A Beginner's Guide to Payroll Processing and Reporting

The most important steps for a small business to correctly pay employees and report to the government.

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Employees can be incredibly easygoing and hardworking, but, deep down, when they come into work, they’re often thinking, “Show me the money.” Small businesses must create a process to pay employees and track all necessary information.

Making incorrect payments and reporting the wrong information is the fastest way to anger both trusted employees and the IRS.

Overview: What is payroll processing?

Payroll processing is simply understanding how payroll works and how to integrate payroll/accounting software with your payroll procedures. Read on to learn how.

How to set up a payroll processing system for your small business

The easiest way to start processing payroll is to break down the procedures into steps and follow those steps each payroll period.

I would recommend creating a proprietary checklist that integrates each of the websites and programs that apply to your specific small business payroll and then following that list each week.

Step 1: Set up a New Employee Procedure

Your first step is to get all necessary paperwork signed by the new employee. This list covers most of those documents:

  • Employment Contract - This spells out the employee’s wages and any incentive or bonus programs.
  • Government Forms - The I9 immigration form and W4 tax withholding forms are necessary for any non-contractor employee. Contractors must complete a W9. Make sure you always have the most recent form from the actual .gov website.
  • Employee Handbook and Training - Manufacturers and construction companies will likely have safety training; restaurants, food safety training; and financial institutions, legal training related to money laundering and client information. Typically, these types of trainings are legislated and it is imperative to have their completion on record. For other businesses, it is very useful to put together an employee handbook and, if employees will be using computers and email, an information security training program to have them complete during the on-boarding process.
  • Benefit Programs - If you offer benefits such as health insurance, share the handbook from the insurance company laying out all plan options. The employee will either choose their plan or complete a form from the insurance company electing not to receive these benefits.
  • Retirement Programs - Retirement programs are typically some type of defined benefit (pensions) or defined contribution (401k). Most small businesses, if they offer retirement help, will use a defined contribution plan as they will then not have to hold a liability for pensions that could be paid decades in the future. Choose which provider you will use (a combination of low cost to the employee/business and diversity of options will be your best bet when choosing a provider) and what percent of the employee’s contribution will be matched. The employee will then choose whether or not to opt into the program and what percent of their gross income to contribute.

Once you set up your new employee process, enter all necessary information into your accounting software or some other database to be used on payday. Scan and save all the completed documentation in a separate folder for each employee for easy access whenever it is needed.

Step 2: Determine how often you will pay employees

Most small businesses pay their employees either bi-weekly (every two weeks) or semi-monthly (twice per month). Typically, employees are paid bi-weekly if they are mostly hourly workers, because it is easy to calculate the two weeks’ worth of pay.

If employees are mostly salaried, semi-monthly might make more sense because it eliminates two pay periods over the course of the year.

If your business is in the construction industry, you may need to pay wages based on the Davis-Bacon Act. Those wages must be paid weekly.

If your bookkeeper or office manager has the bandwidth to process payroll weekly and you may need to pay it weekly in the future, it is a good idea to start paying weekly now to avoid any surprises.

Some businesses choose to pay monthly or, if they employ many contractors, per project. The key is to set a schedule and stick to it — one of the number one stressors for an employee is not knowing when they will be paid.

Step 3: Track employee time and calculate gross pay

Almost gone are the days when employees would line up in front of a punch card machine and stamp their individual time card upon arrival. Most accounting/payroll software programs now have an app for employees to punch in and out that tracks the employee’s location to ensure they are where they should be.

The best of these apps will integrate seamlessly with payroll software to automatically calculate the gross pay for the payroll period.

Digital time recording with time clock and an employee's chip

Employee Punching In to work

Despite technological advances, some businesses will still have their employees track time manually and fill out their own time sheet at the end of the week.

There are no inherent problems with this method — but it must be paired with strong controls. Each timecard should be signed by the employee and then approved and signed by a supervisor, ideally one who actually witnessed the work being performed.

The information would then be manually entered into the software or each employee’s pay rate would be applied to their time to calculate gross pay.

For salaried employees, each pay period should be the same amount and incentive pay should be calculated based on the agreed-upon terms in the contract.

Step 4: Make deductions for fringes, insurance and government charges

The next step is to get from gross to net pay. The following payroll deductions may apply to an employee’s paycheck:

  • FICA (Social Security), FUTA (Federal Unemployment) and SUTA (State Unemployment)
  • Federal and State income tax withholding based on the exemptions taken in the W4 form
  • Employee portion of health/dental insurance premiums
  • Employee 401k contribution
  • Garnishments such as child support
  • Repayment of paycheck advances or 401k loans
  • Charges to pay back company for destruction/damage of company property

This step can be done manually. You could research and discover all the relevant rates for government charges and subtract out all the other deductions. It is almost certainly not worth it.

