What Is Payroll? An Employer Guide
Payroll explained: what it means, how the process works, the taxes you owe, a worked example, and how to run it without a payroll department.
What Is Payroll?
The complete employer guide: what payroll actually means, how the process works, what you owe, and how to run it when you are the one running it
The first time you run payroll, you discover that paying someone is not the same as paying someone. You had assumed it was a bank transfer. It turns out to be a tax filing, a deposit schedule, a set of federal forms, a state registration, and a permanent record-keeping obligation, all triggered by the act of hiring one person.
That gap between what payroll sounds like and what payroll is accounts for most of the trouble small businesses have with it. Nobody is confused about the arithmetic. Multiplying hours by a rate is not hard. What catches people is that the money you withhold from an employee is not your money, the deadlines for handing it over are fixed and unforgiving, and the penalties for missing them can reach past the business to the people who run it.
This guide is the whole thing, written for the person who is running payroll rather than the person who has a payroll department. What payroll actually means, what it is made of, how the taxes work, a full worked example, how to set it up, how to run it, whether you can do it yourself, and when you should stop. I build the onboarding paperwork side of this at FirstHR, which is where payroll data comes from in the first place. One caveat that matters more here than anywhere else in this blog: this is tax territory, the figures change annually, and I am not a tax professional. Treat this as a map, not as advice, and confirm the specifics with your accountant.
What Is Payroll?
Payroll is the process of paying your employees: working out what each person earned, withholding the taxes the law requires, paying them what remains, paying the employer's own share of payroll taxes on top, sending all of that money to the IRS and your state on a fixed schedule, filing the required returns, and keeping the records.
Hold on to one phrase in that definition: on a required schedule. The single most useful thing to understand about payroll, and the thing almost nobody explains up front, is that the money you withhold from an employee is not yours and does not stay with you. You are holding it briefly on behalf of the government, and there is a deadline for handing it over that has nothing to do with when you feel like doing your bookkeeping.
Three Meanings
The word gets used in three distinct ways, and mixing them up produces genuinely confusing conversations. Worth separating them once.
| Usage | What it means | Example sentence |
|---|---|---|
| Payroll as a process | The act of paying employees and handling the taxes | We run payroll every other Friday |
| Payroll as a list | The people you employ and pay | We have twelve people on payroll |
| Payroll as a cost | The total amount spent on wages and employer taxes | Payroll is our largest single expense |
Almost every question that brings someone to a page like this one is about the first sense: the process. When an owner asks what payroll is, they are not asking for a dictionary entry. They are asking what they are now responsible for, having just hired somebody, and the honest answer is a list of obligations rather than a definition.
The second and third senses are worth knowing because they show up in ordinary business conversation and in your accounts. Payroll as a cost line is usually the largest expense a small business has, and it is bigger than the sum of the salaries, for reasons the next few sections will make uncomfortably clear.
The Components
Break payroll into its parts and it stops feeling like one large amorphous obligation and starts looking like six manageable ones. Every payroll run, at every company in the country, is some version of these.
Read down that list and notice how much of it is not arithmetic. Classification, registration, deposit scheduling, and record retention are all compliance work, and they are where the actual risk lives. The calculation, the part everyone worries about, is the easiest thing on the list.
Notice also the fourth item, the employer share. Every first-time employer is surprised by it, because it is invisible from the employee side. Your employee sees their gross pay and their deductions on a pay stub. They do not see the additional 7.65 percent you paid on top of their wages, or the unemployment tax you paid entirely yourself, because none of it comes out of their money. It comes out of yours, and it is why a $60,000 hire is not a $60,000 expense.
Gross vs Net Pay
Two numbers, and confusing them is the most common misunderstanding in the whole subject. Gross pay is what the employee earned. Net pay is what they actually receive.
| Gross pay | Net pay | |
|---|---|---|
| What it is | Total earnings before anything is taken out | What lands in the bank account |
| What it includes | Wages, salary, overtime, bonuses, commissions, tips | Gross pay minus every withholding and deduction |
| Whose number it is | The number in the offer letter | The number the employee actually cares about |
| What comes between them | Income tax, FICA, state tax, benefit deductions, garnishments | |
| Relationship to your cost | Not your total cost either. The employer share sits above it | Well below what you actually spend on that person |
Everything in payroll is calculated from gross pay. Withholding percentages apply to it, the wage base limits are measured against it, and your employer contributions are computed on it. Net pay is simply what is left over, and it is an output rather than an input. If you find yourself trying to work backwards from a desired net figure, you are doing something unusual and it is called grossing up, and it is worth knowing that it is harder than it sounds.
The gap between the two is larger than most people expect. Between federal income tax, FICA, and state tax, a typical employee takes home meaningfully less than their gross, which is why an employee who negotiated hard for a raise can be underwhelmed by the effect on their paycheck. That is worth understanding before you have that conversation with someone.
Payroll Taxes
This is the section that matters. Payroll taxes split into two piles: what you withhold from the employee, and what you pay on top of their wages. They are entirely different things and confusing them is expensive.
| Tax | Rate | Who pays it | Notes |
|---|---|---|---|
| Federal income tax | Varies by W-4 | Employee, withheld by you | From the IRS withholding tables. Depends on filing status and adjustments |
| Social Security | 6.2% each side | Employee and employer | On wages up to the annual wage base, $184,500 for 2026 |
| Medicare | 1.45% each side | Employee and employer | On all wages. No cap at any income level |
| Additional Medicare | 0.9% | Employee only | On wages over $200,000. No employer match. You must still withhold it |
| Federal unemployment (FUTA) | 6% on first $7,000 | Employer only | Usually reduced to an effective 0.6% by the state unemployment credit |
| State unemployment (SUTA) | Varies by state | Employer, in most states | Experience-rated: your claims history moves your rate |
| State income tax | Varies by state | Employee, withheld by you | Nine states have no wage income tax at all |
The IRS overview of employment taxes is the single best starting point if you want the official version of everything in that table, and it is short.
The FICA symmetry is the part to internalize. For Social Security and Medicare, whatever you withhold from the employee, you pay again yourself. Withhold $124 from their check, and you owe another $124 out of your own pocket. That is why the employer share is 7.65 percent of wages and why it is a genuine cost of employment rather than an accounting artifact.
Unemployment tax is different and often forgotten because the employee never sees it. Federal unemployment is 6 percent on the first $7,000 of each employee's wages, but nearly every employer gets a credit for paying state unemployment tax that reduces it to an effective 0.6 percent, or $42 per employee per year. State unemployment is the wild card: rates vary enormously by state and are experience-rated, meaning a business that lays people off frequently pays more than one that does not. It is the only payroll tax where your own management practices show up on the bill.
All of these together constitute the statutory benefits floor that every employer pays before offering a single voluntary benefit, and for a typical low-risk employer they add up to roughly 8 to 8.5 percent of payroll. Sitting alongside them is workers' compensation insurance, which is a state mandate rather than a payroll tax but lands on the same budget line.
How Federal Withholding Works
Federal income tax withholding is the one number in payroll that is not a flat percentage, and that is why it confuses people. There is no rate. There is a calculation, driven by the employee's W-4 and a set of IRS tables, and it produces a different answer for every person.
The mechanics: you take the employee's gross pay for the period, subtract pre-tax deductions, and then look up the withholding using their filing status and the entries they made on their Form W-4. The IRS publishes the tables in Publication 15-T, which is updated annually and is the actual source you use rather than any percentage you may have in mind.
| Method | Who uses it | How it works |
|---|---|---|
| Wage Bracket Method | Manual payroll. Small employers | Look up the employee's wages and filing status in a table. Read off the amount. No arithmetic |
| Percentage Method | Automated systems. Payroll software | A formula rather than a lookup. Handles any wage amount, which is why software uses it |
| Flat 22 percent | Supplemental wages only | Bonuses and commissions paid separately. Not for regular wages |
For a small business doing this manually, the Wage Bracket Method is the one to use. You find the table for your pay frequency, find the row for the employee's wages, find the column for their filing status and whether they checked the multiple-jobs box, and the number in that cell is what you withhold. It is genuinely a lookup, not a calculation.
