How To Calculate Payroll For Your Small Business’s Employees

Small business owners have to be self-sufficient and able to juggle many tasks simultaneously. You pay the rent; you do the books. You fulfill orders and clean the bathrooms. And if you have employees, completing payroll is just another part of your necessary daily routine.

Learning how to do payroll in-house can keep costs down, but crunching the numbers and doublechecking your work takes patience and practice. It’s not impossible, though — no matter how daunting it may seem. Read on! We’ve put together a comprehensive guide to handling payroll that will take the guesswork and stress out of the picture.

How To Calculate Payroll

Figuring out how to do payroll is a useful skill for any business owner, but it’s especially valuable if you run a small business and don’t have access to a lot of resources. There are some necessary forms, definitions, and equations to become familiarized with first. This guide will lead you through the basics and the finer details. Follow along as we show you how to calculate payroll step-by-step.

1) Fill Out The Proper Forms

First, you’ll need to make sure your employees have filled out the proper forms. Your own employees will complete a W4, which will let you know if they have any withholdings. Meanwhile, independent contractors have to fill out an I-9.

Your employees should fill out a W4 any time their personal and financial situation changes, including:

• Marriage or divorce
• Children
• Changes to household income (e.g. a second job)

2) Calculate Your Employee’s Gross Pay

Once all the paperwork is accounted for, it’s time to break out the calculator and spreadsheets and dive into how to figure out payroll for your employees.

Calculating gross pay is step number one. In short, gross pay can be thought of as the total money earned by an employee before deductions and taxes are factored in. To arrive at the correct total, you’ll have to add up an employee’s total wages, salary, commission, tips, bonuses, and any other form of earnings. (Note: Independent contractors are responsible for handling their own taxes, so that’s one thing off your plate. Phew!)

Let’s break down how to calculate the various types of earnings that go into a W2 employee’s gross pay for each paystub.

Salary

Salaried employees have an annual salary that is usually paid out in two-week increments. For example, if your employee has an annual salary of $40,000, and you pay on a biweekly basis, there would be 26 pay periods. Using the gross salary calculation below, we can see that $40,000 divided by 26 would yield $1,538.46

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Hourly Wages

For employees earning hourly wages, you’ll need to have their hourly rate handy, as well as the number of hours they worked during the pay period. If your employee has worked for 40 hours during the pay period, at a rate of $15/hour, their gross hourly wages would total $600.

Overtime

This refers to pay for hours worked beyond a specific weekly threshold (often 40 hours). It’s important to note that not every employee is eligible for overtime. Hourly employees receive overtime for hours worked beyond 40, whereas exempt salaried employees do not qualify for overtime if they make $35,568 or more annually (or $684 per week). Check out this fact sheet from the US Department of Labor if you’re not sure how to classify your employees.

To calculate overtime pay, you must multiply the hourly rate by the overtime rate, and then multiply that by the number of overtime hours worked. Let’s say your employee normally works 40 hours at $15/hour. This week they worked 5 hours of overtime. You pay an overtime rate of 1.5 time the normal rate, so their total overtime pay would be calculated like this: ($15/hr x 1.5) x 5 hours = $112.50

Tips

Some workers, especially in the foodservice industry, receive tips from customers. These are taxable wages that must be calculated and reported for payroll. Regulation varies by state and industry, but some portion of tips may be counted towards meeting minimum wage requirements. Let’s use the example of a foodservice worker making minimum wage ($15/hour) in New York City. There are two ways to calculate this:

Calculating tips for payroll also depends on how a small business allocates tips.

Commission

This represents a percentage from a sale or transaction that an employee receives as earnings. Often, employees who earn commission receive it in addition to a base salary or hourly wage. This income is taxable. The simplest approach for employers is to withhold a flat 22% tax on the employee’s commission. Otherwise, you can consult instructions on page 20 of the 15-T form.

3) Withhold Federal & State Income Tax

Now that each employee’s gross pay is determined, it’s time to begin checking off which payroll taxes and deductions need to be withheld from their paycheck.

