Payroll refers to the various tasks and responsibilities businesses must perform to pay their employees accurately and on time. It encompasses calculating wages and salaries; preparing checks or paying employees via direct deposit; withholding taxes and other deductions from employees’ pay; reporting and paying taxes to the appropriate federal, state, and local agencies; and more.
Businesses must handle payroll correctly because it impacts their net income and can result in additional fines, fees, and penalties if not managed according to federal, state, and local rules. Because payroll has legal and financial implications, it’s wise for business owners to seek guidance from professionals who can advise them on their obligations and the laws they must comply with.
How Payroll Differs from Human Resources and Accounting
So, what’s the difference between payroll, human resources, and accounting? They’re all related and overlap to some extent, but their purpose and functions are distinct in some ways.
Payroll is focused on issuing paychecks (or another method of payment) to employees for the work they perform. Part of the process is accurately calculating wages (regular and overtime) for workers who are paid an hourly rate (non-exempt employees) or salaries for workers who are not eligible for overtime (exempt workers). Payroll also involves calculating and withholding money for federal, state, and local income taxes, FICA (Social Security and Medicare) tax, and other employment-related taxes and benefit contributions. Other components in payroll processing are managing holiday, vacation, and sick pay according to the company’s policies and accurately paying employees for their paid time off.
Accounting encompasses tracking and reporting on the money going in and out of a business. It involves ensuring all income and expenses are appropriately categorized and all bank, cash, and credit accounts are reconciled. Where payroll is concerned, accounting classifies money withheld from employee paychecks as liabilities until the company pays those funds to tax agencies and benefits providers. This may also involve tracking employees’ unused paid time off as a liability so that it can be paid to workers when they exit the company (some states, like California, require that). In larger companies, payroll specialists are often part of a larger accounting department.
Human resources (HR) is concerned with labor and employment laws, ensuring that a company abides by all federal, state, and local regulations when hiring employees and maintaining a workforce. HR is also responsible for establishing company policies regarding benefits like health insurance, 401K plans, paid time off, etc.
What Employers Need to Process Payroll
Different state and local government agencies have different payroll rules. Below are some of the common payroll components.
Tax Identification Numbers
Any business that hires employees must have a federal tax ID number (known as an employer identification number, EIN) from the IRS. It must also obtain any required state or local tax ID numbers related to the jurisdictions where it will conduct payroll activities.
Employee Information and Tax Documents
Employers must request certain forms from employees before placing them on payroll and from contracted workers before issuing them payment for their services.
- Form W-4, Employee’s Withholding Allowance Certificate , Employers must request individuals who will be classified as employees to complete a W-4 form. The W-4 form collects personal information used for tax reporting purposes. It also determines the federal income tax the employer should withhold from an employee’s pay. Note that some states also have their own version of the W-4.
- Form I-9, Employment Eligibility Verification , Documents that each new employee (citizen and noncitizen) hired is authorized to work in the United States.
- Form W-9, Request for Taxpayer Identification Number and Certification , Businesses must request a completed W-9 form from individuals performing work on an independent contractor basis to whom they paid $600 or more during the tax year. The W-9 form collects personal information from contractors and freelancers and is used for reporting compensation to non-employee workers. W-9 workers do not have taxes or other deductions withheld from their pay. Those workers must report and pay all tax obligations independently via their tax returns.
Employee Salary and Wage Information
Employee payroll includes wages, salaries, overtime pay, paid time off compensation, tips, bonuses, tuition reimbursements, and commissions. To process payroll, employers need to calculate and report employees’ gross pay and net pay (after deducting tax withholdings and benefits contributions). Workers classified as independent contractors are paid according to the contracted rates agreed upon between a company and the contractor. No taxes, benefit contributions, or other deductions get withheld from compensation made to independent contractors.
Health Insurance and Retirement Plan Documentation
These documents verify the desired deductions and authorize the employer to withhold money from the employee’s pay.
Documentation Examples:
- Health insurance , Section 125 plan document
- SEP Plan , Form 5305-SEP
- Simple IRA Plans , Form 5304-SIMPLE
- 401K and profit-sharing plans , Plan document, plan amendments, or an adoption agreement
- Participant records , account balances, earnings and contributions, loan documents, compensation data, and statements and notices to participants
Employee Bank Information
Businesses must obtain workers’ banking information if they direct deposit pay into employees’ bank accounts. Information required includes:
- Bank name
- Account type (e.g., checking or savings)
- Account number
- Bank routing number
Some states require that employees sign a consent form before their employer may deposit funds into their bank accounts.