Two further points. An employee may claim exemption from federal income tax withholding on their W-4 if they meet the conditions, and that exemption expires annually: they must file a new W-4 by mid-February each year to continue it, and if they do not, you revert to withholding as single. And the W-4 has no expiry otherwise, so the one you collected three years ago is still the operative document until they give you a new one. Employees can update it whenever they like, and you should let them.
A Worked Example
Abstract percentages are hard to hold on to. Here is a single employee, a single biweekly pay period, worked all the way through from gross to net and then out to what it actually costs you.
Three things are worth pulling out of that table. First, the employee earned $2,000 and received $1,467, which is a gap of more than a quarter of their gross. Second, you spent $2,172.30, which is more than the $2,000 you thought you were spending. Third, the difference between what the employee received and what you paid out is $705.30, and almost all of it went to the government, in two directions, on two different schedules.
Multiply the employer share by 26 pay periods and you get roughly $4,480 a year, on top of the $52,000 salary, purely in employment taxes and before you have offered health insurance, retirement, or a single day of paid leave. That is the number that should be in your head when you budget a hire, and it is the number that is missing from most hiring plans I have seen.
How to Actually Run It
Everything above is what payroll is. The procedure, meaning what you physically do and in what order, has a guide of its own: how to run payroll, which covers what has to exist before your first run, the nine steps of an actual run, and the calendar you work backwards from.
The short version, so you know what you are dealing with: a payroll run is nine steps, and paying your employees is step eight. The ninth is depositing the taxes you withheld, on a schedule assigned by the IRS that has nothing to do with your payday. That distinction is the single most common source of penalties at businesses that thought they were doing everything right.
Before the first run you need an EIN, state withholding and unemployment registrations in every state where an employee works, an EFTPS enrollment for federal deposits, and a signed W-4 and completed I-9 for each person. Two of those take weeks rather than minutes, which is why the time to start is when you decide to hire rather than the week they arrive.
Whether you do it manually, with software, or by handing it to someone else is a separate question, and the honest framing is that you are buying deadline compliance rather than arithmetic. That case is made in payroll automation.
Calculating Pay
Gross pay is where every payroll run starts, and it is rarely as simple as hours times rate. Overtime has its own arithmetic, deductions come out in a specific order, bonuses are withheld differently, and tips and garnishments each carry rules of their own. This section is the arithmetic in full.
Overtime and the Regular Rate
Overtime is time and a half over 40 hours in a workweek for non-exempt employees. Everyone knows that. What almost nobody knows is that the rate you multiply by is not the hourly wage, and getting this wrong is the most common wage-and-hour error there is.
Per DOL Fact Sheet 23, the law requires overtime at one and a half times the regular rate, and the regular rate is a calculated figure: total pay for the week, excluding a short statutory list of exclusions, divided by total hours actually worked. If an employee earned anything beyond their base hourly wage that week, the regular rate is higher than their wage, and so is their overtime.
Practically, the trap works like this. You announce a $100 monthly safety bonus, which feels like a generous gesture entirely separate from wages. It is not separate. It raises the regular rate of every non-exempt employee who receives it, in every week they worked overtime, which means it retroactively raises the overtime you owed. If the bonus covers a period longer than a week, you have to apportion it back across the weeks it was earned and pay the additional overtime premium for each.
Three more things worth knowing. Overtime is calculated per workweek, a fixed and recurring 168-hour period, not per pay period: an employee who works 50 hours one week and 30 the next has 10 hours of overtime, not zero, even though the biweekly total is 80. Paid time off is not hours worked, so a week with 8 hours of holiday pay and 36 hours worked contains no overtime, which is covered properly in does PTO count toward overtime. And some states impose daily overtime rules on top of the federal weekly one, so check yours.
Two adjacent rules worth knowing while you are here. Overtime applies only to non-exempt employees, and the exempt versus non-exempt test is a legal one rather than a matter of job title or salary alone. Calling someone a manager and paying them a salary does not make them exempt.
The second is that offering time off instead of overtime pay, known as comp time, is generally not legal for private-sector employers, however reasonable and however mutually agreeable it sounds. Whether it can ever work is covered in is comp time legal.
The whole framework, including the overtime threshold itself, sits under the Fair Labor Standards Act, which is the single statute most worth understanding if you employ hourly people.
Pre-Tax vs Post-Tax Deductions
Deductions come out in a specific order, and the order determines how much tax the employee pays. Pre-tax deductions reduce taxable wages before withholding is calculated. Post-tax deductions come out of what is left. Same dollar, very different effect.
| Deduction | Pre-tax or post-tax? | What it reduces |
|---|---|---|
| Traditional 401(k) contribution | Pre-tax | Federal and state income tax. Not FICA: 401(k) money still gets Social Security and Medicare |
| Health insurance premium, Section 125 plan | Pre-tax | Federal and state income tax and FICA. The most tax-efficient deduction there is |
| HSA and FSA contributions | Pre-tax | Federal income tax and generally FICA, under a cafeteria plan |
| Commuter benefits | Pre-tax | Up to the monthly limit set by the IRS |
| Roth 401(k) contribution | Post-tax | Nothing. Taxed now, tax-free later |
| Wage garnishment | Post-tax | Nothing. Calculated on disposable earnings, which are already post-tax |
| Union dues | Post-tax | Nothing |
| Charitable giving through payroll | Post-tax | Nothing at the payroll level |
Notice the asymmetry in the second column: a traditional 401(k) contribution escapes income tax but not FICA, while a Section 125 health premium escapes both. That is why a health premium taken pre-tax through a proper cafeteria plan is genuinely valuable to both sides: it lowers the employee's taxable wages and it lowers your employer FICA, because you are matching on a smaller number. It is one of the very few places where a benefit costs the employer less than its face value.
Non-cash compensation follows its own rules, and some of it is taxable wages even though no money changed hands. That is the territory of fringe benefits, and it matters at year end. Retirement deductions have their own eligibility rules, including for part-time employees and 401(k) plans.
Getting the order wrong is a real error rather than a rounding issue. If you take a pre-tax deduction after calculating withholding, you have over-withheld and the employee has overpaid tax all year. It is fixable, and it is annoying, and it is exactly the kind of quiet mistake that manual payroll produces.
Bonuses and Supplemental Wages
Bonuses are not taxed differently, despite what everyone believes. They are withheld differently, which feels the same on payday and is not the same at all when the tax return is filed.
The IRS calls them supplemental wages: anything that is not a scheduled regular wage. Bonuses, commissions, overtime pay, severance, back pay, retroactive raises, awards, prizes, taxable fringe benefits, and payouts of accumulated leave all qualify.
You have two methods. The flat-rate method, above, is simplest: pay the bonus separately, withhold 22 percent, done. The aggregate method combines the bonus with the regular paycheck and runs the whole thing through the normal withholding tables, which usually withholds less on modest bonuses but requires more work. Either is acceptable. Most small businesses use the flat rate because it takes ten seconds.
The conversation to have with your employee before you pay the bonus, not after: they are going to see 22 percent go to federal income tax, plus FICA, plus state tax, and the check will be substantially smaller than the number you announced. That is not a mistake and it is not you being cheap, it is withholding. Say so in advance, because otherwise a bonus intended as a thank-you arrives as a disappointment.
And the connection back to the previous section: if that bonus is nondiscretionary and goes to a non-exempt employee who worked overtime, it also raises their overtime rate. A bonus is never just a bonus. The wider category is covered in supplemental pay, and if you are designing a bonus scheme rather than paying a one-off, the small business incentive programs guide is the place to start.
Retroactive Pay and Back Pay
Retroactive pay is money you owe for work already done and already paid for, at a rate that turned out to be wrong. A raise approved in March but effective from January. An overtime error you found and are correcting. A misclassification you unwound.
