Running payroll for the first time is one of those tasks that sounds simple until you start doing it. You know roughly how much to pay someone. You know when they should get paid. But between federal taxes, state taxes, FICA contributions, tax deposits, W-4s, I-9s, quarterly filings, and year-end reporting, what seems like "just paying someone" turns into a process with real legal obligations and meaningful penalties for getting it wrong.
This guide covers everything a founder needs to know to set up payroll correctly from day one. Not the "payroll is easy, sign up for our tool" version - the actual version, with the details that matter.
Before You Run Your First Payroll
Get your EIN
Your Employer Identification Number is required for filing employment taxes. If you haven't already obtained one as part of your business formation, apply through the IRS website. It's free and you get it immediately online.
Register with your state
Most states require separate employer registration for state income tax withholding and state unemployment insurance (SUI). This is a separate process from your state business registration and from your federal EIN. Some states combine these; others require separate applications for each.
If you have employees in multiple states, you need to register in each state where employees work. Remote employees count - if someone works from their home in Colorado, you need Colorado employer registrations regardless of where your company is headquartered.
Determine your pay schedule
Federal law doesn't mandate a specific pay frequency, but most states do. Common schedules are weekly, bi-weekly (every two weeks), semi-monthly (twice a month, usually the 1st and 15th), and monthly. Some states prohibit monthly pay for certain types of workers. Check your state's requirements before deciding.
The most common choice for small businesses is bi-weekly. It's predictable for employees, manageable administratively, and legal in all states for most worker types.
Collect required documents from each employee
Before paying anyone, you need:
- Form W-4 - Employee's Withholding Certificate. This tells you how much federal income tax to withhold based on the employee's filing status and adjustments.
- Form I-9 - Employment Eligibility Verification. Required within 3 business days of the employee's start date. You must examine original identity and work authorization documents in person (or via an authorized remote process).
- State W-4 equivalent - Many states have their own withholding form. Some states accept the federal W-4; others require a separate state form.
- Direct deposit authorization - Bank routing and account numbers if the employee wants direct deposit (which nearly all do).
Classify your employees correctly
Every employee needs to be classified as either exempt or non-exempt under the Fair Labor Standards Act (FLSA). This classification determines whether the employee is eligible for overtime pay.
Non-exempt employees must be paid at least minimum wage for all hours worked and overtime (1.5x regular rate) for hours worked over 40 in a workweek. Most hourly workers are non-exempt.
Exempt employees are salaried and not eligible for overtime. To qualify for exemption, the employee must meet specific tests for salary level (currently $43,888/year federally, though some states set higher thresholds) and job duties (executive, administrative, professional, outside sales, or computer-related).
Getting this wrong is a common and costly mistake. When in doubt, classify as non-exempt and pay overtime.
The Mechanics of Running Payroll
Calculate gross pay
For hourly employees: hours worked multiplied by hourly rate, plus any overtime at 1.5x the regular rate. For salaried employees: annual salary divided by the number of pay periods in the year.
Sounds simple, but the details matter. Which hours count as "hours worked" for overtime purposes? (Answer: all hours the employee is required or permitted to work, including certain types of on-call time.) Does travel time count? (Sometimes.) Do meal breaks count? (Usually not, if the employee is completely relieved of duties for at least 30 minutes - but state laws vary.)
Calculate and withhold taxes
From each paycheck, you need to withhold:
- Federal income tax - Based on the employee's W-4, filing status, and the IRS withholding tables. The IRS publishes Publication 15 (Circular E) with these tables, updated annually.
- Social Security tax (employee share) - 6.2% of wages up to the Social Security wage base ($168,600 in 2025).
- Medicare tax (employee share) - 1.45% of all wages, plus an additional 0.9% on wages exceeding $200,000.
- State income tax - Varies by state. Seven states have no state income tax. Others range from flat rates to progressive brackets.
- Local taxes - Some cities and counties impose their own income taxes (notably in Pennsylvania, Ohio, and New York City).
Calculate employer-side taxes
In addition to withholdings from the employee's pay, you owe:
- Social Security tax (employer share) - 6.2% of wages, matching the employee's share.
- Medicare tax (employer share) - 1.45% of wages, matching the employee's share.
