What Is Payroll? A Complete Guide for Small Business Owners

Nearly 50% of workers would start looking for a new job after just two payroll errors. That statistic alone reveals how critical getting payroll right is for your business. Yet roughly 40% of small businesses incur an average of $845 each year in IRS penalties from payroll mistakes.

Payroll might seem straightforward on the surface: you pay employees for their work. But beneath that simple concept lies a web of tax obligations, compliance requirements, and administrative processes that trip up countless business owners.

This guide breaks down exactly what payroll is, how the process works, and what you need to know to run payroll correctly in your small business.

What Exactly Is Payroll?

Payroll refers to two related concepts. First, it means the total amount of money you pay your employees during each pay period. Second, it describes the entire process of calculating wages, withholding taxes, and distributing payments to your workforce.

When someone asks about your payroll, they might be referring to your total labor costs or asking about your payroll system and processes. Both meanings matter for running a successful business.

The payroll process typically breaks down into three main stages:

1. Data collection: Gathering employee hours worked, salary information, and relevant tax documents
2. Calculation: Computing gross pay, deductions, taxes, and net pay
3. Disbursement: Distributing payments to employees and tax agencies

Components of Payroll

Understanding what makes up payroll helps you manage it more effectively.

Gross Pay

Gross pay is the total amount an employee earns before any deductions. For hourly workers, this equals hours worked multiplied by their hourly rate. Salaried employees receive a fixed amount per pay period regardless of hours worked, though overtime rules may still apply depending on their classification.

Payroll Taxes

Employers must withhold and remit several types of taxes:

FICA Taxes (Social Security and Medicare): These taxes fund Social Security and Medicare programs. For 2026, the combined rate is 15.3% split evenly between employer and employee:

• Social Security: 6.2% each from employer and employee (12.4% total) on wages up to $184,500
• Medicare: 1.45% each from employer and employee (2.9% total) on all wages
• Additional Medicare Tax: 0.9% on wages exceeding $200,000 (employee-only)

Federal Income Tax: The amount withheld depends on employee earnings and their Form W-4 elections. The IRS provides calculation tables in Publication 15-T.

State and Local Income Taxes: Most states impose income taxes, with the exceptions of Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Approximately 4,964 jurisdictions across 17 states also levy local income taxes.

Unemployment Taxes:

• Federal Unemployment Tax (FUTA): 0.6% after credits on the first $7,000 per employee annually
• State Unemployment Tax (SUTA): Rates vary by state and your claims history

Deductions

Beyond taxes, payroll may include deductions for:

• Health insurance premiums
• Retirement plan contributions (401k, IRA)
• Wage garnishments (court-ordered child support, tax levies)
• Union dues
• Flexible spending account contributions

Net Pay

Net pay is what employees actually receive after all taxes and deductions. This is the amount deposited into their bank accounts or printed on their paychecks.

Choosing a Pay Schedule

Your pay frequency affects both cash flow management and employee satisfaction. The most common schedules include:

Weekly: 52 pay periods annually. Employees receive pay every week on the same day. Higher administrative burden but employees appreciate the frequent paychecks.

Bi-weekly: 26 pay periods annually. Employees are paid every two weeks. This is the most popular choice for small businesses because it balances manageable cash flow with employee preferences.

Semi-monthly: 24 pay periods annually. Employees are paid on two specific dates each month (such as the 1st and 15th). This aligns well with monthly expenses but requires adjusting for weekends and holidays.

Monthly: 12 pay periods annually. Employees receive one paycheck per month. This works for salaried employees but may strain hourly workers who prefer more frequent pay.

Once you choose a schedule, consistency matters. Employees rely on their paychecks arriving when expected.

How to Process Payroll Step by Step

Step 1: Get Your Employer Identification Number

Before paying anyone, you need an Employer Identification Number (EIN) from the IRS. This nine-digit number identifies your business for tax purposes. Apply online at IRS.gov for instant issuance.

You must also enroll in the Electronic Federal Tax Payment System (EFTPS), as nearly all federal tax deposits must be made electronically.

Step 2: Register with State Agencies

Each state has its own employer registration requirements. Most states require registration with:

• The state tax agency for income tax withholding
• The state unemployment agency for unemployment insurance
• The state labor department for workers' compensation

Step 3: Collect Employee Information

When hiring, collect these forms from each employee:

• Form W-4: Employee withholding certificate for federal taxes
• State W-4 equivalent: For states with income tax
• Form I-9: Employment eligibility verification
• Direct deposit authorization

Create a new hire packet that includes all required forms. Having employees complete these during onboarding prevents delays when processing their first paycheck.