It is not complicated, and it has three characteristics worth knowing.
| Question | The answer |
|---|---|
| Is retro pay taxable? | Yes. It is wages, in full. Income tax, Social Security, Medicare, state tax |
| Is it a supplemental wage? | Generally yes, which means the flat 22 percent withholding method is available |
| Which year does it belong to? | The year you pay it, not the year it was earned. It goes on this year's W-2 |
| Does it affect overtime? | It can. A retroactive raise raises the regular rate for weeks with overtime, which means additional overtime is owed too |
| Do you have to pay it? | If it is owed, yes. Underpaid wages are underpaid wages regardless of whether the error was innocent |
The overtime interaction is the one people miss and it follows directly from the regular-rate rule. If you retroactively raise a non-exempt employee's hourly rate, and they worked overtime in the covered weeks, their regular rate for those weeks was higher than you calculated at the time, and so was the overtime premium you owed. Correcting the base rate without correcting the overtime leaves you still underpaid, which is a genuinely common way that a good-faith fix stays broken.
Practical guidance: pay it promptly and label it clearly on the pay stub as retroactive pay for the relevant period. An employee who receives an unexplained extra amount will assume it is a bonus, and an employee who receives an underexplained correction will assume you were caught. Neither is what you want.
Tipped Employees and the Tip Credit
If you run a restaurant, bar, salon, or anything else where customers tip, payroll works differently, and the differences carry some of the most litigated rules in wage and hour law. This section is federal baseline; your state is very likely stricter.
The core mechanic is the tip credit: federal law lets you count a portion of an employee's tips toward your minimum wage obligation, which means you may pay a cash wage below the minimum wage, provided tips make up the difference.
Beyond the arithmetic there are rules that generate most of the lawsuits. Advance notice is mandatory: you must tell tipped employees, before you take the credit, what cash wage they receive, how much credit you are claiming, and that they keep all their tips subject to a valid pool. Tips belong to the employee, always, whether or not you take a tip credit, and neither the employer nor managers and supervisors may keep any part of them. Tip pools are permitted, but if you take a tip credit the pool is limited to employees who customarily and regularly receive tips, which excludes cooks and dishwashers. And service charges are not tips: a compulsory 18 percent added to a bill is your revenue, and when distributed to staff it is wages rather than tips.
Two more traps. Deductions for breakage, walkouts, or register shortages are illegal where you claim a tip credit, because any such deduction pushes the employee below the minimum wage. And your state very likely overrides some of this: several states require a substantially higher cash wage, and some prohibit the tip credit entirely, meaning you pay full minimum wage and tips are on top. The stricter rule always wins. If you are building a pay structure on $2.13, confirm your state permits it before you do.
Garnishments and Wage Orders
Sooner or later an envelope arrives instructing you to withhold part of an employee's wages and send it to a third party. This is a garnishment, it is a court or agency order rather than a request, and you do not have the option of ignoring it.
Two things govern how much you withhold: the type of debt, and the federal cap on how much can be taken. Withhold too little and you can become liable for the shortfall yourself. Withhold too much and you have illegally underpaid your employee.
Different debts have different rules and a strict priority order. If multiple orders arrive for the same employee and there is not enough disposable income to satisfy them all, the order below determines who gets paid.
Child support is the one you will most likely encounter and it is the one with the highest limits by a wide margin: up to 60 percent of disposable earnings, and up to 65 percent with the arrears surcharge. That can be a very large fraction of a paycheck, and if the order says so, that is what you withhold. The federal child support employer resources explain the income withholding order process from the employer side.
Practical guidance: when the order arrives, read it, calculate against disposable earnings rather than net pay, note the effective date, and respond by whatever deadline the order specifies. Many orders require an employer answer, and ignoring one is how you become liable for the debt personally. If a state garnishment law is stricter than the federal cap, the stricter one applies and the employee keeps more.
Paying People
Three practical questions once the numbers are right: how often you pay, how the money actually reaches them, and what you have to show them and keep. Plus the one deadline that can arrive with no notice at all, which is the final paycheck.
Choosing a Pay Schedule
How often you pay is a real decision with real consequences, and the correct answer for most small businesses is biweekly. Here is why, and what the alternatives cost.
| Schedule | Runs per year | What it means for you | What it means for them |
|---|---|---|---|
| Weekly | 52 | Four times the admin of monthly. Common in trades and hospitality | Best for cash flow. Frequently expected by hourly staff |
| Biweekly | 26 | The US default. Every other Friday. Two months a year have three paydays | Predictable. Widely expected. Works for hourly and salaried alike |
| Semimonthly | 24 | Fixed dates, such as the 15th and the last day. Payday drifts across weekdays | Simpler for salaried staff. Awkward for overtime calculations |
| Monthly | 12 | The least administrative work by a wide margin | The hardest on employees. Restricted or banned for some workers in some states |
Biweekly wins for most businesses because it splits the difference: half the administrative load of weekly, and far kinder to your employees than monthly. Its one quirk is that 26 pay periods do not divide evenly into 12 months, so two months a year contain three paydays. That is not a problem, but it does surprise the cash flow of anyone who budgeted as though there were always two.
Check your state before you commit. Some states mandate a minimum pay frequency, and some set different rules for hourly versus salaried workers, or for specific industries. Monthly pay in particular is restricted in a number of states. The mechanics of each option are covered in the pay schedule guide, and the semimonthly option, which is the one people most often misunderstand, has its own walkthrough in semi-monthly pay schedules.
Whatever you pick, write it down, put it in the employee handbook, and do not change it casually. Employees plan their lives around payday, and moving it is a bigger deal to them than it is to you.
Paydays also interact with paid holidays in ways that catch people out. A payday falling on a bank holiday moves, which shortens your processing window, and the mechanics of calculating holiday pay are a recurring source of error in the runs around them.
Payment Methods
Three ways to get the money to the employee, and the rules on which you may require are set by your state rather than by you.
| Method | How it works | The catch |
|---|---|---|
| Direct deposit | Electronic transfer to the employee's bank account | Most states prohibit making it mandatory. You generally need the employee's consent |
| Paper check | The traditional method. Still legally safe everywhere | Slow, manual, and someone has to physically hand it over on payday |
| Payroll card | A prepaid card the employee's wages are loaded onto | Heavily regulated. Fees are restricted, and a fee-free withdrawal option is usually required |
| Cash | Legal, and a bad idea | You still owe every tax and every record. Cash payroll is where recordkeeping goes to die |
Direct deposit is what almost everyone uses and it is the right default. The thing to know is that in most states you cannot force it: an employee generally has the right to be paid by another method if they do not want an electronic transfer, typically because they do not have a bank account. Offering a payroll card as the alternative is common, and payroll cards are regulated precisely because they have historically been abused with fees. If you offer one, make sure the employee can access their full wages without cost.
The timing point from earlier is worth repeating here because it belongs in this section too: direct deposit takes days, not seconds. Your bank has a cutoff, and initiating a transfer on payday morning generally means the money arrives after payday. Learn your lead time and build your payroll calendar backwards from payday, not forwards from when you feel like doing it.
Cash deserves one sentence: it is legal, and everything that makes payroll defensible, the records, the stubs, the traceability, is harder with cash, and the burden of proving you paid someone falls on you. Do not pay wages in cash.
Pay Stubs and Registers
Two documents that sound like bureaucracy and are actually your evidence. The pay stub is what the employee gets. The payroll register is what you keep. You need both, and in most states the first one is a legal requirement rather than a courtesy.
There is no federal law requiring a pay stub. There are, however, state laws in most states requiring one, and they specify what it must contain. The common denominator across those requirements is simple: an employee should be able to look at the stub and reconstruct exactly how the number in their bank account was arrived at.
| What a pay stub should show | Why it matters |
|---|---|
| Pay period start and end dates | Establishes which work the payment covers |
| Gross pay | The starting number everything else derives from |
| Hours worked and the rate, for hourly staff | Required in most states. Also your defense in a wage dispute |
| Overtime hours and the overtime rate separately | Proves you paid time and a half on the correct regular rate |
| Each tax withheld, itemized | Federal, Social Security, Medicare, state, local. Not one combined figure |
| Each deduction, itemized | Health premiums, retirement, garnishments. Named individually |
| Net pay | The amount actually paid |
| Year-to-date totals | Lets the employee sanity-check their own W-2 in January |
The payroll register is the internal counterpart: one row per employee per pay run, showing the same figures plus your employer tax liability. It is the document you reconcile against your Form 941 each quarter, and it is the first thing anyone asks for in an audit or a wage claim. If you run payroll in a spreadsheet, the register is your spreadsheet, and it needs to be preserved rather than overwritten each period.