Workers’ Compensation Insurance
Workers’ compensation (“workers’ comp”) is a form of insurance that employers, in most states, are required by law to purchase. A workers’ comp policy covers costs resulting from employees’ work-related injuries and illnesses. Employees that collect workers’ compensation benefits may not sue their employer for lost wages or injuries. However, employees may be able to sue a business for things not covered by the workers’ comp insurance policy.
For most employers, workers’ comp is administered through a state-mandated program. For federal government employees, workers’ compensation insurance and claims are handled through the Federal Employees’ Compensation Act (FECA).
Understanding Payroll Withholdings and Deductions
Here’s an explanation of various types of withholdings and deductions that may be subtracted from employees’ net pay.
Federal Income Tax
The federal income tax an employer should withhold from an employee’s pay is based on the information provided on the employee’s IRS Form W-4, Employee’s Withholding Certificate. The federal income tax withholding amount varies based on the employee’s marital status, dependents, and Form W-4 adjustments.
State Income Tax
In states that levy state income tax (SIT), employers must also withhold that tax from employees’ pay. Nine states (as of this writing) do not have state income tax on employees’ wages and salaries, which include Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Keep in mind, if employees are paid bonuses, that income might be taxed differently from how wages are taxed. What if a business has an employee who lives out of state? Generally, state taxes are withheld for the state where the employee performs their work. Some states have reciprocal agreements whereby taxes are withheld for the employee’s state of residence, even if they work in a different state. When in doubt about which state income tax must be withheld and paid, employers should consult a tax specialist who can advise on the rules and requirements.
Local Income Tax
Not all counties charge local income tax, but employers must withhold local taxes from employees’ pay in the areas that do.
Payroll Taxes
- FICA –Â Payroll taxes are withheld from employees’ pay to the federal government to fund its Social Security and Medicare programs. FICA tax is a flat percentage of an employee’s wages (12.4 percent Social Security tax and 2.9 percent Medicare tax). The IRS generally requires employers to withhold half of Social Security and Medicare taxes from their employee’s wages and salaries, and the employer pays a matching amount. While there is a cap on how much of an employee’s compensation is subject to Social Security tax ($147,000 in 2022), all gross income is subject to Medicare tax.
- Unemployment Taxes –Â Through the FUTA (Federal Unemployment Tax Act) and state unemployment systems, workers who lose their jobs through no fault of their own can receive unemployment compensation. FUTA tax is a cost to the employer; it is not deducted from employees’ wages. The threshold at which employers must file federal unemployment taxes is if they paid wages of $1,500 or more to employees during any calendar quarter in the current year or the one before. The six percent FUTA tax applies to the first $7,000 paid to each employee during a calendar year (after subtracting any FUTA-exempt payment amounts). Many states have their own unemployment insurance programs and require employers to pay a State Unemployment Tax, or SUTA. Some states also require employees to contribute to SUTA. The SUTA (State Unemployment Tax Act) in a state establishes the taxable wage threshold and the unemployment tax rate in the jurisdiction. Employers pay SUTA to the state where an employee’s work is taking place. So, if all of a business’s employees work in the company’s home state, it will pay SUTA only to that state government. If employees work in different states, the business must pay SUTA to each state where employees work.
- State and Local Payroll Tax –Â In some states and municipalities, other payroll taxes may also exist. Employers should check with their state’s department of revenue and local tax authorities about whether they must pay (or withhold and pay) additional taxes to fund programs like short-term disability and family medical leave.
Wage Garnishments
Court-ordered wage garnishments like the examples below must also be withheld from employees’ compensation and submitted to the proper agencies.
- Child support
- Alimony
- Loan payments
- Bankruptcy payments
Benefits Deductions
Employers also withhold money from workers’ pay for employee benefits and then submit those funds to the appropriate vendors and providers.
