Payroll is the process of managing wages, salaries, and taxes for your business team, whether it’s just you or a small group. It involves calculating gross pay (total earnings before deductions) and net pay (take-home amount after deductions), choosing the right pay period and payout frequency, and understanding withholdings and deductions to ensure compliance.
The payroll process also includes distinguishing between W-2 employees and 1099 contractors to understand your tax obligations, streamlining payroll with technology to stay organized, and looping in a professional when it gets to be too overwhelming.
Running payroll is the process of managing and calculating the wages, salaries, bonuses, and taxes for the people who help your business thrive – you and your team.
How Does Payroll Work?
There’s a lot of lingo involved in processing payroll — so to help we’ve included a payroll glossary at the end of this article. For now, we’ll dive into some of the basics and the real-world application as a small business owner.
Understanding payroll basics
Gross pay vs. Net pay: Explaining the difference
Gross pay refers to the total amount your employees or you earn before any deductions are taken out. It’s like the starting point on your paycheck. Net pay is what you actually take home after all the deductions have been subtracted. It’s the money you actually get to keep for yourself that’s deposited into your bank account.
Deductions such as taxes, benefits, and retirement contributions are subtracted from the gross pay to arrive at the net pay. So, while gross pay might look impressive, it’s the net pay that truly matters when it comes to budgeting and planning.
Pay periods: Weekly, bi-weekly, semi-monthly, and monthly
Choosing the right pay period for your business is like picking the perfect tempo for your financial dance. Each pay period has its pros and cons, so let’s review!
- Weekly: every week, usually on the last business day of the week
- Bi-weekly: every other week, falls on different dates each month (26 pay periods/year)
- Semi-monthly: twice a month, usually around the 15th and the last day of the month (24 pay periods/year)
- Monthly: one payment, usually on the last day of the month
The key is to align your pay periods with your business’s cash flow and employee preferences. Just remember, no matter which rhythm you choose, consistency is the key to keep everyone’s feet tapping happily.
Payout frequency: Choosing the right frequency for your business
Selecting the right payout frequency ensures business operations, including payroll processing, are in sync.
- Weekly payroll: provides rapid cash injection, which can be beneficial for businesses with variable income streams or freelancers who love quick access to their hard-earned cash.
- Bi-weekly payroll: a more balanced approach, providing regular paychecks without the administrative overhead of weekly processing.
- Semi-monthly payroll: adds a sense of stability with two fixed dates each month.
- Monthly payroll: creates a predictable rhythm, making it easier to manage cash flow and budgeting.
When deciding, consider your business’s financial situation, employees’ needs, and your administrative capabilities. Remember, no matter the frequency, paying your team on time is the ultimate groove to building a happy and motivated workforce.
Key components of payroll
As a small business owner, some of the administrative obligations are less-than-glamorous. That said, payroll can become less burdensome with a high-level understanding of what it entails.
Withholdings and deductions
- Employee Taxes: As an employer, you’ll need to withhold federal, state and (sometimes) local income taxes from your employees’ paychecks, and the amount depends on their filing status and the information they provide on their W-4 forms.
- FICA Contributions: Both employees and employers are responsible for paying FICA contributions. The contributions are usually withheld from employees’ wages and matched by their employers to meet the required tax obligations. For self-employed individuals, they are responsible for paying the entire FICA contribution themselves, as they serve as both the employee and employer in this context. The current rates for Social Security is 12.4% and Medicare is 2.9% — for a combined 15.3%.
- Pre-tax Deductions: Pre-tax deductions can be a smart move for both you and your employees. These are deductions taken from your employees’ gross pay before taxes, which can help lower their taxable income. Common pre-tax deductions include contributions to retirement plans and health insurance premiums.
Independent contractors: Differentiating W-2 and 1099 workers
As your business grows, you might need to bring in independent contractors to help with certain projects. There’s a difference between W-2 employees and 1099 contractors and how these individuals are paid and treated for your business:
- W-2 employees are part of your team, working under your direction and control. You’ll need to withhold taxes and provide them with a W-2 form at the end of the year.
- 1099 contractors make ‘guest appearances’, working independently and providing specific services. You won’t withhold taxes for them, but you’ll need to collect information using a W-9 form and provide them with a 1099-NEC form at year-end if you pay them $600 or more during the tax year.
