How to Do Payroll for a Small Business
Running payroll for a small business is a repeating six-step cycle: collect hours and pay data, calculate gross pay, calculate and withhold taxes, pay your employees, deposit the withheld and employer taxes with the taxing authorities, and file the required payroll tax returns. Doing it correctly is less about arithmetic and more about hitting deposit and filing deadlines on time, every time.
Most small business owners should not do this by hand. Full-service payroll software handles the calculations, the deposits, and the filings for a monthly fee that is far smaller than a single late-deposit penalty — but you still need to understand the cycle, because you are the one who stays legally responsible for it.
This guide walks the process in the order you actually do it, then covers the mistakes I see most often in practice and the point at which paying for software becomes the obvious answer.
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This is general educational information about how payroll works, not tax, legal, or accounting advice for your specific situation. Rates, wage bases, thresholds, and deadlines change, and your state and locality may impose additional requirements. Confirm the current figures with the IRS and your state agency, and talk to your own CPA before relying on anything here.
The short answer
Running payroll for a small business is a repeating six-step cycle: collect hours and pay data, calculate gross pay, calculate and withhold taxes, pay your employees, deposit the withheld and employer taxes with the taxing authorities, and file the required payroll tax returns. Doing it correctly is less about arithmetic and more about hitting deposit and filing deadlines on time, every time.
Most small business owners should not do this by hand. Full-service payroll software handles the calculations, the deposits, and the filings for a monthly fee that is far smaller than a single late-deposit penalty — but you still need to understand the cycle, because you are the one who stays legally responsible for it.
This guide walks the process in the order you actually do it, then covers the mistakes I see most often in practice and the point at which paying for software becomes the obvious answer.
What you need before you start
- Your federal Employer Identification Number (EIN).
- Your state withholding and state unemployment insurance account numbers for every state where an employee works.
- A completed Form W-4 from each employee, and a completed Form I-9 verifying employment eligibility.
- A completed Form W-9 from each independent contractor you pay.
- A business bank account you can fund reliably before each pay date.
- Your pay schedule (weekly, biweekly, semimonthly, or monthly) and each worker's pay rate, classification, and any benefit or retirement deductions.
Step-by-step
- 1
Confirm each worker's classification before you pay anyone
Every worker is either an employee or an independent contractor, and that determination drives everything downstream. For an employee you withhold taxes, pay employer payroll taxes, and issue a Form W-2. For a contractor you generally withhold nothing and report payments on a Form 1099-NEC.
Classification is based on the substance of the working relationship — how much control you exercise over how, when, and where the work gets done — not on what you'd prefer or what the contract says. Misclassifying an employee as a contractor is one of the most expensive mistakes in this entire process, because it can produce back taxes, interest, and penalties across multiple years.
Some states apply their own, stricter classification tests than the federal one. If you're unsure, get an opinion before the first payment rather than after the first year.
- 2
Collect hours and pay data for the period
For salaried employees this is usually mechanical. For hourly employees you need approved hours by pay period, including overtime hours tracked separately, plus any tips, commissions, bonuses, or reimbursements that belong in this run.
Approve time before you calculate anything. Correcting a pay run after it's been submitted is significantly more work than getting the timesheet approved on time, and repeated corrections make your quarterly reconciliation harder.
- 3
Calculate gross pay
Gross pay is what the employee earned before any taxes or deductions: hours times rate for hourly workers, the periodic salary amount for salaried workers, plus overtime, bonuses, commissions, and any other taxable compensation for the period.
Overtime is where hourly payroll most often goes wrong. Federal law sets an overtime standard based on hours worked in a workweek, and some states impose additional daily overtime or different thresholds — current IRS figure being verified: insert the current federal overtime threshold and note any state rules that apply to your business.
- 4
Calculate withholding and employer taxes
From each employee's gross pay you withhold federal income tax based on their Form W-4, the employee share of Social Security and Medicare tax, and state and local income tax where those apply. Social Security tax stops applying once an employee's wages reach the annual Social Security wage base — current IRS figure being verified: insert the current wage base and the current Social Security and Medicare rates, with the date verified.
Separately, your business owes the employer share of Social Security and Medicare, federal unemployment tax, and state unemployment tax. These are your cost, not a deduction from the employee — current IRS figure being verified: insert the current federal unemployment tax rate and wage base, and note that your state unemployment rate is assigned to your business individually.
Then subtract any voluntary deductions — health insurance premiums, retirement contributions, HSA contributions — in the correct order, since some are pre-tax and some are post-tax. What remains is net pay.
Retirement and HSA contributions are subject to annual limits: current IRS figure being verified: insert current contribution limits for the plan types you offer, and date-stamp them.
- 5
Pay your employees and record the run
Pay by direct deposit or check on your stated pay date, and give each employee a pay stub showing gross pay, each tax withheld, each deduction, and net pay. Several states require you to provide an itemized statement, and employees rely on it for their own tax filing.
Record the run in your books the same day: wage expense, employer payroll tax expense, and the liability accounts for everything you withheld but haven't yet deposited. That last part matters — withheld taxes are money you're holding on someone else's behalf, and treating them as available cash is how businesses end up unable to make a deposit.
- 6
Deposit the taxes on your assigned schedule
Federal payroll tax deposits are made electronically, and your deposit frequency is assigned based on your prior payroll tax liability rather than chosen by you. Most small employers fall on one of two federal schedules, and you have to know which one applies to you before your first payroll — current IRS figure being verified: insert the current federal deposit schedule rules, the lookback period, and the deposit due dates for each schedule.
State deposit schedules are separate and often on a different cadence than the federal one. Missing a deposit is worse than filing a return late, because deposit penalties escalate with how late the payment is.