The failure mode here is a business that pays everyone correctly, keeps no register, and then cannot prove it. In a wage dispute the burden of producing records falls on the employer, and the absence of records is not treated as neutral. It is treated as favoring the employee's account.
Final Paychecks
When someone leaves, the deadline for their final paycheck is set by state law, and in some states it is immediate. This is one of the sharpest edges in payroll and one of the least known, because it is the rare deadline that can arrive with no notice at all.
| Situation | The general pattern | What to watch |
|---|---|---|
| Employee is fired | Many states require payment immediately or within a few days | The strictest states require the check on the spot, at termination |
| Employee quits with notice | Often by the next regular payday | Some states shorten this if notice was given |
| Employee quits without notice | Usually the next regular payday, sometimes longer | Generally the most lenient scenario |
| Accrued unused PTO | Depends entirely on the state and your policy | Some states treat accrued vacation as earned wages that must be paid out |
| Final expense reimbursements | Often owed with the final check | Easy to forget in the rush of an exit |
The PTO payout question is separate and equally state-dependent. In a handful of states, accrued vacation is treated as earned wages that cannot be forfeited and must be paid out at separation regardless of what your policy says. In most states, payout is required only if your own policy promises it, which means your handbook is the thing that binds you. Either way, decide the answer before someone resigns, because deciding it afterward looks like exactly what it is.
The PTO payout question has a guide of its own, because it is genuinely state-dependent and consequential: do companies have to pay out PTO, and the underlying mechanics of accrued PTO.
Practically: build the final-paycheck calculation into your employee exit process rather than treating it as a payroll task that happens later. Final hours, final overtime, PTO payout if owed, expense reimbursements, and the removal of any recurring deductions. The offboarding checklist is where this belongs, so it happens every time rather than when someone remembers. Then check your state's deadline, and work backwards from it.
Deposits and Filing
Here is the distinction that trips up nearly every first-time employer, so it gets its own section: your deposit schedule is not your pay schedule. They are set by completely different rules and they do not line up.
For a small business the practical picture is simple. You are almost certainly a monthly depositor, which means the taxes on everything you paid in January are due by February 15, regardless of whether you ran payroll twice or four times that month. That is the deadline that matters, and it does not move because you were busy.
| What | When | What it covers |
|---|---|---|
| Federal tax deposit | Monthly by the 15th, or semiweekly | Withheld income tax plus both halves of Social Security and Medicare |
| Form 941 | Quarterly, end of the month after the quarter | Reports the quarter's wages and employment taxes. Most employers file this |
| Form 944 | Annually, by January 31 | The annual alternative to 941, for very small employers. Only if the IRS tells you to |
| Form 940 | Annually, by January 31 | Federal unemployment tax for the year |
| W-2 to employees | By January 31 | One per employee, showing the year's wages and withholdings |
| W-2 to the SSA | By January 31 | The same forms, filed with the Social Security Administration |
| 1099-NEC to contractors | By January 31 | For each contractor paid $600 or more in the year. Not a payroll form, but it lands on the same desk |
Federal deposits must be made electronically, in practice through EFTPS, the free Treasury system. There is no paper option for most employers. Full details on what is owed when are set out in the IRS guidance on depositing and reporting employment taxes, which is worth reading once properly rather than skimming.
Two IRS pages are worth bookmarking rather than reading once: the employment tax due dates, and the failure-to-deposit penalty schedule, which sets out precisely what being late costs and how it escalates.
State deposits and filings run on their own separate calendar, with their own forms, in every state where you have an employee. If you employ people in three states, you have three additional sets of deadlines on top of the federal ones. This is the single biggest reason multi-state payroll gets out of hand.
Year-End Payroll
January is the busiest month in payroll and almost all of the pain is avoidable, because the work that makes January hard is work you should have done in December.
The forms themselves: Form W-2 goes to employees and to the Social Security Administration, which runs the electronic filing system most employers use.
Look at the deadline column: January 31 appears four times. W-2s to employees, W-2s to the SSA, 1099-NECs to contractors, and Form 940. That single date is the busiest in the payroll calendar, and it arrives one month after the holidays, which is not an accident of design but is certainly an accident of timing.
The gift card item is the one I would flag. If you handed out gift cards as a thank-you at any point during the year, those are taxable wages, at any amount, and they belong on the W-2. Cash equivalents have no de minimis exclusion. It is a strange rule and it is the rule, and December is when you discover you should have been tracking them.
Contractors and Owners
Not everyone who gets money from your business goes through payroll. Contractors do not, and depending on how your business is structured, neither do you. Both distinctions carry real consequences, and both are commonly got wrong.
Employees vs Contractors
Only employees go through payroll. Contractors do not, and understanding the line between them is a compliance necessity rather than an accounting nicety, because getting it wrong is one of the most expensive mistakes available to a small business.
| Employee | Contractor | |
|---|---|---|
| Goes through payroll | ||
| You withhold income tax | ||
| You withhold and match FICA | ||
| You pay unemployment tax | ||
| You control how the work is done | ||
| Receives a W-2 at year end | ||
| Receives a 1099-NEC at year end | ||
| Covered by minimum wage and overtime law |
The temptation is obvious and it is a trap. Paying someone as a contractor makes every column in that table disappear: no withholding, no employer FICA, no unemployment tax, no overtime obligation. It looks like a discount on employing someone. It is not a discount, it is a classification, and the classification is determined by the nature of the working relationship rather than by what you decide to call it or what the person agrees to sign.
If you control what the work is, when it happens, and how it gets done, that person is very likely an employee regardless of the label on their contract. The IRS and the Department of Labor both take a hard line, back taxes plus penalties are the standard remedy, and the person themselves can trigger the review by filing a form asking the IRS to determine their status. The full test is covered in the employee versus contractor guide, and the definition itself in what is an independent contractor.
Some states apply a stricter test than the federal one. California's AB5 law is the best known, and it has been copied in substance elsewhere, which means passing the IRS test does not automatically mean passing your state's. Check both.
If you are actively engaging contractors rather than merely worrying about the classification, the practical companion is how to hire 1099 workers.
Paying Contractors
Contractors do not go through payroll, but they do land on the same desk, at the same time of year, with their own set of rules. Worth covering because most small businesses have both, and because the contractor process is genuinely simpler in a way that makes the payroll process look worse by comparison.
| Step | What you do | When |
|---|---|---|
| Collect a Form W-9 | Before you pay them the first dollar. It gives you their taxpayer ID | At engagement, not at year end |
| Pay them gross | No withholding. No FICA. No unemployment tax. The full invoiced amount | Per your agreement |
| Track the annual total | You need to know what you paid each contractor across the whole year | Continuously |
| Issue Form 1099-NEC | To each contractor you paid $600 or more during the year | By January 31 |
| File the 1099-NEC with the IRS | The same information, sent to the IRS | By January 31 |
The forms themselves are simple and the IRS publishes both: Form W-9 for collecting the taxpayer ID, and Form 1099-NEC for reporting what you paid.
The W-9 is the step that gets skipped and then hurts. If you have paid a contractor $9,000 across the year and you do not have their taxpayer identification number in January, you are now chasing someone who no longer works for you for a document they have no incentive to send. Collect the W-9 before the first payment, every time, without exception. It takes them two minutes in month one and it is a genuine problem in month twelve.
The paperwork side of engaging a contractor properly, including the W-9 and the agreement, is covered in contractor onboarding.
Note what is absent from that table: no withholding, no employer taxes, no deposit schedule, no quarterly filing. That absence is exactly why misclassification is tempting and exactly why it is policed. The simplicity is not a loophole you have discovered. It is the correct treatment for a genuinely independent contractor, and it is a serious liability for anyone else.
