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Introduction to Payroll

Introduction to Payroll

Remember your teenage years when Fridays were everything? School was out for the weekend and in your inbox at work a paycheck was waiting for you. It was the one day a week you really wanted to go to work because that $100 check meant your weekend was going to be a blast.

To the employee, payday is the day when you get compensated for all the hard work you’ve been doing. With direct deposit you no longer even have to go into work to see that increase in your bank account. But for the employer, payday is quite frankly a royal pain in the rear.

This post is an introduction to payroll, why you need it and what the numbers all mean. I’ll show you how to get ready for payroll and in subsequent lessons how to do all the calculations yourself.

Why Do You Need to Do Payroll?

In my Hire Yourself article I talked a bit about what you’d need to hire your first employee and when you need the paperwork done and noted that it’s primarily payroll driven. If you’re not doing payroll yet there is a lot of paperwork that you can avoid – so why do it at all?

The first reason to do payroll is when you have to pay yourself. As the business owner, profits will trickle down to you if you’re a sole proprietor, an S Corporation or an LLC structured with the ‘S’ election. If you’ve read any of my previous articles on company structure then you know that somewhere around the $50,000 mark of profits is when you want to start thinking about incorporating and doing payroll for yourself.

There are a few reasons to incorporate if you’re a sole proprietor and those are detailed in The Liability Tax Test, but in regards to payroll, the primary reason to give yourself a paycheck is to actually pay less in taxes. How can paying payroll taxes mean you pay less in taxes? Remember if you’re a sole proprietor your income is subject to self-employment taxes and incorporating does away with that. By structuring your payroll and disbursements ratio correctly you can pay less taxes than you did as a sole proprietor.

As an S-Corp you can choose not to do payroll for yourself and just let all the profits trickle into your personal income bucket, but the IRS frowns on that and may make all your income subject to payroll taxes retroactively. It’s best that you avoid this by doing payroll up front and split that income into part disbursement and part payroll so that you can control the outcome.

But I digress… anyway, the second big reason to do payroll is when you actually hire an employee other than yourself. Most people expect to be compensated for the work they’re doing for you and your company and payroll is that compensation. People get pretty grumpy when they don’t get it, or don’t get it on time.

Explaining the Pay Stub

Let’s start with the pay stub and what it means. For the vast majority of employees this is the only part of payroll (aside from the preparatory forms like the W4) that they ever see.

Pay stub example

This is an actual pay stub I produced for an employee a while ago and contains all the important elements for a small business that you need to know. The employee’s name and the pay date and period are displayed on top so it’s easy to see the timeframe for which the pay stub applies.

The pay period is a direct result of the frequency you choose to do payroll. Some businesses pay weekly, though most businesses pay every two weeks or twice a month. Other options include monthly, quarterly, semi-annually or totally random. What you choose for your business is up to you and will affect the calculations used in income tax withholding.

The two “YTD” columns (Year to Date) on the right contain the sums of each row for the current year. I don’t think we need to go into any more explanation for these columns. That’s fairly self-explanatory.

Let’s look at each row on the pay stub line by line:

  1. Gross: This is your actual salary or income as stated in your employment agreement. We have a column for the number of hours worked if applicable, the rate per hour and the total earned for this pay period.
  2. Federal Income Tax: This federal tax is usually the largest reduction on your pay stub and is what most people think of when they hear about taxes. There’s no rate listed because this tax uses a complex series of tables and conditions as part of the calculations and can’t be simplified down to a single rate.
  3. Medicare: This federal tax is part of the Federal Insurance Contributions Act (FICA) and funds the Medicare program that supports health care in your retirement. The rate is the percentage of your gross income.
  4. Social Security: This is the other part of the two FICA taxes and funds the Social Security program that supports an income in your retirement. The rate is the percentage of your gross income.
  5. CA Income Tax: As I live in California we have a state tax that is less than but similar to the federal income tax. Your state income tax goes here. Like the federal income tax this is also too complex for a simple rate.
  6. CA Disability: This tax, also known as State Disability Insurance (SDI), supports the state disability program from which you can draw in the event you become disabled and require financial assistance. The rate is the percentage of your gross income.
  7. Deductions Total: This represents how much of your gross income is going to taxes and other deductions. Most pay stubs don’t show this but I like to know how much I’m paying the goverment.
  8. Net Pay: This represents how much you actually get to keep out of the paycheck and is the amount written on the face of the check or actually deposited if you have direct deposit.

What Your W4 Form Means in the Equation

The federal W4 form is where the employee declares their marital status, multiple jobs, dependents and other income and withholdings if applicable. Each of these sections becomes a part of the calculations used to determine how much federal income tax should be withheld from your paycheck.

This form and any equivalent state form (like the CA DE-4) should be reviewed and updated annually or whenever your tax situation changes. Make sure you have one on hand for each employee you’re going to be paying.

You may have other items in your pay stub like health insurance reimbursements or employer contributions, bonuses, or contributions to a retirement plan like a 401K. Those are more advanced topics and will be tackled later. Though typical in many larger companies, most small businesses don’t have them until they have a sufficient number of employees to support doing them in the first place, or if as a solopreneur you have a high enough profit to support a retirement plan.

How Long Should I Keep Employee Records

According to the IRS you’re going to want to keep employment tax records for 4 years. This is a sliding window so if you’ve had an employee for 5 years you don’t have to retain that first year anymore. I keep an employee file for 4 years after they’ve left the company also.

Staying Informed

The IRS has a tax calendar where you can see the upcoming tax events that may affect your business. They also have an option to subscribe to it via RSS feed which is pretty antiquated but useful if your email software supports that. More useful is their eNews subscription services and I recommend signing up for that to keep up with the latest information. There are a lot of topics and you can pick the ones that are of interest to you.

Next Steps

This has been a brief overview of the common parts of payroll and in the next article I’ll be covering how to do the calculations for manually doing your paychecks. Make sure you have a W4 for each employee and any equivalent state form like the CA DE4 in California before we get started in the next lesson.

You might also want to download the federal Publication #15 – Employers Tax Guide and look through it before starting the next lesson. There’s a lot of information in there but don’t stress about it – I’ll explain what you need to know. The table of contents will give you a good idea of how complicated it can be and the steps required throughout.

Believe it or not the State of California has a similar guide called the California Employer’s Guide, or Publication DE 44. If you’re not in California you can check the Employment Development Department in your state to see if they have one too.

Both guides get updated every year and it’s a good idea to take a look to see if something has changed that you’ll need to account for. Take a brief look at them and we’ll go through the payroll steps for the federal calculations in the next article and the state calculations in the one after that.

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