The first time you hire an employee, paying them stops being a simple transfer. You now have to withhold taxes, pay some taxes yourself, file reports, and keep records. Small business payroll is how you handle all of that accurately and on time.
This guide walks through what payroll includes, how to set it up, how payroll taxes work, how to run each pay period, and what to file and when. It includes a worked example with numbers that add up. Some rules vary by state and by business situation, and the article points those out.
What Is Small Business Payroll and Why Is It Important?
Small business payroll is the process of paying your employees and handling everything attached to that pay. It covers calculating wages, withholding taxes and other deductions, paying employees, depositing the taxes you owe, filing payroll tax returns, and keeping records.
Payroll applies to employees. Independent contractors are generally paid under different rules, which we cover below.
What Does Small Business Payroll Include?
Each pay period usually involves:
- Gross pay: Wages or salary before any deductions.
- Withholdings: Taxes taken out of the employee’s pay, plus any deductions the employee has agreed to.
- Net pay: What the employee actually receives.
- Employer taxes: Taxes you owe on top of the employee’s gross pay.
- Deposits and filings: Paying the government and reporting what you paid.
- Records: Documentation you must keep.
Before You Run Small Business Payroll: Setup Checklist
Do these steps before the first paycheck.
Get an Employer Identification Number (EIN)
If you have employees, you need an EIN to report employment taxes and give employees tax statements. You can apply on the IRS website. Don’t use your Social Security number in place of an EIN.
Decide Who Is an Employee and Who Is a Contractor
Generally, a worker is your employee if you control what work is done and how it is done. What you call the person doesn’t change that. People in business for themselves, offering services to the public, are usually independent contractors.
Getting this wrong can be costly. If you treat an employee as a contractor, you can be liable for the taxes you should have withheld and paid. If you aren’t sure, the IRS lets you request a determination using Form SS-8, and a tax professional can help you decide.
Verify Work Eligibility and Collect Tax Forms
For each new employee:
- Complete Form I-9 to verify identity and work eligibility (see the Form I-9 guidance from USCIS).
- Ask the employee to fill out Form W-4, which tells you how much federal income tax to withhold.
- Record the employee’s name and Social Security number exactly as shown on their card.
- Report the new hire to your state’s new hire registry.
Register With Your State
Federal rules are only part of the picture. Depending on your state, you may also need to register for state income tax withholding, state unemployment insurance, and workers’ compensation coverage. Requirements and rates vary widely, so check with your state’s tax and labor agencies.
Payroll Taxes for Small Business Explained
Payroll taxes fall into two groups: taxes you withhold from employees and taxes you pay as the employer.
Taxes Withheld From Employee Pay
- Federal income tax: The amount depends on the employee’s Form W-4 and the IRS withholding tables.
- Social Security tax: 6.2% of wages, up to an annual wage limit ($184,500 for 2026).
- Medicare tax: 1.45% of all wages, with no wage limit.
- Additional Medicare Tax: A further 0.9% applies once an employee’s wages from you exceed $200,000 in a calendar year. You withhold it from the employee, and there is no employer match.
- State and local taxes: These depend on where you and your employees are located. Some states have no income tax.
Taxes the Employer Pays
- Employer Social Security tax: 6.2%, matching the employee’s share.
- Employer Medicare tax: 1.45%, matching the employee’s share.
- Federal unemployment tax (FUTA): Paid by the employer only, not withheld from employees, and reported annually.
- State unemployment tax: Generally required for covered employers, with rates and rules that vary by state.
Rates and wage limits change over time, so check the current year’s IRS guidance before you set up payroll.
Why Withheld Taxes Matter So Much
The income, Social Security, and Medicare taxes you withhold from employees’ pay are often called trust fund taxes. They belong to the government, and your employees are counting on you to pay them over. If withheld taxes aren’t deposited, penalties can apply, including a trust fund recovery penalty. This is one of the most serious payroll mistakes a business can make.
Small Business Payroll Example
This is a hypothetical example. A small bakery pays one employee $2,000 in gross wages for a biweekly pay period. The federal income tax and state tax amounts are illustrative only. Real amounts depend on the employee’s Form W-4, the IRS withholding tables, and your state’s rules.
| Item | Amount |
|---|---|
| Gross pay | $2,000.00 |
| Withheld from the employee | |
| Federal income tax (illustrative) | $180.00 |
| Social Security (6.2%) | $124.00 |
| Medicare (1.45%) | $29.00 |
| State income tax (illustrative) | $70.00 |
| Total withheld | $403.00 |
| Net pay to employee | $1,597.00 |
| Employer share of payroll taxes | |
| Employer Social Security (6.2%) | $124.00 |
| Employer Medicare (1.45%) | $29.00 |
| Total employer payroll taxes | $153.00 |
| Wages plus employer taxes | $2,153.00 |
How the numbers work:
- Social Security: $2,000 × 6.2% = $124
- Medicare: $2,000 × 1.45% = $29
- Total withheld: $180 + $124 + $29 + $70 = $403
- Net pay: $2,000 − $403 = $1,597
- Employer taxes: $124 + $29 = $153
- Federal deposit for this payroll: $180 income tax + $248 Social Security ($124 withheld + $124 employer) + $58 Medicare ($29 withheld + $29 employer) = $486
The $70 of state tax goes to the state, not to the IRS. The employer’s true cost is higher than $2,153 once you add unemployment taxes, workers’ compensation, and any benefits you offer.
Overtime example: An hourly employee earning $20 per hour works 46 hours in one week. Regular pay is 40 × $20 = $800. Overtime is 6 hours at one and a half times the regular rate ($30), or 6 × $30 = $180. Gross pay for the week is $980.