How to Pay Yourself
Here is a question with a genuinely different answer than every other question in this guide, and one that a great many owners get wrong for years: can you put yourself on payroll? It depends entirely on how your business is structured, and for two of the three common structures the answer is no.
Start with what surprises people most. If you are a sole proprietor, or a single-member LLC that has not elected corporate treatment, you cannot be your own employee. There is no employer and no employee, there is only you. You do not issue yourself a W-4, you do not withhold, you do not get a W-2, and you cannot run yourself through payroll even if you want to. You take an owner's draw, which is simply moving money from the business to yourself, and you pay self-employment tax on the business's profit through your personal return and quarterly estimated payments.
Partnerships work the same way. Partners are not employees, they take draws or guaranteed payments, and they get a Schedule K-1 rather than a W-2. If you are in a multi-member LLC taxed as a partnership, this is you.
The S corporation is where it changes, and where the interesting problem is. As an S-corp shareholder who works in the business, you are an employee. You go on payroll properly: W-4, withholding, FICA, W-2, the whole apparatus. And you can also take distributions of profit, which are not subject to FICA. That gap is the entire tax appeal of the S-corp election, and it is also the trap.
The practical shape of the problem is a temptation. Wages get FICA at 15.3 percent combined; distributions do not. So the arithmetic says pay yourself as little salary as possible and take the rest as distributions. The IRS is entirely aware of this arithmetic, which is why the reasonable compensation rule exists, and low salary against high distributions is a documented audit flag. A zero salary while taking substantial distributions is not aggressive tax planning; it is the pattern the rule was written to stop.
What reasonable actually means: what you would have to pay someone else to do what you do. Not a percentage of revenue, not a percentage of profit, not what you personally need to live on. Market rate for your labor, considering your duties, your hours, your industry, your experience, and what you pay everyone else. Document how you arrived at the number, revisit it annually, and be able to explain it to a stranger. That documentation is the defense, and it costs you an afternoon.
If you are structuring the business and hiring at the same time, the mechanics of hiring employees under an LLC and of hiring your first employee are the companion pieces to this section.
Two closing notes for owners. Paying yourself too much also has a cost, since every dollar above reasonable is an unnecessary 15.3 percent, so the goal is defensible rather than minimal or maximal. And whichever entity you are, the IRS publishes its own summary at Paying Yourself, which is worth reading. This is the single area in payroll where I would most strongly say: talk to an accountant before you decide, not after. The tax difference is large and so is the downside of getting it wrong.
Staying Accurate
You will make a mistake. Everybody does. What separates a manageable error from an expensive one is catching it early, correcting it properly, and having the controls that make it visible in the first place.
Fixing Payroll Mistakes
You will make one. Everybody does. What separates a manageable error from an expensive one is how fast you catch it and whether you correct it properly, so it is worth knowing the mechanics before you need them.
| The mistake | How you fix it | The catch |
|---|---|---|
| You underpaid an employee | Pay the difference, ideally immediately, off-cycle if needed | Do not wait for the next regular payday. Some states treat late wages as a violation |
| You overpaid an employee | Ask to recover it. Get agreement in writing | You generally cannot simply deduct it from the next check. State rules vary and many require consent |
| You under-withheld taxes | Correct it and remit the difference | You may end up paying the employee's share yourself if the year has closed |
| You filed a Form 941 with wrong numbers | File Form 941-X to correct that quarter | Corrections do not change your lookback period. The originally reported figure stands |
| You missed a tax deposit | Deposit immediately and expect a penalty | Penalties escalate in tiers with lateness. Paying today beats paying next week |
| You issued a wrong W-2 | File Form W-2c and W-3c with the SSA | The employee may need to amend their personal return. Tell them |
| You misclassified an employee as a contractor | Reclassify and pay the back taxes | The most expensive item on this list. Talk to a professional before acting |
The two forms you will most likely need are on the IRS site: Form 941 and its correcting counterpart, and Form 940 for federal unemployment.
The overpayment row surprises people. Having accidentally paid someone too much, you would think you could simply take it back out of the next check. In many states you cannot, not unilaterally, and doing so is itself a wage violation. You have to ask, agree a repayment, and document it. This is a good reason to check a payroll run before you send it rather than after.
The general principle across every row: self-correcting is always cheaper than being found. Penalties for errors you discover and fix are lower than penalties for errors an agency discovers, and the difference is not marginal. If you find something wrong, fix it now, even if fixing it is embarrassing.
Reconciling Payroll
Reconciliation is checking that your own numbers agree with each other. It is dull, it takes twenty minutes, and it is the single highest-return habit in payroll because it catches errors while they are still small.
Three reconciliations matter, at three different frequencies.
The quarterly reconciliation against Form 941 is the one to be religious about. That form is a sworn statement of what you paid and what you withheld, and the IRS reconciles it against what you deposited. A mismatch generates a notice. If your register and your 941 agree, and your deposits match your 941, you are in a defensible position no matter what else happens.
The mundane truth of small business payroll is that most errors are not sophisticated. They are a duplicated row, a wrong rate, a deduction that should have stopped three months ago and did not. Twenty minutes of looking finds them.
Payroll Accounting
Payroll hits your books in more places than people expect, and understanding the shape of it explains something important: the money you withhold is a liability, not an expense, and treating it as anything else is how businesses spend money that was never theirs.
| What | How it lands in the books | Why it matters |
|---|---|---|
| Gross wages | An expense. Wage expense, in full | Your cost is the gross, not the net. The net is just what was left after you paid people's taxes for them |
| Employee tax withheld | A liability, until you deposit it | Money you owe the government. It is on your balance sheet, not your income statement |
| Employee benefit deductions | A liability, until you remit them | Same principle. You are holding it for the insurer or the plan |
| Employer FICA and unemployment | An expense, and also a liability until deposited | It is both: a cost you incurred and money you now owe |
| Net pay | Reduces cash when it goes out | The only part that leaves immediately |
| Tax deposit | Clears the liability. Cash goes out | The liability disappears when you actually pay it, not when you accrued it |
Read the second row again, because it is the whole point of this section. Withheld tax is a liability. It appears on your balance sheet as money you owe. It is not revenue, it is not profit, and it is not available. The reason a business can be profitable and still fail on payroll taxes is that the withheld money sits in the bank account looking exactly like every other dollar in there, and nothing about a bank balance tells you which dollars are yours.
The other thing the table shows is why your true payroll cost is the gross plus the employer taxes, not the net. If you pay someone $2,000 gross and $1,467 net, your wage expense is $2,000. The $533 difference did not vanish; you paid it to the government on the employee's behalf. Owners who think of payroll as the sum of the net checks systematically underestimate their largest expense.
Practically, for a small business: get your payroll into your accounting system, either through an integration or a journal entry each run, and make sure the withheld amounts land in a liability account rather than being netted against wages. Then look at that liability account. If it is growing and the deposits are not going out, you have a problem, and the balance sheet will tell you before the IRS does.
Budgeting for Payroll
Payroll is almost always the largest expense a small business has, and it is consistently underestimated, because the number people budget is the salary and the number that leaves the bank account is considerably larger.
| Cost layer | Roughly | Notes |
|---|---|---|
| Base salary or wages | The headline number | What you actually offered. The only part most people budget |
| Employer FICA | 7.65% of wages | Social Security and Medicare. Non-negotiable, applies from dollar one |
| Unemployment tax | Roughly 0.5% to 1% | FUTA plus SUTA. Varies by state and by your own claims history |
| Workers' compensation | About 1% on average | Class-code dependent. Under 0.5% for office work, far higher for physical trades |
| Statutory subtotal | About 9% to 10% on top | Everything above, before you offer a single voluntary benefit |
| Voluntary benefits | Whatever you choose | Health, retirement, PTO. Where the real variation is |
| Fully loaded cost | Roughly 1.25x to 1.4x salary | The number to use when deciding whether you can afford a hire |
The practical rule I would give any owner: never say a salary number out loud until you have multiplied it by 1.3. A $70,000 hire is a $90,000 decision once employment taxes, workers' compensation, and a modest benefits package are counted. If the $90,000 works, make the offer. If only the $70,000 works, you cannot afford the hire, and finding that out before the offer is considerably better than finding it out in month three.
