The Complete Small Business Payroll Guide: Everything You Need to Know

One in three employers makes payroll mistakes, and those errors cost an average of $291 each to fix. For small businesses already operating on tight margins, payroll problems can quickly become expensive headaches that drain time, money, and employee trust.

Running payroll involves much more than simply cutting checks. You're responsible for calculating wages, withholding the correct taxes, meeting filing deadlines, and staying compliant with federal, state, and local regulations. Get it wrong, and you could face IRS penalties, employee lawsuits, or both.

This guide walks you through everything you need to know about setting up and running payroll for your small business, from initial registration to ongoing compliance.

What Is Payroll and Why Does It Matter?

Payroll encompasses two things: your roster of employees and the total compensation you distribute to them. The process of "running payroll" includes calculating employee pay, managing benefits, withholding taxes, and submitting those taxes to the appropriate government agencies.

Getting payroll right matters for several reasons:

• Legal compliance: Federal and state laws mandate specific withholding, reporting, and payment requirements
• Employee satisfaction: Nearly half of workers would start looking for a new job after experiencing payroll problems
• Financial stability: IRS penalties for payroll errors can devastate a small business's cash flow
• Business reputation: Payroll issues can damage your credibility with employees, vendors, and potential hires

Setting Up Payroll: First Steps

Before you can pay your first employee, you need to complete several essential setup tasks.

Get Your Employer Identification Number (EIN)

Your EIN is essentially your business's Social Security number. You'll need it to open business bank accounts, file taxes, and legally pay employees.

Applying for an EIN is free through the IRS. Online applications receive instant approval, while fax applications take about four business days and mail applications can take up to a month.

Register with State and Local Agencies

Depending on your business structure and location, you may need to register for state and local tax identification numbers. Tax obligations vary significantly by jurisdiction, so check with your state's department of revenue or taxation.

One critical step is enrolling in the Electronic Federal Tax Payment System (EFTPS). Nearly all federal tax deposits must be made electronically, and having this account set up in advance prevents last-minute scrambles at filing time.

Set Up Workers' Compensation

Workers' compensation insurance is mandatory in most states once you reach a certain number of employees. Requirements vary by state, so research your specific obligations. Even if not legally required, carrying workers' comp protects both your employees and your business from the financial fallout of workplace injuries.

Report New Hires

Federal and state laws require employers to report new and rehired employees to the appropriate agency, typically within 20 days of their start date. Some states require faster reporting, so verify your local requirements.

Understanding Payroll Taxes

Payroll taxes represent one of the most complex aspects of running payroll. You're responsible for withholding certain taxes from employee paychecks and paying others directly as an employer.

Taxes Withheld from Employees

Federal Income Tax: The amount depends on each employee's W-4 form and their earnings. Use IRS Publication 15-T to determine the correct withholding amount.

Social Security Tax: Employees pay 6.2% of their wages up to the annual wage base limit ($176,100 in 2025). You also pay a matching 6.2% as the employer.

Medicare Tax: Both employees and employers pay 1.45% of all wages with no cap. Employees earning over $200,000 annually pay an additional 0.9% Medicare tax.

State and Local Income Taxes: Requirements vary by location. Some states have no income tax, while others have complex systems with multiple brackets.

Employer-Paid Taxes

Federal Unemployment Tax (FUTA): Employers pay 6% on the first $7,000 of each employee's wages. Most employers receive a credit of up to 5.4% for paying state unemployment taxes, reducing the effective FUTA rate to 0.6% (maximum $42 per employee annually).

State Unemployment Tax (SUTA): Rates and wage bases vary by state and often depend on your experience rating—employers with fewer unemployment claims typically pay lower rates.

Social Security and Medicare Matching: You match the employee's contributions for both taxes, meaning your total FICA responsibility is 7.65% of each employee's wages.

The Five Steps of Running Payroll

Once you've completed setup, running payroll follows a consistent process for each pay period.

Step 1: Calculate Gross Pay

For hourly employees, multiply their hours worked by their hourly rate. For salaried employees, divide their annual salary by the number of pay periods. Don't forget to include overtime, bonuses, commissions, and other compensation.

Track hours carefully using timesheets, time-tracking software, or a scheduling system. Accurate time records protect you in case of wage disputes and help ensure you're paying employees correctly.

Step 2: Determine Withholdings and Deductions

Calculate each employee's tax withholdings based on their W-4 and applicable tax rates. Also subtract any voluntary deductions like:

• Health insurance premiums
• Retirement contributions (401(k), IRA)
• Life insurance
• Flexible spending accounts
• Wage garnishments (if applicable)

Step 3: Calculate Net Pay

Subtract all withholdings and deductions from gross pay to determine each employee's take-home pay. Double-check your calculations—errors here directly affect your employees' wallets.

Step 4: Process Payments

Pay employees according to your established schedule. Most businesses use one of these frequencies:

• Weekly: 52 pay periods per year
• Biweekly: 26 pay periods per year
• Semi-monthly: 24 pay periods per year (typically the 1st and 15th)
• Monthly: 12 pay periods per year

State laws often dictate minimum payment frequencies, so verify your local requirements. Direct deposit is the most efficient and secure payment method, though some employees may prefer paper checks.

