How a Payroll System Works

A payroll system is a necessary tool for small, medium, and large businesses, helping them to manage all aspects of paying employees and filing employment taxes. The payroll process is implemented over multiple steps at the end of each payroll period, ensuring that employee pay is properly calculated and provided and that the correct amounts are withheld for taxes, benefits, and other deductions.

Without good payroll management in place, a company risks making mistakes that can lead to unhappy staff, as well as legal and compliance problems with government tax and labor laws, which can come with heavy penalties.

Why Is a Payroll System Necessary?

A payroll system takes care of everything and anything involving the payment of employees and the filing of ­employment taxes. This includes:

  • Keeping track of worked hours
  • Calculating wages
  • Withholding taxes and other deductions
  • Printing and delivering checks
  • Paying government employment taxes

Whether you use a manual process or payment software or turn to outsourcing, you need a payroll system for your business to track the hours each staff member has worked, understand what deductions you need to make, and issue on-time payments to your workers.

As a small business owner, you can easily get overwhelmed trying to run payroll while taking care of your day-to-day operations if you don't have a good system in place. Whatever part of the administrative burden a payroll system can help with is appreciated by company owners who want to focus on more important things like running the business (especially during the COVID-19 pandemic).

How to Process Payroll

To process payroll is a multistep endeavor involving setting up tax IDs, entering correct employee information, identifying pay rate and frequency, calculating gross pay, making the proper deductions, calculating net pay, and, finally, issuing payments to employees.

Collect All of Your Tax IDs

You need to first set up tax IDs, which allow the government to track your company's payroll taxes so they know that you are meeting official requirements. Tax IDs include:

  • Employer identification number (EIN): The EIN — also known as the federal employer identification number (FEIN) or the federal tax identification number — is a unique nine-digit number used by the Internal Revenue Service (IRS) to identify businesses and enable companies to report employment taxes. If you don't have an EIN, you can set one up on the IRS website.
  • State withholding ID number: If you have employees, your company generally has to apply for a state withholding ID number from the state in which you are operating. The number is used on state tax forms that report state income taxes withheld from employees' pay. Seven states don't impose income taxes on individuals, and another two only levy tax on income from dividends, so this number would be unnecessary in those instances. Check with your state site to find out if you need a number and whether you need local or municipal IDs, as well.
  • Federal Unemployment Tax Act (FUTA): This federal legislation imposes a payroll tax on any business with employees, and the revenue it raises is used to fund unemployment benefits. The taxes are usually paid by businesses quarterly or annually.
  • State Unemployment Tax Act (SUTA): Sometimes known as State Unemployment Insurance (SUI), SUTA is a payroll tax required by states to help pay for unemployment insurance benefits to unemployed workers. In the majority of states, only employers pay this tax. However, in a few states, employees must also pay an SUI tax. The employer must withhold the tax from worker wages and then give them to the government.

One of the main purposes of payroll systems is to withhold and pay taxes. Besides the taxes named above, businesses also have to match employee contributions to Social Security tax and Medicare tax.

Ensure You Have All Relevant Employee Information

Before you can begin processing payroll, you must get staff to fill out W-4 and 1-9 (when onboarding new employees) forms. The W-4 form dictates how many allowances the staff member qualifies for when calculating how much should be withheld for their federal income taxes. (Depending on where your business operates, you may also have to provide state and local forms.)

Not only are businesses required to keep the W-4 form for four years but they must also keep track of critical information, such as addresses where paychecks are sent or bank account information in the case of direct deposit.

The kind of employee information that employers need to collect is usually found on the W-4 form and includes:

  • Name
  • Address
  • Social Security number
  • Tax filing status
  • Up-to-date information on deductions and contributions

You may also have to garnish the wages of an employee if required to because they owe money to the IRS for back taxes or because they owe child support.

Identify the Correct Pay Rate and Pay Frequency for All Employees

Once you have the required tax and employee information, you should set up a payment schedule that suits the needs of your business. The main schedules include monthly, semimonthly (twice a month), biweekly (once every two weeks), and weekly. A weekly payment schedule may be liked by employees because they are paid more often and receive overtime pay faster, but it is more expensive for employers to do payroll processing 52 times a year.

Monthly payments are the least expensive option for employers and also line up with monthly reports they need to make taxes on deductions. However, employees might find some strain in waiting this long between paychecks. Paying this way may also contravene laws in some states that require more frequent payment.