Payroll software, or a free payroll calculator at the very least, will reduce the risk of overpaying an employee and struggling to get the money back or underpaying and creating badwill — especially if the error is not discovered until the employee does their taxes in the following year.

Finally, if Davis-Bacon wages are paid, keep in mind that many employee benefits, such as the employer portion of insurance premiums and employer 401k match, can be subtracted out of the cash fringe portion of payroll. Do not make the mistake of double paying employees.

Step 5: Make the payment to employees

This is the moment of truth. Employees have been integrated into the business, time has been tracked and used to calculate gross pay and deductions have been subtracted out. It is time to make the actual payment.

The easiest way to do this is to require direct deposit for employees and open a second business checking account specifically for payroll. Each week, print out a report with the paycheck totals and taxes to be paid and transfer that amount from the operating account to the payroll account.

Then, the paycheck ACH (ACH stands for automated clearing house and it is how the bank sends money out to be direct deposited) information can be exported and uploaded to the bank and the government charges can be withdrawn.

Each bank will have its own ACH process, so you may need to work with your relationship manager or an IT professional to get the file process set up correctly.

During this part of the process, set up as many checks and balances as you can. Each time you export or upload information, check with the software to make sure the numbers are correct. If something goes wrong and an employee brings it to your attention, correct it as soon as possible.

If you must print physical checks, it still makes sense to have a separate payroll checking account. Also, make sure you set up a different check type within your accounting software to ensure you are printing all necessary paystub information (such as hours, taxes withheld, etc.) on the physical check.

Step 6: Submit any necessary information to third parties

After the money has been transferred, it’s data time. Endless third parties need payroll information. Here are the related tasks you will need to do each pay period and complete payroll for the period:

  • The IRS EFTPS system - Enrolling your business in this system is the easiest way to make required federal government payments. Set it up to pull payments directly from the payroll checking account and then find the EFTPS (Electronic Federal Tax Payment System) report in your payroll software and print it out each payroll period to report. Keep track of these payments as you will need them for reporting each quarter.
  • Workers’ Compensation - You won’t necessarily need to report worker’s compensation with each period, but some providers will require it. It is typically a fairly simple process: create a report that shows each employee and their gross and overtime pay for the period and upload it with their workers’ comp class codes.
  • 401k Contributions - Same as above - create a report that shows the 401k deductions along with the employer contribution and upload it to the 401k provider website.
  • Vacation/Sick Time - If you use a time tracking app that does not integrate with your accounting system, it makes sense to import current vacation/sick time into the app to avoid confusion.

There are also items that will need to be submitted (and likely paid) each quarter or year:

  • IRS Form 941 - This is the quarterly accumulation of each pay period’s EFTPS payment.
  • State Specific Reporting - Unfortunately, there is no standard for what each state requires to be reported and paid quarterly (or even monthly in some instances). Most states will require unemployment and withholding to be reported and paid quarterly. Some monopolize workers’ compensation and don’t allow the business to use a third party. Some local municipalities require more reporting beyond the state requirements. If you are not confident in what you should report and pay, make a call to the local and state government and have them walk you through the process.
  • General Liability Insurance - This is likely paid in installments throughout the year based on an estimate of what payroll will be. The insurance company then audits the numbers at the end of the year and makes any necessary adjustments to what is owed.
  • W2s and 1099s - At the end of the year, these must be printed out and sent both to the IRS and the employee or contractor.

Good payroll software and payroll companies will be able to do all this reporting. They keep track of changes in forms and file types for you and export the information in the correct format.

Save a version of everything that is reported to third parties. Small businesses that could easily access their IRS form 941s and knew how to print reports from their payroll/accounting software had a huge leg up on getting PPP loans.

PPP (Paycheck Protection Program) loan applications required historical payroll information. Avoid being the business owner who is pulling their hair out digging through ancient emails trying to find information.

How much of the payroll process should you do?

The payroll process is intense and involves a lot of busy work. It is fraught with the potential for data entry error that can lead to mispayments that engender badwill with employees.

Choosing a payroll company or online payroll service would go a long way toward limiting these errors. If this is too costly, at the very minimum, business owners should rely on a smart and trusted employee to complete the process.

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The Motley Fool has a Disclosure Policy. The Author and/or The Motley Fool may have an interest in companies mentioned.