The Payroll Process

Setting up a payroll system maximizes your ability to stay on top of your federal, state, and local withholding and tax requirements. This section breaks down the basics of the payroll process.

Obtain an Employer Identification Number (EIN)

Before hiring employees, you need to get an employment identification number (EIN) from the IRS. The EIN is necessary for reporting taxes and other documents to the IRS, and for reporting employee information to state agencies. You can apply for an EIN online or contact the IRS directly.

State and Local IDs

Some state and local governments require businesses to obtain state ID numbers to process taxes. Check to see if this applies in your state with this State Tax Guide.

Distinguish Independent Contractors from Employees

The distinction between being an independent contractor and being an employee will directly affect withholding, income taxes, Social Security and Medicare taxes, and unemployment taxes. To understand the difference between an independent contractor and a full-time employee, please click here.

Deductions and Contributions

Other employee compensation and business deductibles, such as health plan premiums and retirement contributions, must also be deducted from employee paychecks and paid to the appropriate entities.

Form W-4

Employees must fill out IRS Form W-4 and return it to you, so that you can withhold the correct federal income tax from their pay. 

Decide on a Pay Period

Setting up a pay period (e.g., weekly, bi-monthly, or monthly) is generally determined by state law. The IRS also requires that you withhold income tax for a given pay period, even if your employee does not work the full period.

Recordkeeping

It is important to track employee hours, overtime, exempt versus non-exempt status, paid time off, and other business variables. You must comply with recordkeeping requirements under the federal Fair Labor Standards Act and state wage and hour laws.

Other federal and state laws also require you to keep certain records for specified periods. For example, W-4 forms must be kept on file for all active employees and for 4 years after an employee is terminated.

Running Payroll

Once you've collected all forms and necessary information, you can start running payroll either internally or through a third-party payroll service, which is one of the easiest and most efficient ways to stay on top of the payroll process. See Outsourcing Payroll for more information.

Direct Deposit

With direct deposit, employees authorize you to automatically deposit their pay into a designated bank account. You must also comply with any applicable state wage payment laws, which may govern when wages are paid (e.g., weekly or bi-weekly) or require you to provide employees with a direct deposit option. 

Setting up direct deposit usually entails having the employee submit a voided check to you to identify: (1) the routing number of the employee’s financial institution; and (2) the account number for the account that will receive the deposit. Please click here for a sample direct deposit authorization form.

Employees generally may also stop their authorization of direct deposit. Please click here for a sample authorization to stop direct deposit.

Report Payroll Taxes

To understand your tax filing obligations, please review the Employer's Tax Guide, which provides guidance on all federal tax filing requirements. It is also important to check with your state tax agency for specific state tax filing requirements.

Required Notice to Employees

The IRS requires you to notify each employee who worked for you at any time during the year and from whom you did not withhold income tax of the Earned Income Tax Credit (EITC). The EITC is a refundable federal income tax credit for low- to moderate-income working individuals and families.

When the EITC exceeds the amount of taxes owed, it results in a tax refund to those who claim and qualify for the credit. There are several methods you may use to satisfy this notice requirement, including providing employees with Form W-2, which has the required information about the EITC on the back of Copy B. Click here for more guidance.