How to RunSmall business Payroll Step by Step
- Collect hours or confirm salary. For hourly employees, review time records. Keep them accurate, because they support the wages you pay.
- Calculate gross pay. Include regular pay, overtime, and any bonuses or commissions.
- Calculate withholdings. Apply the employee’s Form W-4 information, Social Security and Medicare, state taxes, and any approved deductions.
- Calculate net pay. Subtract total withholdings from gross pay.
- Pay your employees. Direct deposit or check from your business bank account, not a personal account, so payroll stays separate and traceable.
- Set aside and deposit the taxes. Withheld taxes plus the employer share must be deposited on schedule.
- Record everything. Save pay records, tax deposits, and filings. Your bookkeeping should reflect each payroll accurately.
Payroll Deposits and Filing: What to Pay and When
Federal Tax Deposits
Employers must make federal tax deposits electronically. You generally deposit on a monthly or semiweekly schedule, depending on how much employment tax you reported during a past lookback period. Larger liabilities can trigger faster deposit rules, so follow the schedule that applies to you. IRS Publication 15 Circular E, Employer’s Tax Guide explains the rules in detail.
Quarterly Filing
Most employers file Form 941 each quarter, with returns due at the end of April, July, October, and January. Some very small employers may be allowed to file an annual Form 944, but only after the IRS notifies them in writing. If a due date falls on a weekend or holiday, it moves to the next business day.
If you aren’t a seasonal employer and haven’t filed a final return, you generally must keep filing even for periods when you paid no wages.
Annual Filing
- Form W-2: Give each employee a W-2, and file copies with the Social Security Administration, generally by the end of January.
- Form 940: Report federal unemployment tax annually.
- Form 1099-NEC: If you paid contractors, you report payments to them separately. For payments made in 2026, the reporting threshold is $2,000.
Payroll Options: Do It Yourself, Software, or a Provider
| Option | Best for | Things to know |
|---|---|---|
| Do it yourself | One or two employees, simple pay | You calculate, deposit, and file everything. Mistakes are on you. |
| Payroll software | Owners who want automation | Often calculates taxes and prepares forms. Check what it files for you. |
| Payroll service | Growing teams or multiple states | Costs more but handles much of the workload. |
| Accountant or bookkeeper | Owners wanting oversight | A small business accountant can review your payroll setup and filings. |
Whichever route you take, remember that outsourcing doesn’t transfer responsibility. If a payroll provider fails to file or deposit correctly, you are still responsible.
Payroll Records You Need to Keep
The IRS says employment tax records should be kept for at least four years. Records include:
- Your EIN
- Employee names, addresses, Social Security numbers, and dates of employment
- Amounts and dates of all wage payments
- Copies of each employee’s Form W-4
- Dates and amounts of tax deposits
- Copies of filed returns
Good small business bookkeeping makes this much easier, because each payroll is recorded as it happens instead of reconstructed later.
Overtime, Minimum Wage, and State Rules
Federal law (the Fair Labor Standards Act) requires covered employees who aren’t exempt to receive overtime at one and a half times their regular rate for hours worked over 40 in a workweek. The workweek is a fixed period of 168 hours, and hours can’t be averaged across two weeks. The U.S. Department of Labor’s overtime guidance explains who is covered and who is exempt.
State rules can add requirements. Minimum wage, overtime, paid leave, pay frequency, and final paycheck rules vary by state. For minimum wage, an employee covered by both state and federal law is entitled to the higher of the two. For other rules, check your state labor department.
Common Small Business Payroll Mistakes
- Misclassifying employees as contractors. This can create tax liability and back pay problems.
- Missing or late deposits. Penalties can add up quickly.
- Not collecting Form W-4 or Form I-9. Without them, you can’t withhold correctly or prove eligibility.
- Mixing payroll money with other money. Keep withheld taxes set aside so they’re there when due.
- Ignoring state requirements. Federal compliance alone isn’t enough.
- Poor records. If you can’t show what you paid and deposited, it’s hard to defend or correct.
- Not updating for new rates. Wage limits and thresholds change.
Payroll and Your Financial Statements
Payroll is usually one of your largest costs, so it shows up everywhere in your finances. Wages and employer taxes appear as expenses on your profit and loss statement. Payroll timing affects your small business cash flow, because you pay employees and make tax deposits on a schedule whether or not customers have paid you yet. And a realistic payroll estimate is the foundation of small business budgeting when you plan to hire.
Frequently Asked Questions
What is small business payroll?
It is the process of paying employees and handling the related tasks: calculating pay, withholding taxes, depositing taxes, filing returns, and keeping records.
How do I start payroll for a small business?
Get an EIN, confirm that your workers are employees, complete Form I-9 and collect Form W-4 for each one, register with your state agencies as required, and set up a way to calculate and track pay. Then run payroll on a regular schedule.
What payroll taxes do small business owners pay?
Employers withhold federal income tax, Social Security tax, and Medicare tax from employee wages, and pay a matching share of Social Security and Medicare. They also pay federal unemployment tax and, in most states, state unemployment tax.
How long should I keep payroll records?
The IRS says to keep employment tax records for at least four years. Some other records or state rules may call for longer, so check with a tax professional.
Can I do payroll myself?
Yes, many owners with one or two employees do. Payroll software can help with calculations and forms. If it feels risky, a payroll provider or accountant can take on the work, though you remain responsible for accuracy.
Conclusion
Small business payroll comes down to a repeatable routine: set up each employee correctly, calculate pay and taxes, pay on time, deposit and file on schedule, and keep clean records. The first few payrolls take the most effort, and the process gets easier after that.
Start with the setup checklist, choose the payroll method that fits your size, and check the current IRS and state guidance each year, since rates and limits change.
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