How Payroll Systems Work

By: Dave Roos

What is a Payroll System?

Payroll systems take care of getting your employees paid so you can concentrate on other duties.




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 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:

­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:

At the end of the year, an employer uses the payroll system to take all of the wage 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.