What is Payroll?

The term “payroll” actually refers to the list of employees that receive compensation from a company. However, most companies generally use the term to refer to the money that is paid to the employees or the records that detail how much each employee has made. Payroll may also refer to the company, department, or software that is used to process paychecks and taxes or to the process of calculating and distributing employee paychecks.

Processing payroll is a very important function of any business and necessitates an understanding of current regulations, detailed tax knowledge to ensure proper withholding and filing, and a highly organized system that can be relied upon to pay each employee the right amount of money. For many organizations, using payroll systems or outsourcing payroll can help to mitigate stress and minimize errors.

Payroll and Form W-4

Form W-4 is required for each employee and helps to keep their information and tax filing status straight. Form W-4 should be filled out by each employee at the time of hire to ensure compliance with tax laws and other regulations. Form W-4 can be filled out and signed electronically using paperless onboarding functionality through some HRIS solutions, which can help to eliminate clutter and ensure more accurate and organized


Time Keeping and Payroll

Time and attendance tracking are valuable to payroll. Whether employees are salaried or hourly, time and attendance tracking can help to ensure that employees are being paid the correct amount for time worked and can cover a company from a legal standpoint. When time and attendance tracking functions and payroll functions are done electronically, it can be very helpful to connect the systems so that hours worked can be seamlessly imported into the payroll system.

Calculating Payroll

An hourly employee’s gross pay is calculated by simply multiplying the number of hours worked by the hourly wage. For salaried employees, the amount of gross pay is the salary per pay period. The actual amount received by each employee is net pay, however, which is the gross pay minus any deductions.

Payroll Deductions

Payroll deductions include many different items, including:

  • Federal income taxes
  • Social security taxes
  • State income taxes
  • Local tax withholdings
  • Health insurance
  • Dental insurance
  • Charitable contributions
  • Garnishments

Processing Payroll

Payroll must be processed on a recurring basis and must be accurate each and every time. Since payroll is the single largest expense for most companies, it is very important that payroll is processed in a way that is efficient and reliable. There are several options for processing payroll.

Processing payroll manually is an inexpensive option but can be arduous. The IRS provides tax tables that you can use to calculate withholdings, but voluntary deductions must be figured out, as well. Keeping good records, organizing information, and ensuring consistent accuracy may be more difficult when payroll is processed manually.

Outsourcing payroll is an expensive option but may save you labor time and prevent costly errors. A payroll company will take care of all of your taxes and other payroll issues, ensuring a high degree of accuracy and reliability. A payroll company may also be able to help answer any questions that you have.

Payroll software is a good middle of the road option, affordable for most companies and simple to use so it saves some labor time. There are many different payroll software options, so you can select the amount of assistance that you need with payroll. Since payroll is still taken care of in-house with payroll software, it may be easier to make changes and retrieve historical data, which may also be a bonus over payroll outsourcing.

How Payroll Systems Work

A payroll system involves everything that has to do with the payment of employees and the filing of ­employment taxes. This includes keeping track of hours, calculating wages, withholding taxes and other deductions, printing and delivering checks and paying employment taxes to the government.

The payroll system starts when a company hires its first employee. In the United States, every new employee must be reported to the state along with a completed W-4 tax form. The W-4 determines how many allowances the employee qualifies for when calculating the federal income tax that should be withheld from each check. Generally, the more dependents you have, the less income tax you have to pay.

As an employer, the W-4 is the first of many forms that you must keep on file as part of your payroll system. In fact, the W-4 needs to be kept on file up to four years after the employee is fired or quits [source: Intuit]. You must also keep track of the employee’s critical personal information, like the address to which checks are sent, or in the case of a direct deposit, the bank information and account number where the money is wired. All of this information is highly sensitive, meaning that a good payroll system should also be very secure.

Withholding and paying taxes is one of the most important responsibilities of the payroll system. In the United States, the following are the major withholdings required by the government:

  • Federal income tax
  • State and local income taxes (where applicable)
  • Social Security tax
  • Medicare tax

When an employer withholds taxes from a paycheck, he acts as the trustee for those funds until they are paid to the IRS, the Social Security Administration (SSA) or other government agency. To avoid confusing this money with profits or other business income, all withheld taxes must be held in a separate bank account or trust fund.

In the case of Social Security and Medicare withholdings, when it’s time to hand that money over to the government, the employer is required to match the employee’s contributions. For example, if an employee is paying 6.2 percent of every check for Social Security, then the employer has to pay an equal 6.2 percent.

In addition to matching Social Security and Medicare contributions, the employer has to pay federal and state unemployment taxes (FUTA and SUTA) for each employee. The employer pays these taxes himself, meaning nothing is withheld from the paycheck.

