How To: Set Up Payroll

Paying contractors who work for you is relatively simple; as long as you maintain a close watch on tax-related issues, you just write a check when needed. But, from the first time that you hire a full- or part-time employee on a W-2 basis, you officially add payroll responsibilities to your permanent to-do list.

You have several options for handling the setup and periodic payroll processing, ranging from doing it entirely yourself to outsourcing the bulk of the work to someone else. The best way to make the right decisions is to gain a greater understanding of the process and potential issues.

Do You Really Need to Run Payroll?

Let’s start by seeing if you even need to run payroll right now. The bottom line is that businesses that have no W-2 employees do not need to run payroll. On the other hand, if you currently employ contractors, then you definitely need to make sure that they are not actually legally defined as employees.

If you have read our article about choosing between hiring W-2 employees and contractors, then you already know that the IRS has five different classifications for people you hire, but they typically assume that the people who work for you are employees (and thus subject to income tax withholding), unless you prove otherwise. State and local laws may carry additional requirements, as well.

The bottom line is that you have to be really sure that your contractors are not employees in disguise, subject to W-2 requirements — and payroll processing. Otherwise, you need not read any further until you hire your first W-2 employee.


Understand Your Payroll Processing Options

You have three basic options for processing payroll:

  • Do it all yourself: If you feel comfortable with the inner workings of payroll, have a relatively small workforce - and understand the federal and local laws - then you might want to consider keeping the process in house. Of course, you will want to choose from a variety of specialized software and online processing options to keep it efficient and legal.
  • Assign the task to your bookkeeper: Your bookkeeper undoubtedly uses specialized software to maintain the books, and will probably use compatible software to handle the payroll, as well. This is certainly one way to get the job done well without paying fees to a professional payroll service.
  • Outsource the process to a professional payroll service: Companies like Paychex and ADP specialize in payroll processing while possibly offering additional Human Resource support as well. You still have to do some work to get it set up initially and keep it accurate, but they guide you through the entire process. Once set up, you basically hand them some information and write a check.

Preparation is Required Before Issuing a Single Paycheck

No matter which processing option you choose, paying employees carries certain requirements. Before you can pay even one W-2 employee, you need to perform all steps needed to meet legal and logistical needs, such as the following:

  • Obtain all needed identifiers for your business: You will need to get an Employer Identification Number (EIN), and check to see if you need state and/or local identifiers, as well.
  • Carefully classify each person you need to pay: Assess employees individually to determine if they are employees or contractors. Then assess each employee to determine if they are hourly (paid by the hour) or salaried (payed per pay period regardless of hours worked). Do you base salaries for sales people partially on commissions earned? These are examples of some of the variables that affect the different calculations that must be used to compute each paycheck.
  • Decide on W-2 employee pay period: Employees are paid on a pre-defined schedule. The most common options are weekly, bi-weekly (every two weeks) or semi-monthly (such as the first and the 15th of the month).
  • Decide whether direct deposit makes sense for your business:  Offering direct payment to employees’ personal bank accounts can provide convenience to everyone. Of course, you may still need to offer print checks to employees who do not have bank accounts. Most business banks offer this service, but it’s not right for every company, particularly if the fees are too high to make it cost-effective. Check with your bank to learn the costs. If you decide to pay through direct deposit, your bank will provide the instructions needed to get started.
  • Choose a payroll service: You might want to outsource payroll responsibilities to a reliable service (Paychex and ADP are two companies that are well-known for payroll and even human resource management services for small, medium and large businesses). If you have a small workforce, you might prefer to use online services from providers such as QuickBooks Payroll, Xero, Gusto and others. Or, you can combine these options by hiring a bookkeeper who takes on most responsibilities — probably using a version of the same software that you would use when you do it yourself.

Before Choosing a Payroll Service, Make Sure that you Clearly Know What’s Involved

No payroll system is a set-it-and-forget-it proposition. You will always have to input detailed information about your company and employees during initial setup, and you have to maintain information to account for new hires and terminated employees and special payroll considerations before each pay period.

