Knowing how to pay employees in a small business is critical. Why? There are steps and regulations you have to be in compliance with no matter what industry you are in. Overlooking even one regulation could cost you big in fines and ability to do business.
Aside from that…getting paid is the single most important thing to any employee.
So, you’ve made the decision to hire your first employee. That’s great! But before making a great hire, you’ll need to have a plan in place for paying employees. Use these steps as a guide to create your plan.
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Table of Contents
Why is knowing how to pay employees in a small business important?
Knowing how to pay employees in your small business is super important. It is important not only for the employee but also for you as an employer.
As a first time business owner you might think: “I have the money to pay someone…so what’s the big deal?” Well, having the money is a good start. But, there are many federal, state and local regulations that apply to employers. Not following the rules can cost you a lot.
Fail to comply and you could face big fines, license forfeitures, and many lawsuits. Make sure to seek advice from professionals on what your specific requirements are.
How to pay employees in a small business.
Ok. By now, we know there are major implications for missing something when you pay employees. It sounds scary. But don’t worry – the benefits of adding an employee to your small business should overpower that fear.
Plus, we are here to help you get started with a great plan to pay your employees.
Let’s dig in and go through some of the steps you should take to make sure you are ready to pay employees.
Obtaining an EIN Number and any applicable state or local IDs
If you are new to business you may be thinking, “What the heck is an EIN number?” An Employer Identification Number (EIN) is a 9 digit number. It’s used to identify business (and other) entities.
If you are hiring employees (one or many), you must get an EIN to use on tax returns and other documents you submit to the IRS. There are also other reasons you may need an EIN including:
- Opening a bank account
- Self Employed retirement plans
- Situations such as sole proprietorship bankruptcy
- To file excise tax returns or alcohol, tobacco, and firearms returns
So, now you know what an EIN is. Now you have to apply for one. There is a list of certain information you should have ready before you do. That information includes:
- The legal name of the entity & trade name (if it’s different than legal)
- An authorized person to act for the entity (could be a corporate officer, a partner, an executor, etc.
- Mailing addresses for the legal entity and the authorized person
- Responsible party’s name and SSN, Tax ID Number, or existing EIN.
- Type of entity (e.g., Corporation, partnership, LLC, etc.)
- Number of LLC members if that is the entity type
- The state or foreign country of incorporation (if requesting for a corporation)
- Reason for applying (common reasons include new business, hiring employees, banking purposes, etc.)
- Closing month of your accounting year. If you are unsure, please check with your tax professional
- Estimated highest number of employees expected in the next 12 months (can be zero)
- First day you paid wages to employees (if applicable)
- Your principal business activity
- Applicant’s name, title, telephone # and signature
- Third party nominee’s contact info if someone is acting on your behalf
One last thing about EIN’s before we move on. Be sure to update the IRS on any changes in your business. You have an ongoing obligation to notify the IRS when certain events take place. This could be a business address or name change. You’ll have to notify them in writing, signed by an authorized person for your legal entity.
State and Local IDs
The EIN is a federal identification number. There are also state and local ID numbers required for businesses. Each state is a bit different so it would be hard to narrow down your specific obligation into only one article.
The SBA can help you determine what your specific state mandates. Additionally, be sure to look into your local government requirements as well.
Ensure new employees fill out the proper paperwork.
When it comes time to make a great hire, you will need to collect some forms from the employees. These documents serve as a guide to withhold specific amounts from each paycheck. Those amounts are then remitted to the appropriate taxing organizations.
Some of the most common requirements consist of:
- IRS W-4 form for federal tax withholding
- State forms
- Other state forms and local withholding forms
- USCIS I-9 form for verifying work eligibility
Note: Planning on paying your employees via direct deposit? You will also want to request their bank information as well.
Set the wage you will pay them.
Determining how much you should pay employees can be quite unique to your situation. There are many factors that go into determining what you should pay an employee. Some of those factors are:
- Your available funds.
- Revenue potential for the value the position adds (i.e., are they billable? more capacity?)
- What are your competitors paying for a similar role?
- What is the skillset worth to your company?
- What is the average compensation for this role in your field and location?
We recommend first starting with narrowing down the role that you want filled. Then do some market research using a tool like PayScale or Salary. You will know the average range of compensation for that role.
Then, look at your budget. Will you be able to afford someone in that range? If so, how will it impact your top and bottom line?
If everything checks out and you are comfortable – it’s time to determine how and when the employee will get paid.
What type of compensation is best for employees in your small business?
There are many different ways to compensate employees. In this article we will discuss the 3 primary ways that small businesses pay employees.
Hourly rates and time worked during a pay period determine the amount of pay.