There are numerous other possible deductions, withholdings and contributions that can be subtracted from an employee’s gross wages and that need to be tracked by the payroll system:

  • Health insurance or life insurance premiums
  • 401(k) or other retirement fund contributions
  • Workman’s compensation
  • Union Dues
  • Vacation days
  • Sick days
  • Employee loans
  • Court-ordered wag­e garnishments (for outstanding debts)
  • Child support payments

At the end of the year, an employer uses the payroll system to take all of the wages and withholding information from the previous year and summarize it on a W-2 form for full-time employees or a 1099 form for contract workers. Copies of that form must be sent to the employee, the IRS and the SSA.

You can see how it might be difficult for a small business owner to keep track of all of these withholdings, pay all pertinent employment taxes and still mail the paychecks on time. That’s why so many businesses use payroll services, which we’ll talk about next.

The Confidentiality of Payroll Information

Payroll and confidentiality go hand in hand. The former involves executing the tasks necessary to pay employees and operate the business legally; the latter involves protecting the financial data used in the payroll process. As a small-business owner, you should take steps to ensure that your payroll information stays confidential.

Types of Data

Payroll generally includes employee and employer data. Employee information includes employee name, address, Social Security number, date of birth, mandatory deductions such as payroll taxes and wage garnishment, pay rate, pay frequency, earnings such as regular and overtime wages, salary, bonus and commission, employee benefits such as retirement contributions and health insurance premiums, and bank account information for direct deposit purposes.

Employer information includes the employer’s payroll liabilities, such as federal and state unemployment taxes, Medicare and Social Security taxes, the amount the employer pays for employee benefits such as 401k match and health insurance, and in some cases, the employer’s bank account information.

Confidentiality Importance

Confidentiality of employee payroll data is critical because a leak can result in discord among employees and compromise the employer or employee’s financial situation. For example, two employees perform the same job; however, you decided to pay one of them at a slightly higher rate because she has more experience than the other worker. If the lower paid employee discovers that she’s being paid less, it can result in her feeling resentful. In such a situation, there’s not much the employee can do provided she’s being paid at least the federal or state minimum wage. Still, she’s likely to feel under-appreciated. Further, a leak of an employee’s direct deposit information or the employer’s financial data can cause the respective bank account to be compromised by fraudulent activity.

Wages and Salary Discussion

It can be difficult to maintain the security of certain payroll information, particularly if an employee chooses to share his own data with other workers. Still, you can take certain measures. For example, so employees know where they stand, including in the company handbook that your compensation and benefits packages are competitive but also depend on job performance and experience. Note that although the practice of employees discussing wages with each other is typically frowned upon, you cannot make it company policy to ban such discussions. Federal labor law and some states have provisions that say employers may not forbid employees from discussing their pay and benefits.

Payroll System Security

Strengthen payroll confidentiality by assigning the necessary payroll tasks to specific personnel. For example, if the employee processes only time cards and tax-withholding forms, his system access should allow him to complete only those tasks. Specifically, do not give him access to wages and deductions data if his job does not require him to have access to that information. Some employers use payroll software to process their payroll in-house, and this software sometimes has accounting or human resources features attached. Always give the employee only the access that he needs. If your small business does not have an information technology specialist, use an IT consultant to set up the computer system so the necessary accesses are given.

Record Keeping

Payroll software stores payroll information in the computer system; however, keeping hard copies increases the filing system’s reliability and serves as a useful backup. Store hard copies in a secure, locked location. Some employers with only a few employees keep spreadsheet copies of payroll data. In this case, ensure that only the record-keeping personnel have access to the computer drive with the data.

Payroll Staff Security

Even if you have only one payroll person, ensure that she works in a confidential location, separate from other employees. Before you hire payroll personnel, emphasize the importance of keeping payroll data private, such as logging off the payroll software before leaving the computer and not disclosing payroll information to non-payroll staff. To protect sensitive information, you may have the payroll staff sign a confidentiality agreement upon hiring them. Some employers make termination of the payroll staff immediate rather than giving advance notice if there is a leak of confidential information. Check with your state’s department of labor for its termination policies prior to making it company policy.

Practical Considerations

Only the payroll staff and a restricted number of upper-management employees should have the access code or key to the payroll department. If you outsource your payroll duties to a payroll service provider, ensure that the provider sends the payroll in confidential envelopes to a designated onsite staff member.

Controlling Disclosure

The payroll staff should know who is privy to confidential information and who is excluded from it. For example, have a policy listing the payroll documents that internal and external auditors are entitled to see. This limits misunderstandings if an auditor wants to remove or photocopy restricted data from the department. Further, including that, an employee’s spouse cannot receive any payroll data for the employee without the employee’s consent. Typically, if the request is from a government agency, you must honor it provided it is presented in written form; these types of queries are usually made by fax, email or mail. If an employee requests to see his payroll records, state law may require that you make these records available to the employee within a reasonable time.