After initial setup, however, the time and effort can differ, depending on the processing option that you choose.

1) Do it Yourself (DIY)

If you feel comfortable with the inner workings of payroll, have a relatively small workforce  — and understand the federal and local laws — then you might want to consider keeping the process in house. Of course, you will want to choose from a variety of specialized software and online processing options to keep it efficient, accurate and legal.

When you choose a DIY approach, be prepared to do some additional work for every pay period — and understand all concepts related to paying employees to make sure that you do everything right. The following are things to consider before deciding to handle each aspect of payroll on your own:

  • Do you clearly understand payroll terminology? If you can define the difference between salaried (exempt) and hourly (non-exempt) employees, can distinguish between contractors and W-2 employees, know how accruals apply to vacation or sick time and understand the ins and outs of employee benefits, then you might be ready to take on the mantle yourself.
  • Are you comfortable with technology? Certainly, a learning curve exists when you use any type of software. But, you also need to understand enough about security to grant access only to those employees who need it — and keep everyone else away. Finally, you’re dealing with employee livelihoods, so do you know how to fix computer or software outages or have experts who will come in very quickly to avoid missed deadlines?
  • Are you  prepared to devote regularly-scheduled time for payroll processing? Particularly in the early days of a new business, owners cannot accurately predict their schedules. If you have a small staff of hourly employees, you might spend less than an hour to handle the entire task each period. Add lots of complexities, such as multiple pay rates, commissions, accrued time, benefits, child support and garnishments and any number of other variables, and you might spend significantly more time each pay period. Payroll processing deadlines are etched in stone, so if you can’t do it yourself, make sure that someone on your staff can be trusted with confidential information — and can handle the task.
  • Can you keep up with changes in the law? All employers must comply with the Federal Labor Standards Act (FLSA), and its provisions can change at any time, leaving you to make payroll changes that fully comply. In fact, back in  2015, we provided information about anticipated changes to overtime pay rules, which were later officially implemented pretty much as anticipated. However, subsequent lawsuits combined with the policies of the Trump Administration appear to be on track to roll those rules back. State and local laws can also change. Payroll software updates typically make the proper adjustments; however, you should keep up with changes in the law, as well. At any level, non-compliance can result in severe penalties. Also, don’t forget about the reporting and other requirements that are spelled out in the IRS Employer’s Tax Guide

Once all initial information is accurately within the system, you can process payment for each employee. You will perform the following basic steps each time you run the payroll:

  • Entering adjustments: First, make sure that all employees are accounted for. This means entering information for new employees and deactivating information for each employee who leaves.
  • Checking hours worked: You probably can expect systems to default to a standard number of hours worked by hourly employees. But, if an employee does something outside of the norm, such as taking unpaid time off, then you may have to make adjustments. Since salaried employee pay is not based on hours worked, of course, this step probably does not apply to their paychecks, but there are some exceptions, such as if they qualify for overtime pay.
  • Accounting for variations: On a similar note, any good online payroll system automatically computes things like overtime pay for qualified employees, deductions for taxes and benefits and accruals earned for vacation and sick time. But, you’ll probably have to enter much of the information needed to pay commissions.

2) Assign it to Your Bookkeeper

If this all seems like more work than you want to handle, you do not necessarily have to fully outsource your payroll to get the help you need. If you already have a bookkeeper who handles your books, then you might want to enlist his or her help. Bookkeepers typically use the same software that you would use, although they might have access to special versions, possibly at a discounted price.

Even if the bookkeeper uses the same software that you would use, you gain some advantages, such as the following:

  • First, you save time; the responsibilities that arise for each pay period are on someone else’s plate.
  • You have someone who understands the inner workings of your books and knows how and when information can be transferred from one system to another.
  • You have access to the knowledge and resources of someone who eats and breathes payroll and the associated regulations.

To be fair, it never hurts to know the answers to some or all of the DIY questions, even if your bookkeeper does the processing. Still, it’s more important for the bookkeeper to know the concepts and any legal considerations. Again, he or she probably uses payroll software, too, but bookkeepers typically choose high-quality payroll software that incorporates any future changes in the law.

