Payroll 101: A Small Business Owner's Guide to Hiring Your First Employee

Hiring your first employee is a major milestone and a big responsibility. From setting up pay schedules to handling taxes and benefits, payroll can feel overwhelming. But with the right foundation, you can build a system that's compliant, efficient, and fair. This guide walks you through the payroll basics every small business owner needs to know.

Step 1: Create Your Payroll Foundation

Before you hire your first employee, you need to get your business payroll-ready. Unfortunately, processing payroll isn't as simple and just writing a check.

Apply for an Employer Identification Number (EIN)

Acquiring an EIN from the IRS is typically a standard part of business formation if you work with an attorney or accounting professional. It's kind of like your business' Social Security number--a unique identifier used in reporting to the IRS.

Register With The State Tax Agency

Each state has its own tax agency or agencies. The state tax agency is where state income tax and state unemployment insurance is reported and remitted. Some states, like Texas and Florida, don't have state income tax, but all states require unemployment insurance. Deciding which states to register with will depend on where your business is located, where work is performed, and where your employee lives. If you hire out-of-state employees, or perform services in other states, you will likely need to register with multiple states.

Decide On A Pay Schedule

Your pay schedule dictates when your employees get paid. The most common pay schedules are weekly, bi-weekly, semi-monthly, and monthly. When selecting a pay schedule, you might consider employee needs, business cash flow, payroll processing costs, and payroll tax payments. A business can have multiple payroll schedules; for example the officers get paid monthly and the employees get paid bi-weekly. But once a pay schedule is selected, it's best not to change it.

Choose a Payroll System

To ensure your payroll processing goes as smoothly as possible, it's necessary to have a reliable payroll system. There are many options available, such as QuickBooks Payroll, ADP, Gusto, and Paychex. To decide which system is right for your business, you might consider your business needs, budget, and desired features--like time tracking, software integrations, and automated reporting.

Step 2: Collect the Right Documents

Whether you hire a part-time employee or full-time employee, colleting the right documents is crucial. They ensure you maintain compliance with governing agencies, and report each worker's wages accurately.

Form W-4

Every employee you hire must complete Form W-4 before they can receive their first paycheck. This form determines the employee's federal withholdings. The amount withheld for federal taxes will vary between employees, based on the information they provide on Form W-4.

Form I-9

To protect your business from costly penalties and operational disruptions, it's important to verify each employee's eligibility at the time of hiring. Form I-9 is designed to confirm the employee's work status and employment eligibility. This form instructs the employee to provide personal details and attest their employment authorization, by supplying documentation granting work authorization. As the employer, you will review the documents to confirm they appear reasonably genuine and that the information provided by the employee is related to the employee.

State Withholding Forms

Withholding forms provided by state tax agencies work similar to IRS Form W-4, and they are only required in states with income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming do not have state income tax). These forms must be completed by each employee to determine their unique withholding amounts.

Direct Deposit Authorization

If you're a business owner who doesn't want to sit down and right paychecks for every employee each pay period, offering direct deposit is the solution for you. Most employees prefer direct deposit payments, because the funds are automatically deposited into their account each payday.

Step 3: Understand Payroll Taxes and Withholdings

Federal Income Tax

Each employee's Form W-4 will determine the amount of Federal Income Tax withheld from their paycheck. Because this amount is unique to each employee, it's vital that Form W-4 is collected at the time of hire and prior to processing their pay. This money goes directly to the IRS.

Social Security and Medicare (FICA)

FICA stands for the Federal Insurance Contributions Act. Both you and your employee pay into Social Security and Medicare. Each pays 6.2% for Social Security and 1.45% for Medicare. Essentially you, as the employer, are matching your employee's contribution to these programs that provide retirement and healthcare benefits.

Federal Unemployment Tax (FUTA)

The Federal Unemployment Tax Act requires employers to pay a tax that funds unemployment benefits for workers who lose their jobs. Unlike Social Security and Medicare (FICA taxes), this tax is paid only by employers--nothing is withheld from the employee's paycheck.

State Income Tax and Unemployment Insurance

Depending on where you business operates, you may need to withhold state income tax to pay into state unemployment insurance. State income tax is paid by the employee, much like federal income tax.

