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What is Payroll:
The Definitive Guide

This guide provides a concise overview of payroll and its role in organizations. It covers payroll as both a business process and a software application.

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Payroll Fundamentals

This is your high-level guide to the basics of payroll management.

1. What is Payroll?

Payroll is the total compensation a business owes and pays to its employees for a period of time or on a given date.

In a broader sense of the word, payroll also refers to processes and systems for paying employees, filing and paying payroll taxes, filing forms, maintaining compliance, and keeping records.

2. Why is Payroll Important?

Payroll is among the most important elements of a business. It is often one of a business’s biggest expenses.

Payroll affects company morale because employees need to be able to rely on getting paid consistently and on time. It reflects the financial stability and reputation of the business.

3. How Does Payroll Work?

The payroll process consists of these elements:

  • Compilation of time worked
  • Calculation of wages and salaries
  • Calculation of withholding taxes and other deductions
  • Compliance with payroll-related laws and regulations
  • Calculation of payments due and preparation of payments
  • Payment of payroll taxes
  • Recordkeeping
  • Reporting and analysis

Components of Payroll

Payroll consists of the four key elements you’ll learn about here.

1. Employee Information

Employee payroll information includes such data as the employee’s name and address, social security number, job position, pay rate, tax exemptions claimed, withholding tax rate, benefits status, employment status, voluntary deductions, and more.

2. Salaries and Wages

A wage is a form of compensation calculated at an hourly pay rate. It’s the product of the hourly pay rate times the hours worked.

A salary is a fixed amount of compensation stated as an annual or monthly amount. Both hourly and salary  are paid at regular intervals such as weekly, bi-weekly, semi-monthly, or monthly.

3. Deductions

Deductions are amounts subtracted from salary or wage payments from an employee’s paycheck.

The amounts may be voluntary or involuntary.

Voluntary deductions are within the control of employees. They include amounts subtracted to pay for health benefits, stock options, insurance premiums, optional payments to charities, etc.

Employees have no control over involuntary deductions. They include amounts for taxes, garnishments, and other withholdings.

4. Net and Gross Pay

Gross pay is the total compensation cost a company pays to employ a person. It’s the employee’s wage or salary before deductions or withholdings.

Net pay is the amount payable after all deductions have been made. It’s the amount that appears on the employee’s paycheck.

Steps Involved in Processing Payroll

Whether you manage payroll manually or through automated systems, payroll processing involves the same four steps.

1. Define Your Payroll Policy

A payroll policy describes how a company handles salaries, timekeeping, payroll schedules, and payment methods. It addresses legal, regulatory, and tax requirements the employer must comply with. And it sets controls used in calculating the company’s payroll.

An effective payroll policy ensures that all employees are paid the right amount at the right time.

In setting payroll policy, employers should consider these factors and more:

  • Responsibilities and accountabilities of payroll staff and management
  • Controls and safeguards
  • Compliance with federal, state, and local laws and regulations

The policy establishes uniform and consistent application of internal rules and practices:

  • The definition of paid and unpaid overtime, consistent with the federal Fair Labor Standards Act (FLSA)
  • Pay dates, including the length of pay periods
  • When and how you will pay employees
  • How you will manage payroll deductions and withholdings
  • How the benefits you offer will affect employees’ paychecks

2. Onboard Employees and Collect Data

When you hire new employees, you must collect certain kinds of data that enable you to pay them accurately and in compliance with laws and regulations.
onboard-employees-payroll

The data you collect may include these elements and more:

  • Tax withholding forms including the Internal Revenue Service (IRS) forms W-4 (Employee’s Withholding Certificate) and I-9 (Employment Eligibility Verification), as well as appropriate state withholding forms. The names and numbers of the state forms vary.
  • Employee’s personal information, including social security number (SSN) and tax filing status
  • Documentation for voluntary withholdings or deductions
  • Specification of how employees will be paid, including employee consent forms and bank information for direct deposit of paychecks

3. Calculate Payroll and Issue Payments

Calculation and payment of payroll involves these four steps:

  • At the end of a pay period, you collect data about the days or hours employees actually worked. For employees who earn wages, you may collect timecards or data from electronic time clocks.
  • You review calculations of work hours and seek appropriate approvals from supervisors
  • You calculate your paycheck per employee and your total payroll across the company
  • You issue payments for each employee in the appropriate form (direct deposit, physical check, credit to a cash card)

4. Pay Taxes and Report to Entities

With your payments issued to employees, you update your payroll records. The records show how much you’ve withheld for federal income taxes, Social Security, and Medicare taxes. They also show the tax contributions you’ve made.

pay-taxes-and-report-to-entities

You share your payroll information with appropriate federal, state, and local tax authorities. You issue payments for payroll withholding taxes due to each tax authority.

How to Calculate Payroll

The process of calculating payroll may seem simple at a high level, but the devil is in the details.

1. Choose Your Payroll Schedule

In the United States, you can choose any of four common payroll schedules:

01

weekly

02

biweekly

03

semimonthly

04

or
monthly

People are often confused about the differences between biweekly and semimonthly.

On a biweekly schedule, you run your payroll on the same day of the week each time. Your employees also receive their payment on a consistent day of the week. In two months of the year, employees receive three paychecks. Companies pay 26 paychecks a year.

On a semimonthly schedule, paychecks come out on the same two days of every month. Employees always receive two paychecks per month. Your company cuts 24 paychecks per year.

Some states require a minimum payment period. In such states, monthly payroll schedules may not be allowed.

2. Calculate Gross Pay

Gross pay is the amount of salary or wages to be paid, before deductions and withholdings.

3. Pre-tax Deductions

Pre-tax deductions may include both voluntary and involuntary amounts.

