and pencil? Or will an online service make more sense?

The business of actually calculating payroll can be a little tough, and small business owners spend between one and five hours a month trying to get it right.

You’ll want to research your options and make sure you set up a payroll method that will help you save time and enable you to get all the nitty-gritty details right.

Ask other entrepreneurs what they use and recommend, look at reviews online, and decide whether you want to handle payroll in-house or outsource it.

Here are a few more considerations if you’re thinking about choosing the right payroll company.

Step 7: It’s go time

Once you have your act together and decided on things like pay periods, you can actually start paying people. We hope some of that excitement you feel about your business is creeping back in.

Remember, though, that cutting a few paychecks isn’t the end of the road. If you only want to know the basics of what you need, you can stop reading right now. If you want to know what you’ll need to do once you’ve set up payroll for the first time, read on.

Fall in love with modern payroll

Ongoing payroll best practices

Process payroll on time, every time

Be on time with payroll each pay period. It keeps employees happy and keeps you from making mistakes like overpaying employees (or worse, underpaying them) because you’ve rushed through payroll.

Note also that many states have requirements about how soon you need to provide the final paycheck to a departing employee, so it’s good to be in the habit of sticking to a regular payday every month.

File payroll taxes on time

Be sure to meet the IRS deadline for payroll taxes, so you don’t get fined the IRS’s 10% Failure to Deposit Penalty.

You’ll need to pay city and state payroll taxes on time throughout the year, too, or risk getting hundreds or even thousands of dollars in additional fines from local tax agencies.

Be meticulous and fill out forms correctly

Before you submit your payroll taxes, make sure you line up all those columns and lines, then triple-check to make sure each line item corresponds to your financial statement and payroll reports. Mistakes mean doing it all over again, which can cost a lot of time and money in the future.

Maintain squeaky-clean payroll records

Each time you run payroll, you’ll have to withhold federal income tax, Medicare, and Social Security from your employees’ pay. Each quarter, you’ll need to file Form 941, also known as the Employer’s Quarterly Federal Tax Return, to report how much you withheld (along with state-specific withholding forms).

Organize and find a secure place to keep up to four years of I-9 forms, W-2s, W-4s, state new hire forms, and copies of all your filed tax forms (Form 941, Form 940, and state tax forms). You’ll also need to maintain the dates and amounts of all tax deposits, timesheets, and pay stubs.

Keep everything on file for all active employees, and keep those files around for at least three years after an employee is terminated. Check with your state labor office and double-check federal laws to make sure you’re keeping track of everything that’s required.

This step can make it easier to spot issues before they arise, and it can help audits go smoothly (should they ever arise).

It may be kind of a lot to absorb, but the good news is that you only have to set up payroll once. After that first time, you should get into a routine of handling your weekly and monthly payroll responsibilities, and then preparing quarterly and year-end tax filing and reporting. But it gets easier with time.

And pretty soon, you’ll be blown away by how much you rock (and roll) with payroll.

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Updated: January 8, 2021


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