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Setting Up a Payroll System in 10 Steps

Whether you have one employee or 50, setting up a payroll system not only streamlines your ability to stay on top of your legal and regulatory responsibilities as an employer, but it can also save you time and help protect you from incurring costly Internal Revenue Service (IRS) penalties.

Here are 10 steps to help you set up a payroll system for your small business.

  1. Obtain an Employer Identification Number (EIN). Before hiring employees, you need to get an employment identification number (EIN) from the IRS. The EIN is often referred to as an Employer Tax ID or as Form SS-4. The EIN is necessary for reporting taxes and other documents to the IRS. In addition, the EIN is necessary when reporting information about your employees to state agencies. You can apply for an EIN online or contact the IRS directly.
  2. Check Whether You Need State/Local IDs. Some state/local governments require businesses to obtain ID numbers in order to process taxes.
  3. Independent Contractor or Employee - Know the Difference. Be clear on the distinction between an independent contractor and an employee. In legal terms, the line between the two is not always clear and it affects how you withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes.
  4. Take Care of Employee Paperwork. New employees must fill out Federal Income Tax Withholding Form W-4. Your employee must complete the form and return it to you so that you can withhold the correct federal income tax from their pay.
  5. Decide on a Pay Period. You may already have a manual process for this, but setting up a pay-period (whether monthly or bi-monthly) is sometimes determined by state law with most favoring bi-monthly payments. The IRS also requires that you withhold income tax for that time period even if your employee does not work the full period.
  6. Carefully Document Your Employee Compensation Terms. As you set up payroll, you'll also want to consider how you handle paid time off (not a legal requirement, but offered by most businesses), how you track employee hours, if and how you pay overtime, and other business variables. Don't forget that other employee compensation and business deductibles such as health plan premiums and retirement contributions will also need to be deducted from employee paychecks and paid to the appropriate organizations.
  7. Choosing a Payroll System. Payroll administration requires an acute attention to detail and accuracy, so it's worth doing some research to understand your options. Start by asking fellow business owners which method they use and if they have any tips for setting up and administering payroll. Typically, your options for managing payroll include in-house or outsourced options. However, regardless of the option you choose, you - as the employer - are responsible for reporting and paying of all payroll taxes.
  8. Running Payroll. Once you have all your forms and information collated, you can start running payroll. Depending on which payroll system you choose, you'll either enter it yourself or give the information to your accountant.
  9. Get Record Keeping Savvy. Federal and some state laws require that employers keep certain records for specified periods of time. For example, W-4 forms (on which employees indicate their tax withholding status) must be kept on file for all active employees and for three years after an employee is terminated.  You also need to keep W-2s, copies of filed tax forms, and dates and amounts of all tax deposits.
  10. Report Payroll Taxes. There are several payroll tax reports that you are required to submit to the appropriate authorities on either a quarterly or annual basis. If you are in any way confused about your obligations, take a look at the IRS's Employer's Tax Guide, which provides some very clear guidance on all federal tax filing requirements. Visit your state tax agency for specific tax filing requirements for employers.