Payroll processing: Streamlining your payroll operations
Now that you’ve grasped the essential components of payroll, you can start to explore the right payroll solutions to streamline your payroll process:
- Choose the right payroll software: You can opt for traditional methods with spreadsheets and manual calculations, but should you? There are tons of payroll solutions on the market (we like Gusto!) for small and large businesses. These tools will automate calculations, generate pay stubs, and even handle tax filings, saving you time and reducing the risk of costly errors.
- Stay compliant with laws and regulations: Payroll tax laws and employment regulations can change, so it’s important and challenging to keep tabs on tax compliance. Luckily, most automated payroll solutions will integrate updates and push educational resources to keep you informed of changing tax law.
- Keep accurate records: Proper documentation is crucial for smooth payroll processing. Using payroll software can remove a huge administrative burden in keeping track of employee information, time records, pay stubs, tax forms, and more.
- Don’t forget about year-end tasks: Make sure you provide employees with their W-2 forms, submit 1099-NEC forms to contractors, and file necessary payroll tax reports to the government. Having a clear checklist and starting preparations early can help you avoid last-minute scrambles.
- Seek professional help if needed: Running your small business ship means wearing many hats, but there’s no shame in employing the right support system to help you manage so many moving parts. If payroll and taxes become overwhelming, consider working with a professional
Payroll and employee benefits
A huge part of paying employees is including employer-provided benefits or accounting for pre-tax deductions. We can take a deep dive into these subjects in another article, but here are a few things to consider that are part of the payroll process:
- Paid time off (PTO) policies
- Understanding overtime and holiday pay
- Providing pay stubs and tax forms
- Determining the best health and retirement benefits for your team
Does Collective Offer Payroll Support?
As a small business owner, mastering payroll is essential for smooth operations and a contented workforce. Understanding the nuances of payroll and when to loop in a professional can set your business up for success.
Collective is revolutionizing the way solopreneurs work as the first bookkeeping, payroll, tax and accounting solution designed exclusively for Businesses-of-One.
We combine technology and a team of trusted advisors to give our members the freedom to focus on what they do best: being their own boss. From business formation, bookkeeping, payroll and taxes, to a thriving community – all in one place – running a business can be as seamless as taking a full-time job. And we’re here to make that your reality.
Learn more about how Collective can help with payroll here.
Other Payroll FAQs
What is payroll?
Payroll is the process of managing and calculating wages, salaries, bonuses, and taxes for the individuals who work for your business, including you and your team.
What is the difference between gross pay and net pay?
Gross pay refers to the total earnings before deductions, while net pay is the amount an employee takes home after taxes and other withholdings are subtracted.
How do pay periods work, and which one should I choose?
Pay periods determine how often employees are paid, such as weekly, bi-weekly, semi-monthly, or monthly. The best choice depends on your business’s cash flow and your employees’ preferences.
What is payout frequency, and how does it impact payroll?
Payout frequency refers to how often employees are paid. It influences cash flow management and employee satisfaction. Options include weekly, bi-weekly, semi-monthly, or monthly pay.
What are withholdings and deductions in payroll?
Withholdings are amounts deducted from an employee’s paycheck to cover taxes and other authorized expenses. Deductions can include retirement contributions and health insurance premiums.
What is the difference between W-2 employees and 1099 contractors?
W-2 employees are part of your regular team, while 1099 contractors are independent workers providing specific services. Different tax and reporting rules apply to each.
How can I streamline payroll operations for my small business?
You can streamline payroll with automated payroll software, staying compliant with laws and regulations, keeping accurate records, and seeking professional help when needed.
What benefits should I consider when handling payroll for my team?
Consider offering benefits like paid time off (PTO), health insurance, retirement plans, and overtime pay to keep your crew motivated and engaged.
What is a pay stub, and why is it important?
A pay stub is a document that breaks down an employee’s earnings and deductions for a specific pay period. It provides transparency and helps employees understand their compensation.
What is the significance of year-end tasks in payroll?
Year-end tasks involve providing tax forms to employees and contractors, like W-2 and 1099-NEC forms, as well as filing necessary tax reports to the government.
What is payroll processing, and how can it be simplified?
Payroll processing involves calculating earnings, deductions, and tax withholdings for employees. Simplify it with payroll software that automates calculations and handles tax filings.
What is FICA, and who is responsible for paying it?
FICA (Federal Insurance Contributions Act) is the obligation to contribute to Social Security and Medicare taxes. Both employees and employers share this responsibility.