- Federal Unemployment Tax (FUTA) - 6.0% on the first $7,000 of wages per employee, though you get a credit of up to 5.4% if you pay state unemployment taxes on time, making the effective rate usually 0.6%.
- State Unemployment Tax (SUTA) - Rates and wage bases vary significantly by state. New employers typically pay a default rate until they establish an experience rating.
Deposit taxes on time
The IRS requires employers to deposit employment taxes on either a monthly or semi-weekly schedule, depending on the total tax liability reported during a "lookback period." New employers typically start as monthly depositors.
Monthly depositors must deposit taxes by the 15th of the following month. Semi-weekly depositors must deposit taxes by the following Wednesday (for wages paid Wednesday through Friday) or the following Friday (for wages paid Saturday through Tuesday).
Deposits must be made electronically through the Electronic Federal Tax Payment System (EFTPS). State tax deposit schedules are separate and vary by state.
Missing deposit deadlines triggers penalties that escalate based on how late the deposit is: 2% for 1-5 days late, 5% for 6-15 days late, 10% for 16+ days late, and 15% if not paid within 10 days of the first IRS notice.
Ongoing Filing Requirements
Quarterly filings
- Form 941 - Employer's Quarterly Federal Tax Return. Reports total wages paid, taxes withheld, and employer tax liability. Due by the last day of the month following the quarter end (April 30, July 31, October 31, January 31).
- State quarterly returns - Most states require quarterly unemployment tax returns and income tax withholding returns. Deadlines vary.
Annual filings
- Form W-2 - Wage and Tax Statement. One for each employee, reporting total wages and taxes withheld. Must be furnished to employees and filed with the Social Security Administration by January 31.
- Form W-3 - Transmittal of Wage and Tax Statements. Summary form filed with the SSA along with all W-2s.
- Form 940 - Annual Federal Unemployment Tax Return. Due January 31 of the following year.
- State annual returns - Requirements vary by state.
Common First-Time Payroll Mistakes
Misclassifying workers
Treating employees as independent contractors (1099) to avoid payroll taxes is the most common and most expensive payroll mistake. The IRS and state agencies audit this aggressively, and the penalties include back taxes, interest, and fines.
Missing deposit deadlines
Tax deposits are time-sensitive. Setting up automated deposits through your payroll system eliminates this risk almost entirely. If you're doing payroll manually, calendar every deposit deadline and treat them as non-negotiable.
Forgetting state obligations
Many founders focus on federal requirements and overlook state-specific obligations. Each state where you have employees has its own registration, withholding, unemployment tax, and reporting requirements. Multi-state payroll multiplies the complexity.
Not keeping records
The FLSA requires employers to keep payroll records for at least three years (some records for two years). The IRS requires you to keep employment tax records for at least four years. In practice, keep everything for at least seven years. Digital records are fine as long as they're accurate and accessible.
Paying the wrong overtime rate
Overtime is 1.5x the "regular rate of pay," which isn't always the same as the employee's hourly rate. If an employee earns bonuses, commissions, or shift differentials, those may need to be included in the regular rate calculation. This is one of the most common wage-and-hour violations.
Should You Use Payroll Software?
Yes. Without qualification.
Manual payroll is technically possible - you can calculate withholdings using IRS tables, generate checks, file returns by hand, and make deposits through EFTPS. But the complexity, the penalty risk, and the time cost make this impractical for any business that's paying more than one or two people.
Modern payroll software handles tax calculations, withholding, direct deposit, tax deposits, quarterly and annual filings, W-2 generation, new hire reporting, and multi-state compliance automatically. The cost is typically $40-$80/month plus $5-$12 per employee - far less than the cost of a single payroll error.
The key things to look for:
- Automatic tax filing and deposits - The software should calculate, deposit, and file all federal and state taxes on your behalf.
- Multi-state support - If you have employees in more than one state, the software needs to handle registrations, withholding, and filings for each state.
- Year-end reporting - Automatic W-2 generation and filing.
- Compliance updates - Tax rates and rules change frequently. The software should update automatically.
- Accuracy guarantees - The best payroll software comes with a guarantee that they'll cover penalties if an error on their end causes a late filing or incorrect calculation.
Payroll is one of those functions where the ROI of software is unambiguous. The question isn't whether to use it - it's which one to use.
