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A step-by-step guide for setting up payroll for your small business

Posted by Neha De

September 5, 2023

Running a small business comes with its own set of challenges, and one crucial aspect that often gets overlooked is setting up an efficient payroll system. Payroll is the process of calculating and disbursing employee wages, taxes and deductions. A well-organized payroll system not only ensures that your staff is paid accurately and on time, but it also helps you stay compliant with tax laws and regulations.  

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Let’s look at the 11-step process of setting up payroll for your small business, so you can manage this essential aspect with confidence. 

Step 1: Obtain an Employer Identification Number (EIN).

Before you can begin processing payroll, the first thing you need to do is to secure an Employer Identification Number (EIN) from the IRS. An EIN is “a 9-digit number (for example, 12-3456789) assigned to employers, sole proprietors, corporations, partnerships, estates, trusts, certain individuals, and other entities for tax filing and reporting purposes,” as per the IRS

Applying for an EIN is straightforward, and you can do it online through the IRS website using Form SS-4. Gather the required information, such as your business name, legal structure and contact details, and complete the application to receive your EIN promptly.  

Step 2: Secure your local or state business ID, if necessary.

While it may not apply to all companies, there are some local or state governments that require businesses to obtain local or state ID numbers in order to process taxes. As the collection process varies from state to state, you’ll need to consult your local government agency where your business is located for details.  

Step 3: Collect employee information.

The next step is to gather all necessary information about your employees for the purposes of accurate payroll processing. This includes their full legal name, date of birth, current address, employment start date, Social Security number, Form I-9 (for verifying the identity and employment authorization of individuals hired for employment in the U.S.) as well as Form W-4 for full-time employees (for withholding the correct federal income tax from the employee’s pay) or Form W-9 for independent contractors (for obtaining the correct Taxpayer Identification Number, or TIN).

You will need all this information to prepare and deliver your staff’s annual Form W-2, Wage and Tax Statement.  

Step 4: Determine employee classification.

It’s essential to correctly classify your workers as either employees or independent contractors. Misclassifying employees can lead to legal and tax complications. Employees are typically subject to more oversight and tax obligations, while independent contractors are responsible for their own taxes. Understanding the distinction will help you adhere to labor laws and avoid potential penalties. 

The IRS states, “To determine whether an individual is an employee or an independent contractor under the common-law rules, the relationship of the worker and the business must be examined. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered. 

“Facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties.”  

Step 5: Select a payroll system.

Now it’s time to decide on the best payroll system for your specific business needs. You can opt for payroll software if you would prefer to do your own payroll or outsource the process to a payroll service provider. Consider factors such as the size of your company, budget and specific payroll needs when making this decision. A good payroll system will streamline the process, ensure accuracy and save you valuable time. 

Step 6: Calculate salaries and wages.

Next, determine how you will pay your workers. Consider the different pay structures, such as hourly wages, salaries or commission-based earnings. Don’t forget to factor in overtime pay and any additional incentives or bonuses. Make sure you comply with minimum wage laws, and set up a fair and competitive compensation system.  

Step 7: Withhold necessary taxes and deductions.

It is vital to withhold the correct amount from employee paychecks. This includes local, state and federal income taxes, as well as Social Security and Medicare taxes. Additionally, take into account other deductions like health insurance premiums and retirement plan contributions. Your chosen payroll system should automate these calculations to minimize errors. 

Talk to us about how Escalon’s PeopleOps can help you establish an effective payroll system.


Step 8: Set up a payroll schedule.

Choose a payroll schedule that aligns with your business’s cash flow and the needs of your workers. Typical options are weekly, bi-weekly, semi-monthly or monthly payroll. Communicate this schedule clearly with your employees so they know when to expect their pay. 

Step 9: Buy worker’s compensation insurance.

A worker’s compensation insurance policy ensures that you and your employees are just as well protected as your customers and clients. This insurance policy covers injuries incurred by you or your staff while on the job.

Step 10: Process payroll and generate payslips.

Your chosen system should streamline the payroll process by calculating wages, taxes and deductions automatically. After processing is complete, generate payslips for every employee, either digitally or in printed format, so they have a clear breakdown of their earnings and deductions. 

Step 11: File payroll taxes and reports.

As an employer, you too have specific forms for filing payroll taxes regularly. The most common ones are Form 941, Employer’s Quarterly Federal Tax Return (for reporting income taxes, Social Security tax or Medicare tax withheld from employee’s paychecks, as well as paying the employer’s portion of Social Security or Medicare tax) and Form 940, Employer’s Annual Federal Unemployment, or FUTA, Tax Return (for reporting your annual FUTA tax, which provides funds for paying unemployment compensation to workers who have lost their jobs). Be mindful of the filing deadlines and ensure you submit these reports accurately and on time to avoid penalties. 

Note: Payroll requirements and regulations can vary based on the size of your business and location, so it’s crucial that you consult with your local tax authorities or a qualified professional if you have specific questions or concerns.  

Outsource your payroll services to save money

Hiring a full-time accountant to do payroll can be a costly expense for a small business, despite being one of the most important. The U.S. Bureau of Labor Statistics reveals that the average annual salary for accountants was US$ 77,250 in May 2021. Moreover, studies have shown that businesses may need to plan for higher payroll costs going forward.  

One way to save money is to outsource your payroll services to a reputable and reliable outsourcing partner with a proven track record, positive reviews and expertise in handling the specific needs of your company.  

In addition to saving time and money, the expert outsourced payroll provider can also help ensure compliance with state and federal regulations, which ultimately reduces your risk of expensive mistakes and unforeseen penalties from the IRS. 

However, consider conducting thorough research and getting referrals before finalizing any outsourcing arrangement. In addition, always weigh the potential cost savings against the quality of service provided to ensure you are making a sound financial decision for your business.  

Want more? In addition to HR, benefits, recruiting and payroll through its PeopleOps, Escalon’s Essential Business Services include FinOps (CFO services, taxes, bookkeeping and accounting) and Risk (business insurance). Talk to an expert today.

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This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.


Neha De
Neha De

Neha De is a writer and editor with more than 13 years of experience. She has worked on a variety of genres and platforms, including books, magazine articles, blog posts and website copy. She is passionate about producing clear and concise content that is engaging and informative. In her spare time, Neha enjoys dancing, running and spending time with her family.

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