For instance, if you pay an employee $20.00/HR and they work 40 hours – they will gross $800.00 for the pay period. (Note: Gross means before taxes are withheld, benefits, etc.)
Hourly wage compensation is ideal for those that don’t work a consistent schedule. For example, a part-time worker or a restaurant server. Keep in-mind it is typical for hourly employees to be “non-exempt”. This means that they qualify for overtime pay. Make sure you factor this into your budgeting if you expect they will work more than 40 hours per week.
Hourly wages are good for startups that are getting their business up and running. They are also good for businesses with fluctuating demand periods. Those are not the only use cases – but two scenarios in which hiring hourly employees make a lot of sense.
Salaried employees are usually paid a fixed annual rate. Each payday is a consistent amount determined by Annual Salary/Number of Pay Periods. Example: $52,000.00/52 Pay Periods = $1,000.00 Gross Pay per Period.
Salaries are best suited for roles where the employee’s time put in is predictable. Usually, you will find this in corporate or management type roles. It is also important to note that salaried employees are usually overtime “exempt”.
You can also pay employees based on the direct results of their efforts. This method allows the employees to earn a percentage of a predetermined goal. Commission-based positions are usually centered around a lower base rate of pay. Then the employee earns money on top of that based on their performance.
For example: A staffing recruiter earns a base salary of $35,000/Year. If the recruiter places an employee with a company – they earn a % of what the employee’s salary will be at the new firm. So in one pay period it could look something like this:
Gross Pay from Salary: $673.08 ($35,000/52)
Commission Earned from Placement: $550.00 (Placement Salary of $55,000 per year x 1% commission)
Total Gross Pay: $1,223.08
As you can see, the commission can add a significant boost to a paycheck. This method incentivizes employees to perform.
You will most likely find this type of compensation in sales roles. It can also apply to managers and executives as well.
Be sure that you understand the Fair Labor Standards Act for proper compensation. It is very important to adhere to wage and overtime laws.
How often should you pay employees?
Setting the wages is only one part of the equation. You will also need to determine how often employees will get paid. There is no one size fits all selection here. The most common examples of pay periods are:
Weekly: A weekly pay period results in 52 paychecks in a year. This is the preferred method of employees because everyone wants their money fast. Most who use this method pay employees in arrears. This means that employees record their time sheets at the end of one week and get paid a week later. This allows the payroll processor time to make the necessary calculations.
Bi-weekly: This structure results in 26 paychecks a year.
Semi-monthly: Results in 24 paychecks in a year. You will most likely find this pay structure with a large amount of salaried employees.
Monthly: This is a more rare pay period and results in 12 paychecks a year. This is almost always used for salaried employees.
What pay period is best for your small business?
Many factors come in to play when determining the frequency that you pay your employees. One of the most critical elements of knowing how to pay employees in a small business is knowing when to pay the employees.
The biggest consideration, in our opinion, is your cash flow. How much starting cash do you have, how much consistent revenue do you bring in, and how quick do customers pay you? These are all questions you should ask before determining your pay period.
For instance: A small consulting firm may have a month’s worth of cash on hand. They have a steady book of business and employee hours will be billable. The only problem is that their payment terms are NET30. This means that they do not get paid for 30 days after submitting an invoice (if it’s approved by the client). Less frequent cash in will make it unrealistic to pay employees weekly.
The opposite scenario could be something like a coffee shop. With cash coming in daily – it makes it more likely that they can pay their employees faster.
Payroll processing can also play a big role. We will discuss payroll processing in the section below. The importance of it in this scenario is the cost. If you use a third party processor, there will generally be fees. More payroll periods will most likely result in more fees.
Last, but not least, you should consider employment laws. The IRS does not regulate the frequency of pay periods but some states do. Please check with your state’s department of labor for information on pay regulations.
Choose your method of processing payroll.
Processing payroll is where the time turns into money. This step involves calculations, tax withholding, time verification, and more. To be honest, it’s a lot. But if you can figure this out, you can say you know how to pay employees in a small business!
Two common ways payroll processing gets done is either in-house or outsource to a third party.
If you are a small business owner and have only a couple of employees, you can try to tackle this yourself. Arm yourself with a good accounting system, Excel workbook, or a fancy ledger from the 1700s.
Don’t have the time or confidence to do the payroll processing? You could hire an employee that specializes in payroll processing to take this task on.
It is common for companies to have an in-house payroll clerk. Why? To take away some risk of dealing with third party providers.
Risks may include timely completion, missed benefit remittance, or hour discrepancies. Having someone in-house makes it easy to make corrections and get answers. No elevator music while you are stuck on hold!
Third Party Payroll
For those of you who would rather focus on the other aspects of your business, a third party processor may be ideal.