State Unemployment Insurance, sometimes referred to as SUI or SUTA, is paid by the employer in most states. This tax funds unemployment benefits for workers who lose their jobs through no fault of their own. The rate paid by the employer depends on industry, number of employees, and the company's history of claims.

Step 4: Decide on Pay Format and Frequency

How to Pay

Employees may be compensated in various formats. The most common are hourly, salary, and commission. This is typically communicated to the employee in an offer letter at the time of hire. Your business may have some employees who are paid hourly, some who are paid a salary, and others who are paid commissions.

Hourly pay means the employee is paid a set rate for every hour worked. These employees will track the time they work, and submit a timesheet for calculating their compensation.

Salary employees receive a fixed amount per pay period, regardless of the hours worked. In most cases, full-time roles with responsibilities that go beyond a time clock will be assigned an annual compensation rate that's distributed in installments based on the pay schedule.

Commission pay is tied to performance, often as a percentage of sales or profit. This format is common in sales roles, and can be combined with hourly or salary wages.

When to Pay

Just as important as how you pay your is when you pay your employees. This step includes your pay schedule, your pay period, and your payday.

Pay schedule refers to how often your employees are paid--weekly, bi-weekly (every two weeks), semi-monthly (twice per month), or monthly. Your choice may depend on state laws, industry norms, or cashflow.

A pay period is the range of dates used to calculate the employee's pay. For example, a bi-weekly pay period might run from Monday, March 1 to Sunday, March 14. Hours worked during that time are included in the paycheck.

Employees are most interested in payday--the actual date they receive their paycheck or direct deposit payment. This usually falls a few days after the pay period has ended, allowing time for processing payroll. If the pay period ends on Sunday, March 14 you might have a pay day of Wednesday, March 17 or Friday, March 19.

Step 5: Offer Benefits and Handle Reimbursements

As an employer, you can make your workplace more attractive to quality employees with simple benefits.

Paid Time Off (PTO)

Whether it's vacation days, sick time, or holidays, having a clear PTO policy shows you value your employees' well-being and respect their time. There are many ways to structure and disperse paid time off benefits, so it's important that you explain to your employees what benefits are available to them and how to use them.

Bonuses

For employees that experience peak seasons or have specific performance metrics, you might consider offering bonuses to reward hard work and boost morale. Some employers enjoy giving employees a holiday or end of year bonus based on the company's success. These bonuses are considered wages, so they should be included in a regular paycheck or processed as a supplemental paycheck.

Expense Reimbursements

If you have employees who pay for business expenses, such as mileage, supplies, or travel, you'll need a process for reimbursing them fairly and quickly. This typically includes collecting mileage reports, receipts, or expense reports for approval, and adding the reimbursement payment to their next paycheck.

Step 6: Stay Organized and File on Time

The last piece of payroll is staying compliant. Neglecting to collect necessary forms, missing deadlines, and submitting inaccurate reports can be costly for your business.

File Payroll Taxes Quarterly and Annually

The IRS requires regular filings, and states often do too. Make sure you note deadlines on your calendar or use your payroll software to automate reminders. Two of the most common payroll tax reports are federal 941 reports (due quarterly) and federal 940 reports (due annually).

Issue W-2s to All Employees by January 31

As an employer, you are also required to provide your employees with a Form W-2 by January 31 of each year. This document summarizes their earnings and taxes withheld, so they can complete their annual tax return.

Keep Payroll Records for At Least Four Years

Payroll records should be kept in an employee-specific folder for at least four years. This protects your business if you're audited or need to reference past payroll activity.

Build a Payroll System That Grows With You

Hiring your first employee is a big step forward, and while payroll may seem daunting at first, it doesn't have to be. By building a solid foundation, understanding the basics of payroll taxes, and staying organized, you can create a system that keeps your business compliant and your employees happy.

Remember, payroll isn't just about writing checks. It's about showing employees you value their work and are committed to doing things the right way. Offering quality employment is key to building a successful business.

Need Help Setting Up Payroll for Your First Hire?

At Basswood we understand the importance of an organized and effective payroll structure. If you're looking for a financial partner to assist you in setting up payroll for your first hire, we're here to help. Learn more about our payroll processing services and connect with us to get started.