- Retirement fund contributions (e.g., 401K)
- Health and life insurance premiums
- Union dues
Steps to Processing Your Payroll
Register a New Business for Payroll
To withhold, report, and file employment-related taxes, businesses need to register for accounts with, and obtain tax ID numbers from, the tax authorities they must comply with. Registering for payroll taxes isn’t overly complicated, but it can be confusing because different states have different requirements and processing policies.
Calculate Payroll Pay and Deductions
The math to calculate payroll involves factoring several elements into the equation.
- Gross Pay , Employers must calculate employees’ gross pay. For non-exempt employees, this involves tracking workers’ time and calculating their pay according to their hourly wage. For exempt employees, gross pay is their salaried amount. Gross pay also includes bonuses, reimbursements, and commissions earned by employees.
- Pre-Tax Deductions , Next, pre-tax deductions should be subtracted from gross pay. Examples include 401K contributions, medical insurance premiums, and HSAs (health savings account contributions).
- Tax Deductions , Employers should then deduct taxes (e.g., federal, state, and local income taxes; FICA tax (Social Security and Medicare); and possibly state and local payroll taxes from that adjusted amount. It is important to calculate them accurately according to the employees’ W-4 forms and state and local income and payroll tax rates.
- Other Deductions , Any additional voluntary or court-ordered deductions should be subtracted from that adjusted amount. Examples include Roth IRA contributions, charitable contributions, and court-ordered wage garnishments.
- Net Pay , Ta-da! The end result is the employee’s net pay. That’s the amount the employer should pay the employee.
Process Payroll
So what’s next after calculating payroll?
- Pay Employees , Employers must pay their employees what it owes them (their net pay) by issuing a paper check or via a direct deposit into employees’ bank accounts.
- Report Taxes , Employers must complete tax filings for federal tax withholdings to the IRS. They must also report state tax withholdings to the state’s department of revenue (or other agencies in charge of state income and payroll taxes) and local income tax withholdings to the appropriate local tax authority.
- Remit Withholdings to Tax Agencies and Benefits Providers , Monies withheld from employees’ pay must be sent to the appropriate tax authorities and providers of benefits such as retirement plans and health insurance. Employers pay their federal payroll taxes online using the Electronic Federal Tax Payment System (EFTPS). The methods for paying state and local taxes vary.
Important Federal Forms
When reporting and paying taxes, here are some important federal forms employers must prepare and file.
- Form W-2, Wage and Tax Statement , Reports the employee’s annual wages, salaries, and any taxes withheld from that compensation.
- Form W-3, Transmittal of Wage and Tax Statements , Provides a summary of the annual compensation and deductions the employer reported to its employees via W-2 forms.
- Form 940, Employer’s Annual Federal Unemployment Tax Return , Reports the employer’s annual FUTA liability.
- Form 941, Employer’s Quarterly Federal Tax Return , Used to report the income, Social Security, and Medicare taxes withheld from employee’s pay and pay the employer’s portion of Social Security and Medicare taxes; filed quarterly.
- Form 944, Employer’s Annual Federal Tax Return , Used by businesses that will have an annual employment tax liability of $1,000 or less; employers must contact the IRS by April 1 of the current year to request to file Form 944 instead of Form 944.
- Form 1099-NEC, Nonemployee Compensation , Reports payment made to each non-employee person or entity a business paid at least $600 for services.
- Form 1099-MISC, Miscellaneous Income , Reports payment made to each person or entity a business has made in royalties ($10 or more) or rents, medical, health care, and certain miscellaneous forms of payment ($600 or more).
- Form 1096, Annual Summary and Transmittal of U.S. Information Returns , Collectively summarizes information from the 1099-NEC and 1099-MISC forms that a business issued to persons and entities.
- Forms 1095-C, Employer-Provided Health Insurance Offer and Coverage , Provides information about the employer’s health coverage offered to employees; required to be sent to all of a business’s employees when the employer has 50 or more full-time employees.
- Form 1094-C, Transmittal of Employer-Provided Health Insurance Offer and Coverage Information Returns , Collectively summarizes the information reported on the 1095-C forms that an employer issued to its employees.
Options for Processing Payroll
Do It Yourself Manually
Many small businesses gravitate to this route to save money. This method requires calculating, processing, and tracking many details manually in-house. It also requires that the business owner (or whoever handles a company’s payroll) understands all of the rules, is detail-oriented, and has the time to complete tasks accurately and on time.
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