Third Party providers help you establish a system that can track:
- Deductions and withholdings
- Direct Deposits and Withholdings
Not to mention it somewhat uncomplicates the process.
It takes time to gather info, make calculations and ensure the right withholdings. Not to mention you have to track records and organize them in an efficient way.
There are several flexible payroll processing options out there. You can find the best fit for you: whether it be a monthly fee or a percentage of your payroll. Do some research and find the best fit for your organization!
What’s our choice? We like QuickBooks because it makes up our entire accounting system. It is handy being able to get help from one company and see our data working seamlessly.
Distribute paychecks to employees.
Well, you have made it this far. Now you know how much you are going to pay your employees when the pay period is up. It’s time to figure out one of the most critical parts of knowing how to pay employees in a small business…putting the money in their hands.
The two most common ways are Direct Deposit and Paper Checks.
Direct Deposit means you will transfer the net pay amount from your bank account into theirs. If you are not using a third party processor, you will want to work with your financial institution. They may have a business in mind and have processes in place to make this easy for you. Also, it is important to understand any fees they may charge. Don’t forget to collect the employees bank information at the time of hire so you know it’s going to the right place.
Direct deposit is popular and easy. But, there are some risks to be aware of. Security/privacy concerns are always going to be there. Accurate routing information needs to be in place for the money to get where it needs to go. You also have to find a way to get the employees their pay stubs. If you aren’t mailing a check, you cannot stuff a stub in the envelope. Make sure these items are a priority when setting up your system.
Paper Checks are being phased out but are still very relevant. Employees in today’s world do prefer speed. That means waking up, clicking a button, and seeing that their money is there. They don’t have to worry about the check disappearing in the mail. No need to try to find a slot between 9 and 5 to get to the bank to cash it. It’s convenient.
Businesses have seen tremendous savings, both time and money, from phasing out checks. They save on stationary, postage, ink and more. Also, they do not have to stuff envelopes or reconcile the number of checks.
There are still employees who prefer paper checks though. They like the paper trail. They like the security of it. And some of them enjoy seeing the results of their hard work as a tangible item in their hand.
Paper checks are usually mailed out or handed out in person. The choice is up to you on the easiest and most cost effective way to get them to your employees!
File taxes and pay into applicable benefits.
As an employer you are responsible for paying taxes on behalf of your W-2 employees. You will need to remit the withheld amount of an employee’s paycheck and distribute the funds. Depending on your requirements, the funds will go to the IRS, your state and local agencies.
Many small businesses offer employee benefits. If you do, you will need to give new hires paperwork that describe the terms and conditions. You will also, more likely than not, have to get their signature to agree. You will need to make payments to offer some benefits. Make sure you are current with payments to ensure the employees get what you offered.
Update payroll records.
You will need to keep your payroll records accessible for several years. Why? Well, you might get audited. If you keep your payroll register up to date, accessible and organized – you will be fine if someone asks for info. At the very least, include info about who got paid, how long they worked, how much they made and taxes withheld.
Note: Third Party payroll processors can be very helpful with this!
Tips and reminders on how to pay employees in a small business.
We covered a lot of information in this article. It is our hope that you are less confused than you were when you started. As a refresher, here is a quick recap of our top suggestions:
- Make sure all of your paperwork is in order. This includes getting an EIN, State & Local ID’s, Employee tax paperwork, benefit information and more.
- Set wages that fit in your budget. Do research on average wages. Adjust responsibilities and requirements to reflect your budget.
- Figure out what pay period works best with your business model. Long gaps in cash flow? Use longer pay periods. Money coming in frequently? Use shorter pay periods. Also, consider fees if using a third party processor.
- Weigh the benefits of using a third party processor v. doing payroll in house. If you are not comfortable with the calculations, do not have the time to focus, or have a larger team: a third party will benefit you the most.
- Figure out the most efficient way to distribute paychecks. Be sure to pay any withholdings to the appropriate agencies.
- Keep tidy, accessible, and clear records in case of an audit.
Knowing how to pay employees in a small business is of the utmost importance. No one is going to work for free. That’s why it is critical you understand everything that goes into the process.
You don’t want to screw up employee pay, miss tax withholdings, or be non-compliant and face big fines. Instead, you want to garner a good reputation. You want to be an employer who pays fairly, on-time, and is compliant with all applicable laws and regulations.
The process seems complicated. You can do it though. There are plenty of resources out there at the Federal, State and Local level. Third Party payroll processing companies are there to assist you. You have us…
Don’t let the fear of the process hold you back from hiring the employees you need to grow your business. Make a great hire and use your newly acquired knowledge to pay them.