You still need to participate in the setup of your system and hand over information each pay period to ensure that you issue correct payments. However, a good bookkeeper will guide you through the process that you need to follow — and help ensure that the bookkeeping system can easily transfer appropriate data directly to payroll.

3) Outsource it to a Professional Payroll Service

Choosing an outsourced payroll system tends to be straightforward; once initial setup is complete, you periodically hand over information and make sure that your bank has the funds needed to pay all employees.

Of course, outsourcing payroll comes at a price. Current estimates indicate that basic costs, typically covering basic processing, online access, direct deposit and some tax support, range from $25 to $200 per month. In many cases, businesses may spend additional money for services such as more advanced tax assistance or even delivery of paper checks. In these cases, they typically charge a base rate plus a small fee per employee (Paychex, for example charges $60 plus 6.25 per employee).

Also, be aware that many professional payroll firms don’t stop with just payroll. Many small businesses might appreciate the Human Resource (HR) services that they provide (like creating HR policies, retirement benefit management and more). You probably don’t have to ask about these services; they’ll be sure to keep you well-informed about all offerings.

Keep in mind, however, that your time is money, too. When analyzing fees, be sure to factor in the savings you realize by avoiding spending time to process periodic payrolls. You may discover that the savings meet or exceed the fees presented by prospective full-service providers.


Things to Consider When Choosing an Online Payroll Service Provider

Before taking the leap to an online service provider, consider the following:

  • Compatibility with your accounting/bookkeeping software that allows you to transfer data without re-entering it manually.
  • Ability to switch to different software if you change your mind after starting with another package, for example if you need more functionality.
  • Full costs, which include the initial purchase, periodic rates, and the costs of any features that do not come with the base product.
  • Features, which vary from one product to the next. For example, 1099 processing may serve as an extra convenience if you have to pay contractors.
  • Tax support can vary significantly. Most software will create the forms, but you may have to handle the filings yourself. You also want to check to ensure that taxes are supported for all states that you need.
  • Availability of software updates applies to what you have to do to obtain software updates in the event of changes in the law. Do updates apply only to federal issues, or do they also include state law updates? Can you view a list of the changes made by each update so you remain informed?
  • Ease of use can also vary between products, so be sure to look at sample screens to see if they seem simple to understand.
  • Support is essential for payroll processing. Can you call or email and expect a response during normal business hours within your time zone? Is weekend support available? Can you find out how long it takes for them to respond — and whether that response is helpful?

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Each time you add a new employee to your payroll system, be prepared to enter information such as the following:

  • W-4 Information: This IRS form provides personal information along with the variables needed to computer the withholding applied to each pay check.
  • Pay frequency: Most commonly, businesses pay on a weekly, bi-weekly or semi-monthly basis.
  • Benefits information: This is the information that is used to calculate withholding for benefits that the employee pays for.
  • Exemption status: Hourly employees receive extra pay for overtime, but might be docked when they work less than full-time hours. Salaried employees typically receive a flat rate of pay per period regardless of hours, with some exceptions.
  • Commission information: The payroll system must have all information needed to compute commissions, if applicable for sales staff.
  • Application of overtime pay: Overtime pay of 1-1/2 times the hourly rate is generally required by federal law for hourly employees who work longer than 40 hours in a given week. However, at the end of 2016, The U.S. Department of Labor (DOL) extended overtime rules to certain salaried employees that meet certain earnings and other requirements.
  • Accrual information: The system must understand how (and if) vacation and sick time are accrued or used.
  • Direct deposit details: If you want to offer direct deposit, make sure that your bank offers this service. As a general rule, you’ll need to provide bank information for each employee plus a canceled check. Your bank will help guide you through the setup process and let you know what you need to do to ensure that employees have an online means for viewing and printing their pay stubs, which is required by law.

Of course, for each employee on the payroll, you must also be prepared to provide the following information, which must be up-to-date for each pay period:

  • Hours worked (if applicable)
  • Whether accrued hours apply (sick or vacation)
  • Overtime hours, if applicable
  • Commission data, if applicable