Payroll Part 1: Getting Started with Payroll
Whether you’re just starting your business or adding your first employee, getting started in payroll can be a daunting experience. There all kinds of new thing to learn about: over-time requirements, taxes and withholding schedules, reports and deposits. It seems the list goes on.
This three part series will to give you an overview of what you need to know and do to get started with payroll.
In this part we’ll explain what you need to do to get started, registering with the IRS and your state labor department, etc. The second part will take you through a detailed payroll example and show exactly how to calculate payroll, the net checks for your employees to the tax deposits you’re required to make to the government. The third part will explain the various reporting requirement, quarterly (941) and annual (W-2s & 940). We’ll include detailed examples in this part too.
Reviews of payroll software and services are planned for the future. If you’re interested in a specific product, let me know & I’ll try to include that in the reviews.
First Things First: Getting your EIN
Before you can really get started you need to register with the IRS for an Employer Identification Number or EIN. Your company’s EIN, sometimes referred to as its Taxpayer Identification Number or TIN, is kind of like its social security number. It identifies your company uniquely on all the various tax returns, payroll and income, that it files.
To apply for an EIN you need to file, Form SS-4. The good news is it’s faster than ever to get an EIN. The quickest way is to use the IRS’s SS-4 Online Application. . Help is available that explains all the fields, which are pretty much self-explanatory. If you need more detailed information the instructions for the form are available here.
If you don’t want to use the online application, you can call the toll-free IRS number, (800)829-4933, and request an EIN. Using the online application or the toll-free number you can get your new EIN right away. You can also fax or mail in your application; see the instructions for where to send your form.
Once you have your EIN you’re ready to start the federal payroll process. You should receive a copy of IRS Publication 15, Employer’s Tax Guide. It’s sometimes referred to as Circular E. It has the answers to almost every employer’s question. If it isn’t there, try Publication 15A, Supplemental Tax Guide or Publication 15B Fringe Benefits.
What about the state?
Every state a department of labor or employment and has different rules for employers to navigate. You need to find the department for your state and apply or register with that department. Every state is different so you’ll need to find out what rules apply for your state. The IRS has a collection of links to State government web sites with useful information for businesses. Most states have a handbook for new employers, or you could try calling the employment department and ask a few questions to get you started. It’s likely you’ll need an equivalent of the EIN for your state. It will be helpful if you already have your federal EIN. If not, and your completing a form write "Applied For" in the federal EIN field. This should get you started but you may need to do a little extra leg work to get your deposits applied to your account correctly. It’s best to have both the EIN and the state EIN before you make your first payroll tax deposit.
Both the IRS and the states are making it easy to pay and report payroll taxes online. Once you have your EIN and State ID numbers you should enroll in these programs.
Electronic Funds Tax Payment System or EFTPS, is the way to make electronic payments for all kinds of federal taxes, income and employment. The enrollment process is a bit cumbersome because you must wait for snail mail for the confirmation. Once you’re enrolled, the IRS payments will go straight from your checking account to your IRS account. You can pay both business and personal taxes here but, obviously, you’ll need a separate EFTPS account for each. Even if you decide to have a payroll service handle all the details for you, you should consider enrolling with EFTPS to pay your income taxes.
Currently you cannot directly file any IRS employment forms online without going though a third party. Personally, I have a beef with this. I don’t think you should have to pay a third party to file your taxes electronically. But more on this when we get to federal payroll reporting requirements.
Several states have online reporting too. California’s EDD site is very convenient. You can enroll to pay your taxes and file most required forms online at no charge. Take time to check out your state's site and carefully read any handbook you get. There could be some savings there. For instance in California corporate employee-owners are exempt from certain taxes but you have to file a form to request the exemption. This is something you might also find out talking to a representative from the department.
If you’re going to hire employees you need to provide them with an Employee’s Withholding Allowance Certificate, Form W-4. This information stays in the employee file; you don’t need to send it to the IRS unless more than 10 exemptions are claimed. The IRS has a new online withholding calculator employees can use to help them determine appropriate withholding levels.