Set a recurring calendar reminder a day or two ahead of every deposit deadline, and never rely on remembering. current IRS figure being verified: insert current deposit due dates for your federal and state schedules.
- 7
File the quarterly payroll tax returns
Most employers file a quarterly federal employment tax return, Form 941, reporting wages paid, federal income tax withheld, and Social Security and Medicare taxes for the quarter, and reconciling that against the deposits already made. Your state generally requires its own quarterly withholding and unemployment filings.
Reconcile before you file. Total your gross wages and each tax withheld across every pay run in the quarter, compare it to your deposits, and resolve any difference then — not at year end, when it has compounded across four quarters.
current IRS figure being verified: insert current quarterly filing due dates for Form 941 and for your state returns.
- 8
Handle year-end filings
At year end you file an annual federal unemployment tax return, Form 940, and you issue each employee a Form W-2 while transmitting copies to the Social Security Administration. Contractors you paid during the year generally get a Form 1099-NEC, with copies filed with the IRS.
Your state will have its own annual reconciliation requirements. Year-end is also the point where any uncorrected error from earlier in the year surfaces on an employee's W-2 — which is why the quarterly reconciliation in the previous step matters so much.
current IRS figure being verified: insert current W-2, 1099-NEC, and Form 940 filing deadlines, plus the current 1099-NEC reporting threshold.
Common mistakes
Spending withheld payroll taxes
The income tax and FICA you withhold isn't your money — it's held in trust until you deposit it. Keep it in the account and treat the deposit as non-negotiable. This is the single most damaging payroll mistake a small business can make, and the penalties for unpaid trust fund taxes are severe.
Misclassifying employees as independent contractors
Base the decision on the actual working relationship and the degree of control you exercise, not on convenience. If a worker looks and functions like an employee, treat them as one — reclassification after the fact means back taxes, interest, and penalties, potentially across several years.
Not registering in a state before an employee works there
An employee working in another state generally creates withholding and unemployment obligations in that state, and registration usually has to happen before the first payroll. Register first, then hire — and use a payroll plan that includes multi-state payroll rather than one that treats it as an upgrade.
Getting overtime wrong on hourly payroll
Track hours by workweek, keep overtime hours separate from regular hours, and check whether your state imposes daily overtime or a different threshold than the federal rule. Reconstructing overtime months later from incomplete timesheets is far more expensive than tracking it properly.
Missing a deposit deadline because you didn't know your schedule
Your federal deposit frequency is assigned based on your prior payroll tax liability, not chosen. Confirm which schedule you're on, calendar every due date, and remember that state deposit deadlines run on a separate cadence.
Waiting until year end to reconcile
Reconcile wages, withholdings, and deposits every quarter before you file. An error caught in Q1 is a small adjustment; the same error found in December has flowed into four filings and every affected employee's W-2.
When to use software instead
Honestly, almost immediately. The moment you have a single W-2 employee you're on a deposit schedule and a quarterly filing cycle, and full-service payroll software absorbs the calculations, the deposits, the quarterly returns, and the year-end forms for a monthly fee that's dramatically less than what one missed deposit costs.
The specific cases where doing it yourself is defensible are narrow: you have no employees and only pay contractors, or your CPA or bookkeeper already handles the filings as part of an engagement. Everyone else is trading a few dollars a month for a strict deadline obligation they have to personally track.
Two clear upgrade triggers to watch for: hiring an employee in a second state, and offering benefits or a retirement plan. Both add compliance work that generic tools handle poorly, and both are cheaper to plan for than to retrofit.
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Frequently asked questions
How do I do payroll for a small business?
Run the same six-step cycle every pay period: collect hours and pay data, calculate gross pay, calculate and withhold taxes, pay your employees, deposit the withheld and employer taxes on your assigned schedule, and file the required payroll tax returns. Doing it correctly depends less on the math than on hitting every deposit and filing deadline.
Can I do payroll myself without software?
You can, but you take on the deposit schedule, the quarterly filings, and the year-end forms personally. For most small businesses the monthly cost of full-service payroll software is far less than the cost of a single missed deposit, so doing it by hand only makes sense if you pay contractors only or your accountant is already handling the filings.
What payroll taxes does a small business have to pay?
You withhold federal income tax, the employee share of Social Security and Medicare, and state and local income tax where applicable. Your business separately owes the employer share of Social Security and Medicare, federal unemployment tax, and state unemployment tax. Current rates and wage bases change annually, so confirm them with the IRS and your state agency.
How often do I have to deposit payroll taxes?
Your federal deposit frequency is assigned based on your prior payroll tax liability rather than chosen by you, and most small employers fall on one of two schedules. State deposit schedules are separate and often on a different cadence, so confirm both before your first payroll.
What forms do I file for payroll?
Most employers file a quarterly federal employment tax return on Form 941, an annual federal unemployment return on Form 940, and year-end Forms W-2 for employees. Contractors generally receive Form 1099-NEC. Your state has its own withholding and unemployment filings on top of these.
What happens if I miss a payroll tax deposit?
You can face penalties and interest, and the penalty generally increases the longer the deposit is late. Unpaid amounts you withheld from employees are treated especially seriously because that money was held in trust, so if you're going to be short, talk to a CPA immediately rather than skipping the deposit.
The bottom line
Payroll isn't complicated conceptually — it's a repeating cycle with unforgiving deadlines. That combination is exactly what software is good at and what busy owners are bad at.
If you're running payroll for even one employee, price out a full-service provider before you commit to doing this by hand. The math almost always favors buying the software, and the risk math favors it even more strongly.
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