Payroll is the one HR function you can’t get wrong — people notice immediately when their pay is off, and tax agencies notice eventually when filings are. For a small business, payroll breaks into three jobs: paying people correctly, handling taxes, and keeping records. Here’s how each works.
Employee vs. contractor: get this right first
Before you run payroll for anyone, confirm they’re actually an employee. The IRS looks at behavioral control, financial control, and the relationship — not what you call them or what they signed. Misclassified workers mean back taxes, penalties, and benefits liability. True contractors control how and when they work, serve multiple clients, and handle their own taxes. If someone works full-time hours on your schedule with your equipment, they’re almost certainly an employee.
Setting up payroll: the accounts and IDs you need
- EIN from the IRS (free, online) — your business’s tax ID for employment taxes.
- State employer accounts — unemployment insurance and withholding accounts in every state where you have employees.
- A payroll system — software, an accountant, or a payroll service. Spreadsheets stop being viable fast.
- Pay schedule — weekly, biweekly, semimonthly, or monthly. States regulate this: many require at least semimonthly pay, and some restrict your options. Pick one and put it in your handbook.
- Time tracking — you need accurate hours for every nonexempt employee. See our timesheet template.
Payroll taxes: what comes out and who pays it
| Tax | Employee pays | Employer pays |
|---|---|---|
| Federal income tax (withholding) | Yes | No (but you remit it) |
| Social Security (6.2% each) | Yes | Yes |
| Medicare (1.45% each) | Yes | Yes |
| Additional Medicare (0.9% over $200k) | Yes | No |
| Federal unemployment (FUTA) | No | Yes |
| State unemployment (SUTA) | Varies | Yes |
| State/local income tax | Varies | No (but you withhold/remit) |
Deposit schedules (monthly vs. semiweekly) depend on your total tax liability — the IRS tells you which one you are. Miss deposits and penalties stack fast; this is the single most common payroll failure in small businesses.
Deductions and garnishments
Beyond taxes: benefit premiums, retirement contributions, and court-ordered garnishments (child support, tax levies). Garnishments have strict federal and state limits on how much can be taken — follow the order exactly and never ignore one.
Overtime and the regular rate
Payroll has to get overtime right, which means computing the “regular rate” correctly — total weekly earnings divided by total hours, including most bonuses. Get the details in our overtime pay rules guide, and confirm every worker’s exempt or nonexempt status — misclassification here is the most expensive payroll mistake there is.
Software vs. accountant vs. DIY
- Payroll software (Gusto, QuickBooks Payroll, etc.): best for most small businesses — automates tax filings, direct deposit, and pay stubs. Usually $40–$150/month base plus per-employee fees.
- Accountant/bookkeeper-run payroll: good if your situation is complex (multi-state, tipped workers) and you want a human accountable.
- DIY: only sensible for a handful of employees with simple pay — and even then, use software for the tax filings. Manual payroll tax calculation is where penalties are born.
7 costly payroll mistakes
- Missing tax deposit deadlines.
- Misclassifying employees as contractors (or as exempt).
- Late or missing new-hire reporting to the state.
- Sloppy time records leading to wage claims.
- Forgetting final-paycheck deadlines when someone leaves.
- Commingling payroll funds with operating cash.
- No backup — one person knows how payroll works, and they’re on vacation.
Keeping labor costs under control
Payroll is usually a small business’s biggest expense. Watch it with: overtime trends per employee (a rising line means you’re understaffed or mismanaged), revenue per employee, and fully-loaded cost per hire (wages + taxes + benefits + insurance). Our PTO calculator helps you model the true cost of time-off policies.
FAQ
How often should a small business run payroll?
Biweekly is the most common — it balances employee preference with admin cost. Weekly is popular in retail/hospitality; just confirm your state allows your chosen frequency.
Do I need workers’ comp insurance?
Almost certainly yes — nearly every state requires it once you have employees (a few exempt very small employers). It’s separate from payroll but just as mandatory.
Can I pay employees in cash?
You can pay by cash, but you still must withhold taxes, report wages, and keep records. “Cash” never means “off the books” — that’s tax fraud.
General information only — not tax or legal advice. Payroll tax rules change; confirm with the IRS, your state agencies, or a qualified professional.