Paying Small Business Employees: Employer’s Handbook

One of the most fundamental tasks for any small business is paying its employees. It would appear fairly easy and straightforward, but as any small business owner knows, nothing is ever easy or straightforward. There are many things to consider before you even think about putting money into an employee’s bank account. For some small businesses, the task of how to pay employees is best left to the professionals. 

This guide will walk you through all the steps of paying your employees, from classifying your employees to setting up your payroll system to tax withholding. In the end, you may decide it’s better to outsource payroll to specialists with years of experience. Whether you do your own payroll or pay a professional to do it for you, there are many questions you’ll need to answer before your employees can receive their paycheck.

Classifying Your Employees

Unless you’re a sole proprietor, there’s a good chance your small business will have a mix of employee types: salaried, hourly, commission, and even contractors. Each classification has very specific payroll requirements that must be followed to avoid fines from the IRS.

Salary

Most often, salaried employees are in managerial or professional roles, and are almost by definition, full-time employees. Most have benefits packages that include paid time off, retirement contributions, and health insurance. Their pay is the same regardless of how many hours they work, and many salaried employees work more than 40 hours per week. Salaried employees are considered exempt from overtime rules, though. To calculate pay for salaried employees, take their annual compensation and divide it by the number of pay periods in a year. 

Hourly

Entry-level positions are usually paid by the hour, and an hourly worker’s paycheck varies in size depending on how many hours they were scheduled for during the pay period. By federal law, employees working more than 40 hours per week need to be paid overtime at a rate of 1.5x their hourly wage. 

Commission

Employees working in sales are often paid on commission, receiving a low base salary but with a bonus for meeting specific sales goals. These commissions incentive employees to seek out new customers and align their goals with that of the business. Calculating compensation for a commission-based position is more complicated, as is withholding the correct amount of taxes. Given the complexity, outsourcing to payroll professionals is the best way to pay employees of a small business using commission.

Contractor

Some businesses employ contractors for certain positions, but there are strict rules governing this classification as contractors have no money withheld from their paycheck and do not receive health benefits, retirement, or paid time off. To be considered a contractor, the person must be in full control of how they complete their work, with the employer only dictating the results of the work. Contractors are not considered employees, and their pay is treated as a business expense no different than ordering supplies. 

Determining a Payroll Schedule

Employees can be paid weekly, bi-weekly, or monthly. Deciding how often to pay your employees comes down to the needs of your business and the needs of employees. If your business has consistent cash flow from week to week, with customers regularly paying their invoices, it could make sense to pay your employees on a weekly basis. Employees often prefer this schedule as it doesn’t require as much budgeting.

It’s more difficult to meet weekly payroll requirements if cash flow is more sporadic, in which case monthly payroll may be a better option. There are also some minor costs that come with making more transfers to your employees’ bank accounts.

Understanding Pre-Tax Compensation

Salaried employees can receive generous benefits packages that are not considered taxable by the IRS. To be compliant, these benefits must be excluded from the employee’s pay before calculating tax withholdings. Depending on the scope of these benefits, these calculations can be fairly complex.

Traditional IRAs

Individual retirement accounts give employees the option of saving for retirement by investing in stocks and bonds. Employees set the amount they’d like to contribute, up to $6,000 annually (or $7,000 for employees over 50), which is deducted from their paycheck before taxes are withheld. Many employers offer to match the amount that employees contribute to the IRA to encourage maximum savings.

Health and Dental Insurance

Most employer-provided health insurance plans require buy-in from employees, with the employer footing 80% of the cost and the employee covering the remaining 20%. The employee’s contributions need to be deducted before any taxes are calculated. 

Commuter Benefits, Flexible Spending Accounts, and Other Benefits

There is a wide range of pre-tax benefits available to employees, especially at larger companies. It’s to the employee’s advantage to sign up for these benefits as no tax is levied on them, and so they are 25% less expensive than they would be if purchased after taxes were withheld.

How To Set Up Payroll

Now that you understand the basics of payroll classification, payroll schedule, and pre-tax benefits, it’s time to set up your payroll system. Given how complicated this can be, you’ll want to think carefully about the tax and accounting software you use and whether it fits the needs of your small business. 

Collecting Employee Paperwork 

Employee onboarding usually involves a substantial amount of paperwork; these are the most critical documents to be filled out.

W-4

A W-4 is a tax document employees complete to determine their number of exemptions claimed, which affects how much their employee needs to deduct from each paycheck.

I-9

The I-9 form shows an employee is legally allowed to work for their employer, indicating their citizenship, residency, or visa status.

Direct Deposit Authorization Form

At this point, almost all employers offer or require direct deposit of their employee’s paychecks. To do this, you’ll need the employee’s bank account number(s) and authorization for you to deposit money in their account.

Benefits Forms

If your business provides retirement, health insurance, or any other types of pre-tax benefits, employees will need to fill out all the paperwork associated with them before you can set up their payroll account, as their choices will affect their pre-tax compensation.

Automation: How to Pay Employees in a Small Business 

Once you’ve collected all the necessary documents, that data needs to be input into your payroll software, along with your payment schedule, and any additional deductions. Some payroll software systems allow employees to enter all of this information themselves through an employee portal. While this does save time, you’ll need a payroll specialist on hand to answer any questions or fix errors that arise.

Completing the Payroll Process

After everything’s been set up, the process should run quite smoothly. Your employee time-tracking or sales commission software will relay the number of hours and/or bonuses associated with each employee to calculate their compensation for the pay period and then deduct FICA, federal and state income taxes, and any pre-tax benefits from that before being deposited into your employee’s bank account.

Running a Small Business? LendThrive Can Help

As a small business owner, you’re responsible for every aspect of your business, from payroll to sales to financing. There are an enormous amount of decisions that must be made on a daily basis, and for the most part, none of them are easy.

One of the easier decisions you can make is to work with LendThrive. LendThrive offers fixed rate business loans of up to $150,000, and most approval decisions are made within 24 hours. Apply for a loan or contact us today to see how we can offer flexible assistance that will help your business grow.