Income tax differs by state and sometimes even by locality within a state. Nine states do not charge income tax, so be sure to check the IRS website for specifics about your state’s income tax structure.

To determine federal income tax, you’ll need to have your employee’s W4 handy, as well as their gross pay calculation. As of 2020, Federal income tax withholdings can use either the wage bracket method or percentage method.

These methods are done using tables on the IRS Publication 15-T form. You’ll to consult this form closely, whether you’re using the wage bracket or percentage method. If an employee’s withholdings haven’t changed since prior to 2020, you can use the previous version of the table.

Wage Bracket Method

Withholdings are determined by W4 filing status and gross pay. Filing status from an employee’s W4 form is either:

• Married Filing Jointly
• Single Head of Household
• Married Filing Separately

Payroll period options are as follows:

1. Daily
2. Weekly
3. Bi-weekly
4. Semi-monthly
5. Monthly

With gross pay calculated in one of these payroll periods, find the box on the corresponding wage bracket method table on the 15-T form that represents the employee’s filing status and gross pay. Note that this method only covers up to approximately $100,000 in annual wages. Employers will need to use the percentage method for employees with gross pay exceeding $100,000.

Percentage Method

Similar to the wage bracket method, the percentage uses a table with information on gross pay and filing status. However, this method requires also calculating a percentage to add to this flat dollar amount. Consult the IRS 15-T table to find the correct caluclations. Figuring out how much to withhold is the bulk of the work, but you’re not out of the woods just yet. You still need to pay the federal and (probably) state income tax you withheld.

Employers must use Form 941 to report withholdings to the IRS on a quarterly basis. This includes entering information for any employees who received wages, tips, etc., as well as the total federal income tax withheld for the quarter.

If withholdings are $2,500 or more, you’ll have to make an online deposit through the IRS EFTPS system.

4) Deduct Social Security

Employers must pay half of Social Security taxes themselves and withhold the other half from their employees’ paychecks. This is one of the easier calculations, as Social Security tax has a fixed rate.

As of 2020, the Social Security tax is not deducted on incomes exceeding 137,700. This amount changes on an annual basis, so be sure to find up-to-date information.

If you hire your own children under the age of 18 to help out at your small business, there is an additional step. Specifically, you have to deduct their pay when calculating the Social Security withholding.

5) Deduct Medicare

Similar to Social Security, Medicare follows a fixed rate, and its payment is divided evenly between employers and employees.

6) Factor In Any Other Deductions

After you’ve covered income taxes, Social Security, and Medicare, there may be more deductions you’ll need to make from employees’ pre-tax gross pay. Deductions may be mandatory or voluntary. Here are some possibilities that may apply:

• 401(k) Contributions: Payments made towards a 401(k) or retirement fund are deducted because they aren’t taxable.
• Child Support: You will receive a notification from the court if this deduction applies to an employee
• Health Insurance: A deduction is made for the amount an employee contributes to their own health, dental, vision, or other medical insurance.
• Life Insurance: This voluntary deduction goes towards the employer’s cost of paying for coverage.
• Reimbursements: Payments for meals, mileage, per diem, lodging, etc. are nontaxable and should be deducted.

7) Calculate Net Pay

The net pay is what remains after all of the withholdings and deductions. This is the amount that is paid to employees either through direct deposit or physical paycheck.

8) Cut The Checks

The arithmetic is finally behind you! Now, it is time to pay your employees their net earnings.

Writing the checks by hand could be a way to keep costs down further, assuming you have the time to do so for all your employees. Otherwise, it may be worth looking into payroll software to save precious time and reduce human error

Calculating Your Payroll Is Just The Beginning

After completing payroll, it’s helpful to devise a method for keeping records. Some people prefer electronic records, while others are more comfortable knowing they can access physical records. What’s more important is developing a system that works for your needs.

Additionally, there are regular payroll tax deadlines to keep up on to make sure your hard work is in compliance with IRS and other regulatory agencies.

Looking for a good payroll software solution? Our comprehensive payroll service reviews can help you choose the right app for your business. For more information on running payroll, from payroll taxes to employee onboarding, check out the Merchant Maverick blog.