Deciding how much money to pay employees and on what grounds (e.g., by the number of hours, weeks, etc.) is important to know when doing payroll. Pay rate can be a tricky one to come up with since you want to have a competitive pay rate to attract good employees but you don't want to be so generous that you put a financial strain on your company. You can, of course, do research on what your competitors pay.

You also need to take into account what kind of benefits you are going to offer employees (such as health insurance or a retirement plan) since these can cost 20% to 30% of an employee's wages.

Depending on what kind of business you run, salaries can account for 18% to 52% of your operating budget. In service-based businesses, salaries may be as high as 52% of their gross revenues. Many other businesses are in the 15% to 30% range.

Calculate Employee Gross Pay

With your pay rate determined and payroll schedule set, you can begin processing your payroll. First, you must calculate each employee's gross pay. This is the number of hours they work within a set pay period, multiplied by their hourly rate and including their overtime hours (which have to be paid at a higher rate in keeping with federal law).

If a person works 50 hours in a given week with a pay rate of $12 an hour, for instance, they would be paid $480 in regular wages (40 hours x $12) and $180 in overtime (10 hours x $18) for a gross pay of $660.

Identify Employee Deductions

You also have to calculate deductions for each employee, taking into account information from W-4 forms, federal and state requirements, benefits, and insurance requirements. Common requirements include:

  • Federal taxes
  • State taxes
  • Local taxes
  • Medicare
  • Social Security
  • 401(k) contributions
  • Workers' compensation contributions
  • Other benefits administration

Pay Your Employees After Calculating Net Pay

Eventually, you will pay your employees their net pay by check or direct deposit. Net pay is calculated by taking an employee's gross pay and subtracting their deductions. A $4,000 gross monthly pay with $800 in deductions, for instance, would leave the employee with a net pay of $3,200 to meet all of their monthly expenses.

Your employees are paid on the payday determined in the schedule you set and the deductions should be held for payment with your company's payroll taxes, which might be paid on a monthly or quarterly schedule.

Key Features to Look for in Payroll Services Software

The right payroll management software (including online payroll and mobile app solutions) can save time and money as it automates functions, streamlines processes, and makes fast, accurate calculations. With this automation, company owners can reduce their administrative burdens and focus on running their businesses.

First, you need to decide what functionality you need in your own payroll software solutions. For example, features might include:

  • Multiple payment options
  • Management of paid time off
  • Garnishment of wages
  • Unemployment insurance
  • Detailed payroll reports
  • Time tracking of employee hours
  • Workers' compensation administration
  • Human capital management (HCM)/performance management capabilities

Other in-demand features that make it easier to run payroll include:

  • Tax filing services: Filing taxes accurately and on time ensures you are less likely to have problems with the IRS. Payroll software will make calculations more accurately that you can manually, ensuring there are no issues with federal, state, local, Social Security, or other payroll tax withholdings.
  • Employee portals: Rather than inundating your human resources with requests, exiting staff and new hires can use employee self-service options to quickly find information themselves, including pay stubs, W-2 forms, time and attendance data, and paid-time-off balances. It's a win-win HR and talent management solution.
  • Deductions: Payroll software does not just record work hours and pay; it can quickly and accurately handle more complex jobs, such as deductions for benefits and taxes.
  • Recordkeeping: Payroll software keeps accurate and complete records so you can stay compliant with tax laws and be prepared in case of an audit. The records can also help with financial planning, be used to see trends for workforce management (e.g., how much you are paying for overtime), or be used to see how many employees are contributing how much money to retirement plans.

Let Skynova Help You With Your Small Business Accounting Needs

A good payroll system at the right pricing is essential to the ongoing survival and success of any business, especially with tax compliance. With Skynova's full range of small business software, you have access to powerful modules that can help take care of business concerns ranging from automatically generating professional invoices to creating work orders.

Our accounting software is easy to use (no professional accounting knowledge needed) and is available for a free 21-day trial. You can switch between cash and accrual basis, get a quick overview of paid and owed tax, track expenses and upload receipts, and simply better manage your finances.

With a Skynova solution on your payroll, you can ensure that it's business better than usual.

Notice to the Reader

The content within this article is meant to be used as general guidelines and may not apply to your specific situation when it comes to a payroll solution and the proper tax deductions. Always consult with a professional accountant to ensure you're accurate and legally compliant in your payroll processing.