The other budgeting reality is timing. Payroll is a fixed, recurring, non-deferrable outflow. Your customers may pay late. Your employees will not accept being paid late, and in most states they are legally entitled not to be. That asymmetry is why payroll should have its own cash reserve rather than competing with everything else for whatever is in the account on the 15th. The details of what the statutory piece includes are covered in the statutory benefits guide, and the broader benefits math sits in what benefits cost per employee.
Payroll Fraud and Controls
Payroll fraud is a small business problem specifically because it is a small business. Fraud requires opportunity, and opportunity is created by one person doing every step alone with nobody checking. That describes payroll at most companies under fifty people.
| Scheme | How it works | The control that catches it |
|---|---|---|
| Ghost employee | A person on payroll who does not exist, or who left months ago | Review the employee list against reality every quarter. Genuinely look at the names |
| Inflated hours | Timesheets padded, or overtime that was never worked | Someone other than the employee approves the hours. Anyone other than them |
| Rate tampering | A pay rate quietly adjusted upward between runs | Compare gross pay per person against last period. Any change should have a reason |
| Unauthorized bonus or expense | Payments added to a run that nobody approved | Review the payroll register before you release the run, not after |
| Bank detail substitution | Direct deposit details changed to redirect someone's pay | Any change to bank details is confirmed with the employee, out of band |
| Buddy punching | One employee clocking in for another | Time tracking that ties a punch to the actual person |
Two of those schemes have guides of their own, because they are common enough to warrant it: time theft and time card fraud. Both are fundamentally payroll problems that present as timekeeping problems.
The controls in that third column are all versions of the same idea: separate who does payroll from who approves it. In a business with three people that sounds impossible, and it is not. If the office manager runs payroll, the owner looks at the register before it goes out. Five minutes, once a fortnight. That single habit closes most of the schemes above, because every one of them requires nobody looking.
The ghost employee case is worth naming specifically because it is the one that runs longest. Nobody notices a name on a payroll register that should not be there, because nobody reads the payroll register. Look at the list of people you are paying, once a quarter, and ask whether you can picture each one of them.
The State Layer
Everything above this section is federal, and federal is the easy half. State payroll rules are numerous, they vary enormously, they change annually, and critically, they follow the employee's work location rather than your office. This is the section that catches distributed teams.
| What varies by state | Why it matters to payroll |
|---|---|
| State income tax withholding | Nine states have no wage income tax at all. The rest have their own rates, forms, and deadlines |
| State unemployment insurance rate | Every state sets its own, and yours is experience-rated. A new state means a new registration and a new rate |
| Pay frequency requirements | Some states mandate a minimum frequency, and some restrict monthly pay for certain workers |
| Final paycheck deadline | Ranges from immediately on termination to the next regular payday. The strictest states are very strict |
| Pay stub requirements | Most states require one and specify its contents. A few require it on paper unless the employee consents |
| PTO payout at separation | A handful of states treat accrued vacation as earned wages that cannot be forfeited |
| State disability and paid family leave | Several states run payroll-funded programs with their own contributions and filings |
| Daily overtime | Some states require overtime after 8 hours in a day, on top of the federal 40-hour weekly rule |
| Local taxes | Some cities and counties levy their own income tax. Easy to miss entirely |
The scaling is genuinely brutal, and it is the honest answer to why multi-state payroll pushes people onto software. One state is a set of rules you learn once and then know. Three states is three sets of registrations, three withholding regimes, three unemployment rates, three filing calendars, and three sets of rules that all change independently every January. The work does not triple. It does something worse than triple, because you now also have to remember which rule belongs to which person.
Two specifics worth knowing. Reciprocity agreements exist between some neighboring states, and they change the answer to which state you withhold for. Where an agreement is in place, an employee who lives in one state and works in another may have income tax withheld for their home state rather than their work state, provided they file the right certificate with you. Where no agreement exists, you generally withhold for the work state and the employee sorts out their home state on their own return. If you have cross-border commuters, this is worth ten minutes of checking rather than assuming.
The broader picture of which laws apply to you at which headcount sits in human resource laws, and the operational version of the same question is in HR rules and regulations.
If you are running all of this without an HR department, which describes most businesses reading this, the whole apparatus is the subject of small business HR.
And new hire reporting, which I mentioned in setup and which deserves its own sentence: every state requires employers to report new hires to a state directory, generally within about 20 days of the start date. It exists primarily to enforce child support orders. It takes minutes, it is easy to forget entirely, and it carries penalties. Build it into your onboarding checklist so it happens automatically rather than depending on someone remembering.
Where Data Comes From
Payroll does not generate its own inputs. Every number in a payroll run originates somewhere else, and for a small business that somewhere else is almost always onboarding. This is the connection nobody draws, and it explains why payroll feels so much harder than it should.
| Payroll needs | Which comes from | What goes wrong |
|---|---|---|
| Federal withholding amount | The employee's signed W-4 | No W-4 on file means withholding at the default rate, not at zero |
| Legal right to work | Form I-9, within three days of start | Missed deadline. Penalties per form, and they are not small |
| Where to send the money | Direct deposit authorization | Chasing bank details on payday, which is the worst possible time |
| Which state's rules apply | The employee's actual work location | Assuming the company's state applies. It does not |
| Employee or contractor | The classification decision at hire | Decided casually at hire, discovered expensively later |
| What to deduct | Benefit elections and enrollment | Deductions that do not match what the employee actually signed up for |
Look at the failure column. Every one of those is an onboarding failure that only becomes visible as a payroll failure, usually weeks later and usually at the worst moment. The W-4 that was never collected does not announce itself until the first pay run. The I-9 deadline passes silently. The direct deposit details are missing on payday.
This is the thing I built FirstHR to fix, and I want to be straightforward about the scope: we do not run payroll. We are not a payroll provider and this article is not a pitch for one. What we do is the layer underneath, which is collecting and holding the paperwork that payroll consumes. Digital W-4 and I-9 collection with e-signature, so the forms exist and are signed before day one rather than chased afterward. Employee records in one place, so the work location and the classification and the bank details are retrievable rather than scattered across an inbox. The new hire paperwork is the input to payroll, and getting it right at the start is what makes payroll boring instead of frightening.
The specific documents involved are covered in tax forms for new employees, and the wider set in onboarding documents for new hires.
The other half of the fix is letting people maintain their own details rather than emailing you about them. An employee self-service portal removes an entire category of chasing, because the address change and the new bank details arrive without anyone having to remember to ask.
The honest version of the value here: fixing your onboarding paperwork does not make payroll simple. It removes the specific category of payroll problem that comes from not having the documents you need, which in my experience is most of them.
Recordkeeping
You have to keep the records, the periods are longer than you think, and they differ by document type in ways that are genuinely confusing. This is the part everyone gets wrong because it is boring and there is no deadline reminding you.
| Record type | How long | Under what rule |
|---|---|---|
| Payroll records | At least 3 years | FLSA recordkeeping requirements |
| Records wage computations are based on | At least 2 years | FLSA. Time cards, wage-rate tables, work schedules |
| Employment tax records | At least 4 years | IRS. After the tax is due or paid, whichever is later |
| Form I-9 | 3 years after hire, or 1 year after termination | USCIS. Whichever date is later |
| Form W-4 | At least 4 years | IRS, as part of employment tax records |
The practical advice is to ignore the distinctions and keep everything for four years. The differences between two, three, and four years are legally real but operationally useless: no small business is going to run a document retention policy that shreds time cards at 24 months and payroll registers at 36. Keep it all for four years, keep I-9s according to their own rule, and you have covered every requirement without having to think about it again.
Where these records actually live is its own question, and the answer is not an inbox. The personnel file is the structure they belong in, and how to organize employee files is the practical method.
Retention rules extend well beyond payroll into every other document you hold on an employee, and they have their own set of periods. That wider picture is in how long to keep employee records.
