How Payroll Systems Work

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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.

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A payroll service is an outside company that special­izes in every aspect of the payroll process. The first such service in the United States, Automated Payrolls, was founded in 1949 and relied on primitive technology like electro-mechanical calculators and something called the Comptometer bookkeeping machine [source: Reynolds]. Automated Payrolls grew to become Automated Data Processing (ADP), one of the largest business outsourcing services in the world.

A basic payroll service will collect wage and hour information from the employer and use that information to calculate gross wages, subtract all pertinent withholdings and deductions, print checks, make direct deposits and prepare all employment tax filings. The service will also mail out W-2 and 1099 forms and resolve any inquiries from the IRS or other government agency.

Some payroll services offer more comprehensive help. They can take over some of the responsibilities typically handled internally by human resources, like administrating a company's retirement accounts and benefits programs. They can file new employee forms with the state and help comply with any court-ordered wage garnishment programs. Some payroll services even offer a free phone help line for any questions related to human resources or payroll.

The Internet has made payroll services even more convenient. In the past, an employer had to call the payroll service with information about wages and hours for the upcoming paychecks. Now the employer is provided with a Web-based payroll account that he can update 24/7. All he has to do is log on to the system, punch in the hours for the pay period and the data is updated in real time. Payroll services keep record of all payroll information and make all of this data available online through reports, payment histories and other features.

The cost of payroll services depends on several factors, namely the number of employees, the number of pay periods every month, and the level of comprehensive service of the services required. If a company with 10 employees pays its workers twice a month, it can expect to pay around $50 each pay period, or $100 a month, for basic payroll services. The same company can pay up to $200 a month for upgraded services like online reporting, direct deposit and phone help. In general, costs are calculated per employee and per check [source: ADP].

The biggest advantage of a payroll service is that takes all payroll responsibilities away from the business owner, allowing him to focus on other aspects of running the business. The downside is that a payroll service can get expensive, especially as a company adds more and more employees.

A good compromise between expensive payroll services and time-consuming manual bookkeeping is payroll software, which we'll talk more about in the next section.

Payroll software does a lot of the heavy lifting of payroll management for you. Like outsourced payroll services, payroll software requires very little input from the employer, just employee wage information and hours. All of the tricky calculations and withholdings are calculated by the software, which receives automatic updates every time tax laws are changed. The software can also fill out employment tax forms for you and remind you when to file them.

You can add as many optional withholdings or deductions to each paycheck as you want. Just specify the reason for the deduction (insurance premium and 401(k) contribution, for example), set the parameters (5 percent of each paycheck, $10 every time, or other factors) and the software will calculate that withholding for every check.

Even with all of that help, payroll software can't do everything for you. The employer still needs to be the one to physically print and deliver the checks. And even if the software prepares employment tax forms, the employer still needs to sign them and send them in.

You also need to personally enter all pertinent information. For example, if you offer your employees health insurance, you need to provide all of the information about the insurance provider so the software can not only withhold premiums from each check, but write checks to the insurance company when they're due.

That's not to say that payroll software isn't a huge time-saver. With payroll software, it's much easier to handle complicated withholdings, constantly changing tax laws and keep all your payroll data in one place.

Like payroll services, some payroll software is ditching the physical software and going Web-based. This option streamlines the process even further. A product like Intuit Online Payroll allows you to manage your payroll process from any Web-enabled computer. It offers free direct deposit and free E-PAY of all federal and state tax forms, so you can handle key payroll duties even when you're away from the office. The program will even send you reminder e-mails when deadlines are approaching for tax filings.

Some higher-end payroll software includes a service component. For example, if you don't trust the computer to fill out your tax forms, you can have real people assemble and file your taxes for an extra fee. They'll even guarantee their filings against any possible fines or penalties from the IRS.

Software requires more work than a payroll service, but the price is competitive. For Web-based software, you can pay as little as $10 a month. For the most comprehensive software that includes a full-service tax preparation component, you can pay up to $80 a month for a 10-employee business with two pay periods a month. That's cheaper than most payroll services, but remember, you're still doing some of the work.

So how do you decide which payroll system is the best for your company? Keep reading to find out.

It can be difficult to decide which payroll system is the best fit for your business. The most important factors are the size of your business and the budget you're willing to spare on payroll processing.

For a very small company -- five employees or fewer -- it's certainly possible for a business owner to handle all of the payroll obligations himself with nothing but a calculator and an Excel spreadsheet. But that's only if the business owner is interested or at all gifted in basic accounting. If you're terrible with numbers, then calculating withholdings yourself will not only take more time than it should, but will be prone to mathematical errors. Not only will you waste valuable work time, but you'll potentially get yourself into financial or legal trouble. But if you have a knack for crunching numbers, then handling payroll for a small number of employees could be quite satisfying.

For a medium-sized company -- 10 to 50 employees -- it's no longer feasible to do everything by hand. This is where payroll software probably makes the most sense. For a relatively low cost per month, you can have the computer do all of the grunt work for you. You'll still have to stay up to date with paychecks and tax filings, but it's just a matter of clicking a button, not doing all of the calculations and filling out all of the forms yourself. If you have the budget to spare, or you're just not interested in this aspect of the business, then you could even hire an HR specialist who could manage the software along with his or her other duties.

For larger companies -- up to 100 employees -- even the software will begin to reach its limitations. You might find that you're spending too much time updating wage and employee information for new hires and fires. Or maybe you're starting to get nervous about trusting a machine to cut checks and file taxes for truly large sums of money. Now is probably the time to hire an in-house payroll specialist or outsource to a payroll service. In either case, you'll have the peace of mind that professionals are handling all of the details and devoting their full attention to the process.

No matter which option you choose, here are some criteria to consider:

We hope this has been a helpful introduction to payroll systems. For lots more information about running a small business, follow the links on the next page.