Pre-tax voluntary deductions may include those for benefits such as health care, long-term disability insurance, deferred compensation, retirement savings, flexible-spending accounts, and other such options.

Pre-tax involuntary deductions may include child support and alimony.

4. Deduct Taxes

Deduct required amounts for state and federal withholding taxes.

These include FICA (Social Security and Medicare taxes), unemployment taxes, and other state or local taxes.

5. Apply Voluntary Deductions

Deduct any remaining voluntary deductions or contributions you didn’t subtract in the prior step before calculating taxes.

6. Calculate the Net Pay

Net pay is the amount remaining in the paycheck after all deductions have been subtracted.

Challenges in Handling Payroll Management Process

Administration of payroll can be especially hard for fast-growing companies that need flexibility.

1. The Requirement to Stay Statutory Compliant

In managing payroll, you must comply with federal, state, and local laws and regulations. State and local regulations vary widely, and they change often.

Your company could pay fines and penalties if you miss a change in regulations that leads you to pay the wrong amount in taxes or to miss filing the right forms on time.

You must also keep adequate records for the required periods of time.

2. Complications in Data Inputs

Manual data entry is time consuming and prone to error.

Employee data is likely to change often. For example, employees often change voluntary deductions. And an employee’s move to a new tax jurisdiction may affect withholding calculations and reporting requirements.

Even minor changes in employee data can trigger a need to change payroll calculations and filings.

Automation can both increase efficiency and reduce errors.

3. Data Security

Payroll data is highly sensitive. With the rising number of data breaches and ransomware attacks, you must be vigilant to ensure the security, privacy, and recoverability of your data.

Back up your systems fully and often to maintain continuity of operations.

4. Lack of Flexibility

Payroll processes and systems must be flexible to accommodate a broad range of regulations, taxation rates, benefits, schedules, data-collection methods, and compensation structures.

Your system should be easily configurable to keep pace with constant changes in all.

Your systems should also be easy to integrate with other systems in your company, including financial and accounting systems, human resource systems, and enterprise resource planning (ERP) systems.

How to Choose a Payroll Service

If you’re thinking about hiring a provider of outsourced payroll services, you have several important factors to consider.

1. Pros and Cons of Using Professional Payroll Services

Use of professional payroll services has advantages and disadvantages.

Here are some of the pros:

The service can complete all the payroll-related work for you. This may include payroll calculations, payroll tax payments, year-end tax forms, and more.

They can relieve your staff of the need to stay current with changes in regulations and tax calculations.

They use systems that can run an accurate, reliable payroll in minutes.

They may offer access to current technologies that enable capabilities such as employee self-management of payroll data.

Here are some of the cons:

The service may be more expensive than doing it in house.

The service may not be able to provide the service and flexibility you need as your company grows.

2. Payroll Service Cost

The cost of payroll services varies.

Most providers use one of two standard pricing structures:

  • You pay a flat base fee each time you run payroll.
  • You pay a flat base fee per month, with unlimited payroll runs per month.

Some providers offer pricing plans for varying levels of service. With a basic plan, you may pay only for running the payroll. A more advanced and expensive plan might also pay your payroll taxes and print W-2 forms for your employees.

Base fees are likely to be from $20 to $100, depending on the plan and provider. Most services also charge $1 to $15 per employee or contract worker per month or pay period.

Some services add initiation fees to set up the system. You may also pay fees for direct deposit or to complete year-end tax services.

3. How to Choose a Payroll Service

Apply the weighted decision criteria from your matrix, giving a numerical score to each product and vendor.

Learn more about how CAVU payroll software can help you save money and time!

Read more on our blog

1. What is a Pay Stub?

A pay stub or check stub is a document that lists the details about an employee’s pay. It may be attached to a paper paycheck, or it could be a separate document.

The pay stub includes these elements:

  • The wages earned for the pay period and year-to-date payroll information
  • Taxes and other deductions taken out of an employee’s earnings
  • The net pay the employee receives

2. What is Unemployment Tax?

Unemployment taxes are federal and state taxes that partially protect the income of workers who become unemployed.

The U.S. Department of Labor administers federal unemployment taxes under the Federal Unemployment Tax Act (FUTA). All businesses must pay FUTA taxes unless:

  • They are government or educational organizations.
  • They are exempt as a qualified 501(c)3 charitable or religious organization under IRS guidelines.

Companies pay FUTA taxes to the federal government.

All states have passed a State Unemployment Tax Act (SUTA). Organizations exempt under FUTA are also exempt from SUTA taxes.

Each state sets its own rules for unemployment taxes. Employers pay SUTA taxes directly to each state.

3. What Taxes Do I Need to Withhold from an Employee's Paycheck?

Employers must withhold five kinds of taxes from an employee’s paycheck:

  • Federal income taxes
  • Social Security and Medicare (FICA) taxes
  • Additional Medicare taxes, if applicable
  • Federal unemployment tax (FUTA)
  • State income taxes in 42 states

4. How Long Should I Keep Payroll Records?

Employers are required by federal law to keep payroll records for three years.

You must also keep payroll tax records (such as unemployment taxes) for four years.

Some states and agencies require you to keep payroll tax records for six years.

Disclaimer: CAVU HCM does not provide legal or tax advice. Please confirm requirements for document retention with HR, payroll, legal, and/or tax professionals in your state.

Conclusion

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Payroll management is a key process for any company with more than a few employees. The bigger the company, the more involved its payroll management is likely to be.

The complexity of payroll management poses special challenges for growing companies with more than 10 employees. Such firms often lack the administrative staff and infrastructure to stay ahead of the changes in their business. And they’re reluctant to increase their administrative headcount.

These companies are often good candidates for outsourced payroll services.


For information about how CAVU HCM helps growing companies manage their payroll, please visit CAVU payroll overview.