Per the Department of Labor's recordkeeping guidance under the FLSA, there is no required form for the records, and no requirement that they be kept in any particular place, but the information itself is mandatory. The point is not the format. The point is that if someone asks what you paid a specific person in a specific week two years ago, you need to be able to answer, and answer accurately.
Common Mistakes
Some payroll mistakes are embarrassing. A few are genuinely expensive, and a couple can reach past the business to you personally. Worth knowing which is which.
The last one needs saying out loud because it is the one that ends businesses. The money you withhold from an employee's paycheck is not revenue and it is not working capital. It is trust fund money: you are holding it on their behalf, briefly, before handing it to the government. When a business hits a cash crunch, that money is sitting in the account, and it looks available. It is not.
Unpaid trust fund taxes can be assessed against the individuals responsible for paying them, personally, which means the corporate form does not protect you the way it does for ordinary business debts. Anyone with authority over which bills get paid can be on the hook. If you are ever in a position where paying the taxes means not paying a vendor, pay the taxes. That is the one bill where the consequence of not paying follows you home.
Classification is the other one worth genuine care. It is easy to get wrong in good faith, it is expensive to unwind, and the exposure accumulates quietly the whole time you are wrong. If you are unsure whether someone is an employee or a contractor, resolve that question before you pay them, not after.
If you have been running payroll for a while and have never checked any of this, an HR audit is the structured way to find out what is wrong while it is still cheap to fix.
Payroll Terms
The vocabulary is dense and the acronyms are unhelpful. Here is the working set, in one place, so you can stop looking them up.
| Term | What it actually means |
|---|---|
| EIN | Employer Identification Number. Your business's federal tax ID. Required to run payroll |
| FICA | The umbrella for Social Security and Medicare taxes. Paid by both employee and employer |
| FUTA | Federal Unemployment Tax Act. 6% on the first $7,000 of wages, usually reduced to 0.6% |
| SUTA | State Unemployment Tax Act. Your state equivalent. Rate depends on your claims history |
| Form W-4 | The form an employee completes so you know how much federal tax to withhold |
| Form W-2 | The annual statement of wages and withholding you give each employee by January 31 |
| Form I-9 | Employment eligibility verification. Due within three business days of the start date |
| Form 941 | The quarterly employment tax return most employers file |
| Form 940 | The annual federal unemployment tax return |
| Form 1099-NEC | What contractors get instead of a W-2, if you paid them $600 or more |
| EFTPS | The free federal system for making tax deposits electronically |
| Gross pay | Total earnings before any withholding or deduction |
| Net pay | What the employee actually receives. Gross minus everything |
| Wage base | The wage ceiling above which a given tax stops applying. $184,500 for Social Security in 2026 |
| Lookback period | The window the IRS uses to decide whether you deposit monthly or semiweekly |
| Trust fund taxes | Withheld income tax and FICA. Money you hold on the employee's behalf. Not yours |
| Owner's draw | Money a sole proprietor or partner takes from the business. Not a wage. No withholding |
| Reasonable compensation | The salary an S corp must pay a working shareholder before taking distributions |
| Self-employment tax | The 15.3% a sole proprietor or partner pays on business profit, in place of FICA |
| Supplemental wages | Bonuses, commissions, severance, retro pay. Withheld at a flat 22% if paid separately |
| Regular rate | Total weekly pay divided by hours worked. The rate overtime is calculated on. Not the hourly wage |
| Tip credit | Counting an employee's tips toward your minimum wage obligation. Federal maximum $5.12 an hour |
| Disposable earnings | Pay after legally required deductions only. The base a garnishment is calculated on |
| Publication 15-T | The IRS document containing the federal income tax withholding tables |
| Exempt | An employee not entitled to overtime under the FLSA. A legal test, not a job title |
| Non-exempt | An employee who must be paid overtime over 40 hours in a workweek |
Two of those are worth flagging as more consequential than they look. Trust fund taxes, because the term explains the entire severity of payroll compliance in two words. And exempt versus non-exempt, because it determines who is owed overtime, it is a legal test rather than a matter of job title or salary alone, and getting it wrong produces back-pay claims. The distinction is covered properly in the exempt versus non-exempt guide.
Frequently Asked Questions
What is payroll?
Payroll is the process of paying your employees: calculating what each person earned, withholding the correct taxes and deductions, paying them the remainder, paying the employer's own share of payroll taxes, depositing all of it with the IRS and your state on schedule, filing the required returns, and keeping the records. The word also refers to the list of people you pay and to the total amount you spend paying them, so context matters. For an employer the operative definition is the first one: payroll is a recurring compliance process with legal deadlines, not simply the act of writing a check.
What is the payroll meaning in simple terms?
It means paying your staff correctly and legally. In practice that breaks into four parts: work out what each person earned, take out the taxes the government requires you to withhold, hand over the rest, and then send the withheld money plus your own employer contribution to the IRS and your state by their deadlines. The complexity is not in the arithmetic, which is straightforward. It is in the fact that the money you withhold is not yours, the deadlines are fixed, and the penalties for missing them are real.
What is the payroll definition for a business?
For a business, payroll is the entire system of compensating employees and meeting the associated tax and reporting obligations. It encompasses employee classification, timekeeping, wage calculation, tax withholding, benefit deductions, net pay distribution, employer tax contributions, tax deposits, quarterly and annual filings, and record retention. It sits at the intersection of accounting, HR, and tax compliance, which is precisely why it feels disproportionately heavy for a small business where one person is doing all three jobs at once.
How does payroll work step by step?
In sequence: collect hours worked for the pay period, calculate gross pay for each employee, subtract pre-tax deductions, calculate and withhold federal income tax, Social Security, and Medicare, withhold state and any local taxes, subtract post-tax deductions, arrive at net pay, pay the employee, calculate and record your employer tax liability, deposit the withheld taxes plus the employer share with the IRS and your state on your deposit schedule, and file the required returns each quarter and at year end. The deposit schedule is separate from the pay schedule, which is a distinction that catches many first-time employers.
What are payroll taxes?
Payroll taxes are the taxes tied to wages. Some are withheld from the employee: federal income tax, the employee half of Social Security at 6.2 percent, the employee half of Medicare at 1.45 percent, and state and sometimes local income tax. Some are paid by the employer on top of wages: a matching 6.2 percent for Social Security, a matching 1.45 percent for Medicare, and federal and state unemployment tax which the employee never pays. The employer share is a real cost of employment that never appears on the employee's pay stub and is easy to forget when budgeting a hire.
How much are payroll taxes for an employer?
The employer share of FICA is 7.65 percent of wages: 6.2 percent for Social Security up to the annual wage base, which is $184,500 for 2026, and 1.45 percent for Medicare with no cap. On top of that, federal unemployment tax is 6 percent on the first $7,000 of each employee's wages, usually reduced to an effective 0.6 percent by a credit for paying state unemployment tax. State unemployment rates vary by state and by your claims history. A rough planning figure for a low-risk employer is 8 to 8.5 percent of payroll before any benefits.
What is the difference between payroll and salary?
Salary is one input to payroll, not a synonym for it. A salary is a fixed annual amount paid to a specific employee. Payroll is the whole process by which that salary, along with hourly wages, overtime, bonuses, and commissions for everyone else, is calculated, taxed, paid, deposited, and reported. Put simply, salary is a number and payroll is a process. A business with only salaried employees still runs payroll, and a business with only hourly employees runs payroll too.
How often should I run payroll?
Most US employers run payroll biweekly, meaning 26 times a year, and it is a reasonable default. The other common options are weekly at 52 runs, semimonthly at 24, and monthly at 12. Fewer runs means less administrative work but longer gaps between paychecks for your employees, which matters more to them than it does to you. Some states mandate a minimum pay frequency or specific rules for hourly workers, so confirm your state before deciding, and once you choose, keep it stable and put it in writing.
What happens if I miss a payroll tax deposit?