What are pre-tax deductions, and how can they benefit my employees?
Pre-tax deductions are subtracted from an employee’s gross pay before calculating income taxes. They can include retirement contributions and health insurance premiums, offering potential tax savings for employees.
What is compliance in payroll, and why is it important?
Compliance refers to ensuring that your payroll processes adhere to all applicable laws, regulations, and labor standards. Staying compliant avoids penalties and legal issues.
How can a payroll software solution benefit my small business?
A payroll software solution can save time, reduce errors, handle tax calculations and filings, and keep accurate records, ultimately making payroll management more efficient and stress-free.
Compliance: Ensuring that your payroll processes adhere to all applicable laws, regulations, and labor standards.
Deductions: Amounts withheld from an employee’s gross pay to cover taxes, benefits, or other authorized expenses. Deductions can include voluntary deductions (like retirement contributions) or tax deductions (like income tax withholding).
Direct deposit: A payment method where an employee’s wages are electronically deposited directly into their bank account.
FICA (Federal Insurance Contributions Act): Refers to the employers and employee obligation to contribute to Social Security and Medicare taxes. FICA is also referred to as “payroll taxes” or for a self-employed individual, it’s “self-employment tax.”
Garnishment: A legal order requiring an employer to withhold a portion of an employee’s wages for purposes such as child support or tax debt.
Gross pay: The total amount an employee earns before any deductions, such as taxes or benefits, are taken out. This is also referred to as “gross wages.”
Hourly wage: The rate of pay an employee receives for each hour worked. Hourly wage refers to compensation as it applies to hourly employees.
Net pay: The amount an employee takes home after all deductions and withholdings have been subtracted from their gross pay.
Overtime: Additional compensation given to non-exempt employees who work more than the standard hours per week.
Overtime pay: Additional compensation given to employees who work beyond their regular working hours, typically at a higher rate.
Pay period: The timeframe in which employee wages are calculated and paid, such as weekly, bi-weekly, or monthly.
Pay stub: A document that provides a breakdown of an employee’s earnings and deductions for a specific pay period.
Payroll processing: The management of paying employees, withholding payroll taxes and other deductions on a recurring basis. It involves calculating gross pay and net pay, applying pretax deductions, tracking hours worked, and managing employee benefits. Using a specialized payroll software can help streamline the process and reduce administrative burdens.
Payroll tax: Taxes paid by both employers and employees to fund social security, Medicare, and other government programs.
Pre-tax deductions: Certain expenses or contributions that are subtracted from an employee’s gross pay before calculating income taxes. Pre-tax deductions taxable income, resulting in potential tax savings. The most common pre-tax deductions include contributions to retirement plans, health insurance premiums, or flexible spending accounts (FSAs) for healthcare or dependent care expenses.
PTO (Paid Time Off): Time off provided to employees for vacation, sick days, or personal reasons, with regular pay.
Salary: A fixed amount paid to an employee on a regular basis, usually on a monthly or bi-weekly schedule. Salary refers to compensation as it applies to salaried employees.
Tax withholding: The process of deducting federal, state, and sometimes local taxes from an employee’s paycheck, based on their income and withholding allowances.
W-2 Form: A tax form provided to employees at the end of the year, summarizing their annual earnings and the taxes withheld. This is the form to use when you prepare your annual individual income tax return.
W-4 Form: The W-4 form helps employers determine the appropriate amount of federal income tax to withhold from each paycheck.
W-9 Form: A tax form used to collect essential information, such as the taxpayer’s name, address, and taxpayer identification number (TIN), from independent contractors and freelancers. The information on the W-9 form is used by the payer to report payments made to the IRS and provide the contractor with a 1099 form at year-end.
Year-to-Date (YTD): The cumulative total of an employee’s earnings and deductions from the beginning of the year until the present.
1099 Form: A tax form given to independent contractors, showing the income they received from a business during the tax year.
Marissa Achanzar is part of the sales team at Collective and doubles as a content writer based in Roseville, California. After a successful seven-year-stint in public accounting, Marissa decided to pivot and put her tax compliance and client engagement experience to use by creating practical, people-first educational content.
Marissa is also the founder of Something Good Co., a non-profit that supports foster and at-risk youth in the Sacramento region. In her spare time, she enjoys exercise, trying out new recipes, dabbling on piano or guitar and won’t say no to a good TV/movie marathon. You can find her on LinkedIn or contact her at [email protected]