Step 5: Deposit Taxes and File Required Forms

Deposit withheld taxes according to your deposit schedule—either monthly or semi-weekly, depending on your tax liability during the lookback period. Late deposits incur penalties of 2% to 15% of the unpaid amount.

Key payroll forms include:

• Form 941: Filed quarterly to report income taxes, Social Security, and Medicare taxes
• Form 940: Filed annually to report FUTA taxes
• Form W-2: Provided to each employee by January 31, showing annual wages and withholdings
• Form W-3: Transmits all W-2s to the Social Security Administration

Common Payroll Mistakes to Avoid

Understanding frequent errors helps you steer clear of costly problems.

Misclassifying Workers

Incorrectly labeling employees as independent contractors is one of the most expensive payroll mistakes. The IRS and state agencies actively pursue misclassification cases, and penalties can reach $25,000 or more per violation in some states.

Review the IRS guidelines for worker classification carefully. Generally, if you control when, where, and how someone works, they're likely an employee rather than a contractor.

Miscalculating Overtime

The Fair Labor Standards Act requires paying non-exempt employees 1.5 times their regular rate for hours worked beyond 40 in a week. Some states have additional requirements—California, Alaska, and Nevada mandate overtime for working more than eight hours in a single day.

Track hours accurately and understand which employees qualify for overtime. Exempt employees (typically salaried managers and professionals meeting specific criteria) don't receive overtime, but misclassifying a non-exempt employee as exempt can trigger back-pay claims and penalties.

Missing Tax Deadlines

Late payroll tax deposits cost 2% to 15% of the unpaid amount, depending on how late. Late Form 941 filings incur 5% penalties per month, up to 25%. These fees add up quickly and are entirely avoidable with proper planning.

Set calendar reminders at least a week before each deadline. Mark all quarterly and annual filing dates at the beginning of each year.

Using Outdated Tax Rates

Tax rates, wage base limits, and withholding tables change annually. Using last year's rates results in incorrect withholdings that you'll need to correct—and potentially penalties for underpayment.

Review IRS Publication 15 (Circular E) each January for updated federal rates. Check with your state tax agency for state-specific updates.

Ignoring State-Specific Requirements

Each state has unique payroll rules covering minimum wage, overtime, paid leave, and tax withholding. Operating in multiple states compounds this complexity.

Research your state's specific requirements or work with a payroll provider that handles multi-state compliance automatically.

Payroll Options for Small Businesses

You have several choices for managing payroll, each with different costs and time commitments.

DIY Payroll

Handling payroll yourself costs the least in direct expenses but requires significant time and attention. You'll need to stay current on tax rates, calculate withholdings manually, and file all required forms yourself.

This approach works best for very small businesses with simple payroll needs and owners comfortable with numbers and compliance requirements.

Payroll Software

Cloud-based payroll software automates calculations, tax filings, and payments. Most platforms cost between $4 and $8 per employee per month, making them affordable for growing businesses.

Good payroll software reduces errors by up to 80% and handles compliance automatically. Popular options include Gusto, QuickBooks Payroll, and ADP Run.

Payroll Service Providers

Full-service payroll providers handle everything from calculations to tax deposits to year-end filings. They cost more than software alone but offer peace of mind and free up your time for other business priorities.

Consider a full-service provider if you have complex payroll needs, operate in multiple states, or simply want to offload this responsibility entirely.

Keeping Accurate Payroll Records

Maintain detailed payroll records for at least four years, as recommended by the IRS. Essential records include:

• Employee information (name, address, Social Security number)
• W-4 forms
• Hours worked and pay rates
• Gross and net pay for each period
• Tax withholdings and deposits
• Benefits deductions
• Copies of all filed forms

Organize records by employee and by year for easy access during audits or employee inquiries. Digital records are acceptable as long as they're accurate and accessible.

2025-2026 Payroll Updates

Stay current on these recent changes:

Social Security Wage Base: The 2025 limit is $176,100, up from previous years. For 2026, review the updated cap when it's announced.

Reporting Thresholds: Starting with payments made in 2026, 1099-NEC and 1099-MISC reporting thresholds increase from $600 to $2,000.

W-2 Filing Deadline: The 2025 deadline for W-2s is January 31, 2026. Since that falls on a Saturday, the actual deadline moves to February 2, 2026.

Overtime Reporting: New provisions require accurate overtime tracking and reporting on W-2s starting in 2025.

Track Your Payroll Expenses Accurately

Managing payroll creates ongoing expenses that directly impact your bottom line—from the wages themselves to the employer-paid taxes and any software or service fees. Keeping clear records of these costs helps with budgeting, tax planning, and understanding your true labor costs. Beancount.io provides plain-text accounting that gives you complete transparency and control over your financial data—no black boxes, no vendor lock-in. Get started for free and see why developers and finance professionals are switching to plain-text accounting.