Penalties, and they escalate with how late you are. Failure-to-deposit penalties are calculated as a percentage of the amount owed and grow in tiers the longer it goes unpaid, with interest on top. Worse, withheld income and FICA taxes are trust fund taxes: money you held on behalf of your employees. If those go unpaid, the IRS can pursue the individuals responsible personally, which means the corporate form does not necessarily protect you. This is the single strongest argument for taking payroll deadlines seriously.
How long do I have to keep payroll records?
Longer than most owners assume, and the periods differ by document. Under FLSA rules, payroll records must be kept at least three years, while the records wage computations are based on, such as time cards and wage-rate tables, must be kept at least two years. For employment tax purposes the IRS requires records to be kept at least four years after the tax becomes due or is paid, whichever is later. Form I-9 has its own rule entirely: three years after hire or one year after termination, whichever is later. The safe practice is to keep everything for four years.
How do you calculate overtime pay?
Overtime is one and a half times the regular rate for hours over 40 in a workweek, and the regular rate is not the same as the hourly wage. The regular rate is total pay for the week, excluding a short statutory list of exclusions, divided by total hours actually worked. If an employee earned a nondiscretionary bonus, a shift differential, or a commission that week, those raise the regular rate and therefore raise the overtime owed. An employee paid $20 an hour who worked 48 hours and earned a $100 production bonus has a regular rate of $22.08, not $20. Ignoring this is the most common overtime error there is.
Are bonuses taxed differently from regular pay?
Bonuses are withheld differently, not taxed differently, and the distinction matters. The IRS treats bonuses as supplemental wages, and when they are paid separately from regular wages an employer may withhold federal income tax at a flat 22 percent, rising to 37 percent on cumulative supplemental wages over $1 million in a year. That 22 percent is a withholding rate rather than a tax rate: the employee's actual tax on the bonus is settled on their annual return like any other income, and most employees below the top bracket end up over-withheld and get a refund. Social Security and Medicare apply to bonuses exactly as to regular wages.
How much of an employee's wages can be garnished?
For an ordinary consumer debt, federal law caps it at the lesser of 25 percent of disposable earnings or the amount by which disposable earnings exceed 30 times the federal minimum wage. Disposable earnings means what remains after legally required deductions, meaning taxes and FICA, and not after voluntary deductions like health premiums, which is where employers commonly miscalculate. Child support orders have much higher limits, up to 50 percent if the employee supports another spouse or child and up to 60 percent if not, with an extra 5 percent when payments are over 12 weeks in arrears. Federal tax levies are not bound by the ordinary cap at all.
When do I have to give a final paycheck to a terminated employee?
It depends entirely on your state, and in several states the answer is immediately, at the moment of termination. Others require it within a few days, and others by the next regular payday. The rules commonly differ depending on whether the employee was fired or resigned. Penalties in the strictest states can accrue as continuing wages, meaning the former employee keeps earning their daily rate until you pay, which turns a short delay into a substantial bill. Whether you must pay out accrued unused PTO is a separate state-dependent question. Calculate the final check before the termination conversation, not after it.
What is the difference between pre-tax and post-tax deductions?
Pre-tax deductions come out of gross pay before taxes are calculated, which reduces the employee's taxable wages. Post-tax deductions come out afterward and reduce nothing. The distinction is not uniform, either: a traditional 401(k) contribution escapes federal and state income tax but still has Social Security and Medicare applied to it, while a health premium taken through a proper Section 125 plan escapes income tax and FICA both. That second case also lowers the employer's own FICA, since you are matching on a smaller number, which makes it one of the few benefits that costs the employer less than its face value.
How do I pay a contractor?
You pay them gross, with nothing withheld. No income tax, no FICA, no unemployment tax. What you must do is collect a Form W-9 before the first payment, which gives you their taxpayer identification number, track the total you pay them across the year, and issue a Form 1099-NEC to each contractor you paid $600 or more, both to them and to the IRS, by January 31. The W-9 is the step people skip and then regret, because chasing a taxpayer ID in January from someone who stopped working for you in June is genuinely difficult.
What does an employee actually cost beyond their salary?
Roughly 1.25 to 1.4 times the salary once everything is counted. The employer share of FICA alone is 7.65 percent of wages. Unemployment tax adds roughly half a percent to one percent, and workers' compensation averages around one percent though it varies enormously by job class. That statutory floor is about 9 to 10 percent on top of salary before you have offered a single voluntary benefit. Add health coverage, a retirement match, and paid time off, and the fully loaded figure lands well above the number in the offer letter. The practical rule is to multiply any salary by 1.3 before deciding whether you can afford the hire.
How do I reconcile payroll?
At three levels. Before each pay run, check that the totals look right and that nobody's net pay changed unexpectedly, which takes five minutes and catches most errors before they reach anyone. Each quarter, confirm that the wages and taxes on your Form 941 match the sum of your payroll registers for that quarter. At year end, confirm that the total of all your W-2s reconciles to the total of your four quarterly 941 filings. The quarterly reconciliation is the important one, because the IRS compares your Form 941 against what you actually deposited, and a mismatch produces a notice.
How do I pay myself as a business owner?
It depends entirely on your entity, and for most small businesses the answer is that you cannot use payroll at all. A sole proprietor or single-member LLC cannot be their own employee: there is no employer and employee relationship, only you. You take an owner's draw and pay self-employment tax on the business profit through your personal return and quarterly estimated payments. Partners in a partnership work the same way, taking draws or guaranteed payments and receiving a Schedule K-1. Only if you operate as an S corporation, or an LLC that elected S-corp treatment, are you an employee who goes on payroll with a W-4, withholding, and a W-2.
Can I put myself on payroll as a sole proprietor?
No. A sole proprietor is not an employee of their own business, because there is no separate employer. You cannot issue yourself a W-2, you do not withhold taxes from yourself, and you cannot run yourself through a payroll system. What you do instead is take an owner's draw, which is simply transferring money from the business to yourself whenever you choose. You then pay self-employment tax, which is 15.3 percent, on the business's net profit through your personal tax return, generally by making quarterly estimated tax payments. The same is true of a single-member LLC that has not elected corporate tax treatment.
What is reasonable compensation for an S corp owner?
It is what an unrelated employer would pay someone else to perform the services you actually perform. Not a percentage of revenue, not a percentage of profit, and not the widely repeated 60/40 rule, which is not IRS guidance and never has been. The IRS requires an S corporation to pay reasonable compensation to a shareholder-employee before making non-wage distributions, and it can reclassify distributions as wages where the salary is too low, with back taxes, penalties, and interest. Courts have consistently upheld this. Base your number on market rates for your duties, hours, and industry, document how you arrived at it, and review it annually.
How do I do payroll for tipped employees?
Under federal law you may claim a tip credit, paying a direct cash wage of at least $2.13 per hour and counting up to $5.12 per hour of the employee's tips toward your minimum wage obligation of $7.25. If cash wages plus tips do not reach the minimum wage in a workweek, you must pay the difference. Critically, when you take a tip credit, overtime is calculated on the full minimum wage of $7.25, not on the $2.13 cash wage, and getting that backwards is one of the most common violations in the industry. You must give advance notice of the tip credit, tips always belong to the employee, and many states are substantially stricter or ban the tip credit entirely.
How much federal income tax do I withhold from an employee?
There is no flat rate. Federal income tax withholding is determined by the employee's Form W-4 and the IRS tables published in Publication 15-T, and it produces a different result for every person depending on their filing status and the adjustments they entered. For manual payroll, the Wage Bracket Method is the practical approach: find the table for your pay frequency, locate the row for the employee's wages and the column for their filing status, and the number in that cell is what you withhold. If an employee has never given you a W-4, you do not withhold zero. You treat them as single with no adjustments, which typically withholds more.
Is withheld payroll tax an expense or a liability?
A liability, and understanding that distinction is the most useful accounting fact in payroll. Your wage expense is the gross pay, in full. The tax you withhold from that gross is not an additional expense; it is money you are holding on the employee's behalf, and it sits on your balance sheet as a liability until you deposit it with the government. The reason this matters is that withheld tax sits in your bank account looking identical to every other dollar, and nothing about a bank balance tells you which dollars are not yours. A business can be profitable and still fail catastrophically on payroll taxes for exactly this reason.