You also need to have your new employees complete the Department of Homeland Security Form I-9, Employment Eligibility Verification. The employee presents documentation of eligibility to work in the US which the employer must examine and attest that they reasonable appear to be valid. See the form instruction for what is considered acceptable documentation. Most employers keep a photocopy of the documentation presented as well. The form must be completed within 3 days of hiring. Like the W-4, this form is maintained the employee’s records and not filed with the government.
A new pilot program offered by the Department of Homeland Security, called the Basic Pilot Program (catchy name!), allows employers to verify the validity of the documentation presented online. Advance registration is required, but within seconds you should know if there is a problem with the new hire’s employment eligibility. Given the hubbub over illegal immigration and the call for increased enforcement on employers it seems like it would be worth enrolling.
Your state may also require filing additional forms when you hire a new employee. For instance, in California you must file Form DE-34, within 20 days of your new hire’s start date. Unlike the federal forms this form must be mailed or faxed to the state, Form DE-34 can also be filed online at EDD Online Services Home Page.
Understanding the Taxes
Before you can get started you need to at least a little about the various payroll taxes you’ll be facing. You can categorize these taxes in a variety of ways. One way is who actually pays the tax. Some taxes are paid by the employer and some are paid by the employee. Any taxes that are the responsibility of the employee are deducted from their gross pay. As the employer you are responsible for forwarding any withholding to the appropriate tax authority on behalf your employees.
First, what is gross pay? That’s the total wages before any deductions for the pay period. If you pay your employees once a month and an employee makes $24,000 a year, his gross pay for the period (one month) is $2,000. If someone makes $10 per hour for a 40 hour work week, and you pay weekly, his gross pay is $400. Not too complicated.
Employee Paid Taxes
Employees are responsible for paying federal income, social security and Medicare taxes on their gross pay. In addition, there may some state taxes they pay, like state income tax or disability insurance.
Employer Paid Taxes
As employer, you are responsible for matching social security and Medicare taxes paid by your employees and the federal unemployment taxes. There may also be state unemployment taxes and other taxes that you are required to pay. Check with your state’s employment or labor department.
So let’s go through all these taxes in detail
Federal Income Tax Withholding
Generally, you must withhold federal income taxes from your employees’ wages. We’ll go over the steps for figuring out the withholding later. For now, all you need to know is that you’re required to withhold the income tax and remit it to the IRS.
Social Security and Medicare Taxes
These taxes pay for the benefits workers and families received under the Federal Insurance Contributions Act (FICA). Sometimes you’ll see these referred to as FICA/MC. Employers withhold part of these taxes from the employee’s wages and pay a matching contribution. Currently, employers and employees each pay 6.2% of the first $94,200 (2006) of earning for FICA (social security) tax for a total tax of 12.4%. Medicare tax is 1.45% of all wages for a total of 2.9%.
Federal Income Tax Withheld and both employer and employee portions of the social security and Medicare taxes are reported quarterly on Form 941. We'll go through this form in detail in Part 3.
Federal Unemployment Taxes
The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. The employer is responsible for this tax and it should not be withheld from your employee’s pay. The rules are a bit confusing because you can get a credit for the state unemployment taxes paid. Generally employers pay 6.2% of the first $7,000 of wages per employee. So you would never pay more than $434 per employee. If you pay state unemployment tax there is a credit available that can reduce the FUTA amount upto 5.4%. That makes FUTA 0.8% or $56 per employee.
The FUTA Tax is reported annually on Form 940 or 940-EZ. More details on this in Part 3.
Every state has its own payroll rules, but it’s likely you’ll have to pay some kind of unemployment tax and withhold state income tax (if you live in a state that has an income tax). There may be other taxes like a disability or paid family leave tax. California, for instance also has an employment training tax (ETT). Your state probably has an Employer’s Handbook or other publication that is updated every year to help. For California the Employer’s Guide is available online.
Keeping up with the Changes
Every year there are changes in the details surrounding payroll. The FICA limit and the income tax withholding tables change every year. Withholding schedules usually change every, too, or have been lately) The good news is you should also receive an updated Publication 15 every year and the first section, What’s New, outlines all the changes that will go into effect for the coming year.
Your state’s employer handbook will have a similar section. Some states, like California may even send you a form to confirm your withholding rates for the coming year.
Ready to Roll… or Payroll
With the information presented here you should be able to do all you need to get setup with payroll. See Part 2 of this series to get into the gory details of calculating paychecks.