Step 4: Classify Workers Correctly

Worker misclassification is one of the costliest payroll mistakes. You must correctly distinguish:

Employees vs. Independent Contractors: Employees work under your direction and control, while independent contractors maintain independence over how they complete work. Misclassifying employees as contractors to avoid payroll taxes can result in penalties exceeding $1,000 per violation.

Exempt vs. Non-Exempt: Under the Fair Labor Standards Act, exempt employees are salaried workers who are not entitled to overtime pay. Non-exempt employees must receive overtime (1.5x their regular rate) for hours worked beyond 40 per week. The exemption status depends on salary level and job duties, not simply whether someone receives a salary.

Step 5: Track Time Accurately

For hourly employees, accurate time tracking is essential. Options include:

• Time clocks (physical or digital)
• Timekeeping software
• Mobile apps
• Manual timesheets

Have a supervisor review and approve time records before processing payroll. Errors in time tracking lead directly to payroll mistakes.

Step 6: Calculate Payroll

For each employee during each pay period:

1. Calculate gross pay (hours worked x hourly rate, or salary portion)
2. Apply pre-tax deductions (retirement contributions, some insurance premiums)
3. Calculate and withhold taxes (FICA, federal, state, local)
4. Apply post-tax deductions
5. Determine net pay

Step 7: Distribute Payments

Payment options include:

• Direct deposit: Most popular and efficient. Funds transfer directly to employee bank accounts.
• Paper checks: Still used but requires more handling and creates security risks.
• Pay cards: Prepaid debit cards useful for employees without bank accounts.

Step 8: File and Deposit Taxes

You must remit withheld taxes to the appropriate agencies according to deposit schedules:

• Federal taxes: Deposit schedule depends on your tax liability (monthly or semi-weekly)
• State taxes: Varies by state
• Quarterly filings: Form 941 (federal) and state equivalents
• Annual filings: Form W-2 for employees, Form 940 for FUTA

Common Payroll Mistakes to Avoid

The average cost of a payroll error is $291 per incident. Here are the most common mistakes and how to prevent them.

Misclassifying Workers

Treating employees as independent contractors to avoid payroll taxes is tempting but risky. The IRS and Department of Labor actively pursue misclassification cases. When in doubt, use the IRS 20-factor test or consult with an employment attorney.

Miscalculating Overtime

Federal law requires overtime pay (1.5x regular rate) for non-exempt employees working more than 40 hours per week. Some states have stricter rules. California, Alaska, and Nevada require overtime after 8 hours in a single day.

Missing Tax Deadlines

Late payroll tax deposits trigger penalties of up to 15% of the unpaid amount. Set up automated reminders or use payroll software that handles deposits automatically.

Poor Record Keeping

The FLSA requires employers to keep payroll records for at least three years, including hours worked, payment rates, and pay dates. Many states require even longer retention periods. Missing records create problems during audits.

Errors with Final Paychecks

Terminating employees requires special attention to final paychecks. You must pay out accrued vacation (depending on state law), calculate partial pay periods correctly, and meet state-specific timing requirements for final pay.

Payroll Software vs. Manual Processing

Attempting manual payroll calculation increases error risk significantly. Businesses using manual processes experience error rates around 20%. Payroll software dramatically reduces mistakes while saving time.

Modern payroll software offers:

• Automated tax calculations and updates
• Direct deposit processing
• Tax filing and payment
• Employee self-service portals
• Time tracking integration
• Compliance monitoring

Popular options for small businesses include Gusto, ADP Run, QuickBooks Payroll, OnPay, and Paychex Flex. Costs typically range from $20-80 monthly plus per-employee fees.

If your budget is extremely tight, services like Patriot Software offer plans starting around $17 monthly. The investment is worthwhile considering the cost of payroll errors and penalties.

When to Outsource Payroll

Many small business owners outsource payroll to:

• Save time on administrative tasks
• Reduce error and penalty risk
• Ensure compliance with changing regulations
• Access expertise they lack internally

Professional employer organizations (PEOs) and payroll service providers handle everything from calculations to tax filings. While this adds cost, it transfers compliance responsibility and frees you to focus on running your business.

Consider outsourcing if:

• You have limited administrative staff
• Payroll takes too much of your time
• You struggle keeping up with tax law changes
• You have employees in multiple states

The Connection Between Payroll and Bookkeeping

Payroll directly impacts your financial records. Every paycheck creates multiple accounting entries:

• Wage expenses
• Payroll tax expenses
• Liabilities for withheld taxes
• Cash reductions

Tracking these correctly is essential for accurate financial statements, tax filings, and understanding your true labor costs. Payroll data flows into your profit and loss statement, balance sheet, and cash flow projections.

Maintaining accurate payroll records makes tax time smoother and provides valuable insights into your business finances. You can analyze labor costs by department, track trends over time, and make informed decisions about hiring and compensation.

Keep Your Finances Organized from Day One

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