How To Pay Employees In A Small Business With 8 Steps

If you're a new business owner, learning how to pay your employees may seem tricky. After all, you can't just hand them a wad of cash from your bank account. You need to document every dollar that passes through your hands to theirs in a legal way.

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Fortunately, the process isn’t as daunting as it seems. 

In this guide, you’ll learn:

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• Different types of compensation classifications
• How to determine how much to pay an employee
• How to pay an employee in a small business
• How to pay a worker with a 1099

Different Types of Compensation

There are three primary ways that businesses compensate their employees:

• Hourly wages
• Fixed annual salary
• Commission 

Hourly Compensation

Hourly wages are based on an hourly rate. The employee’s pay is determined by how much time they work during a pay period. 

For example, you could pay an associate $20 per hour for their work. If they work 80 hours in a pay period, they are owed $1,600.

An hourly wage is ideal for a part-time employee or someone who doesn’t work a consistent schedule, like a restaurant server. Typically, hourly workers are “non-exempt,” which means they qualify for overtime pay. You might decide to pay a new hire an hourly wage if you're still getting your business up and running, and sussing out how many employees you need, and how often you need them.

Salaried Compensation

Salaried employees are paid a fixed annual rate. Each payday they are paid a consistent figure, which is determined by dividing their annual salary by the number of pay periods. 

For example, with a $60,000 annual salary and a bi-weekly pay period, an employee will receive $2,307 in pre-tax wages each payday.

Salaries are best for corporate roles in which the employee’s time input is predictable. Salaried employees are typically exempt from receiving overtime pay.

Commission-Based Compensation

You can also pay employees on commission. They would potentially earn a low base rate — which can be hourly or salaried — plus additional pay based on predetermined sales goals. 

For example, a full-time salesperson at your company might have a $35,000 base annual salary. On top of that, they also earn a commission based on a percentage of any deals they close. 

Commission-based compensation is ideal for sales roles, as it incentivizes employees to meet specific goals. 

Refer to the FLSA (Fair Labor Standards Act) to ensure that you are properly compensating your employees while adhering to minimum wage and overtime laws.

How Much to Pay an Employee

How much you should pay your employees depends on what your competitors are paying for similar roles, and the type of company you run.

Conduct market research to see what other companies in your field and location pay for the role you’re hiring for, or for the type of work you need to be done. 

Online tools like PayScale and Salary crowdsource pay rates from around the country. 

How to Pay an Employee as a Small Business

To start paying employees, you’ll need to set up payroll, and be sure to use a payroll system that makes sense to you.

First, let’s uncover what processing payroll involves. Then, we can explore the best payroll options for small business owners.

1. Collect Paperwork from Your Employees

Have new employees and current employees fill out and submit these tax forms:

• IRS W-4 form for federal tax withholding
• State form (like California’s DE 4)
• Any other state forms required, as well as forms for local withholding 
• USCIS 1-9 form for verifying work eligibility

If you plan on paying your employees via direct deposit, you will need to request their banking information as well.

2. Calculate Pre-Tax Pay

Determine how often you'll pay your employees—weekly, bi-weekly, semi-monthly, monthly or a different cadence all together. Then figure out your employees’ gross pay for the pay period:

• Hourly employees: Multiply their hourly rate by the number of hours they worked during the pay period. Remember, if they took any unscheduled time off, be sure to subtract those hours from your calculations.
• Salaried employees: Divide their yearly salary by the number of pay periods in your annual payroll schedule.
• Commission employees: Determine their hourly or salaried base pay. Then, add their commission earnings for that pay period, based on your company’s commission structure.

3. Determine Tax Withholding

Refer to the paperwork you collected from employees to calculate how much of their earnings you need to withhold for (pre-tax and post-tax):

• Federal income taxes
• State income taxes
• Local taxes
• FICA (Federal Insurance Contributions Act), which comprises Social Security taxes and Medicare taxes, a.k.a. payroll taxes.
• Deductions for benefits such as healthcare, retirement savings plans, flexible spending accounts, and commuter benefits

If applicable, you’ll also want to consider the cost of unemployment insurance, including SUTA (State Unemployment Tax Act) and FUTA (Federal Unemployment Tax Act). Typically, this is not deducted from employees but paid on the employer side.

4. How to Pay an Employee: Calculate Net Pay

You’ve determined your employees’ gross pay and how much to withhold from their paycheck in taxes. Calculate their net pay by subtracting the withheld amount from their gross pay.

For example, if an employee’s gross pay for the pay period is $2,500 and $680 needs to be withheld for taxes, the employee receives a payment of $1,820 on payday.

5. Distribute Paychecks to Your Employees

Now it’s time to pay your employees the net pay they are owed. Checks and direct deposits are the most popular ways to pay an employee. 

If you use direct deposit, refer to the bank information your employees gave you. Alternatively, you can have your bank or payroll provider cut checks for employees. Apps like Hourly will automatically pay your employees and provide them with pay stubs they can view from their phones, eliminating the need for paper checks, and hassle on your end.

6. File Taxes

You are responsible for paying taxes on behalf of your W-2 employees. For your tax filings, take the portion of the employee’s paycheck that has been withheld (determined in step three) and distribute those funds to the proper places. Specifically, file taxes with the IRS, your state’s tax collection agency, and (if applicable) your municipality’s tax collection agency. Note that some taxes are paid only by the employer.

7. Pay Into Benefits

Not all withheld pay will go to the government. Depending on your company, a portion may go toward employee benefits. 

This might include contributions toward:

• Health insurance
• Retirement
• Commuter benefits
• Health savings accounts
• Flexible spending accounts

If you offer any employee benefits program, make a payment on behalf of your employees into the relevant accounts.

8. Update Payroll Records

You’ll need to keep your payroll records for several years in case of an audit. Keep your payroll register up to date, organized, and accessible. Include information about who got paid, how much they worked, how much they were paid, and what taxes were withheld.

How to Pay an Employee: Best Payroll Solution for Small Businesses

Payroll sounds complicated, doesn’t it? How do small business owners handle it?

Enterprise-level businesses have in-house teams dedicated to paying employees. Small businesses may not be able to afford a payroll specialist or even have enough people on the payroll to warrant the expense. 

However, even one-person businesses are responsible for labor law compliance and tax withholding in most cases.

Using payroll software is the best way to pay employees in a small business. It’s cost- and time-effective. In fact, payroll software automates each step of the detailed payroll process we just covered, including distributing payments.

How to Pay a Worker with a 1099 

To pay a 1099 worker, simply pay them their gross wages. In other words, follow your normal payroll process but don’t withhold their taxes. 

1099 workers technically aren’t employees. They’re considered independent contractors. 

Independent contractors are responsible for paying their own payroll taxes. They'll file all their state taxes, as well as their federal taxes, themselves. An independent contractor can be classified as such if the person paying for the work (the client) controls the final product or result, but not how the work is done. 

So, can you pay a 1099 worker hourly? Yes. You can pay your 1099 contractors an hourly rate or a fixed fee for deliverables. 

If a 1099 contractor works 60 hours at $20 per hour, their gross pay or remuneration would be $1200. You would pay the contractor the full $1200. Quarterly tax payments with the IRS and state and local treasuries would be handled by the contractor — not your company.

While you can pay independent contractors a fixed fee, you can not pay them on a salary — otherwise, they’d be considered non-exempt employees and would need to get a W-2 from you. 

Can you pay an employee with both a W-2 and a 1099? Yes. For example, let’s say that you own a restaurant. Your employee Amy is both a W-2 and 1099 worker for you. 

She works for your restaurant as a full-time manager, for which she gets a W-2. As the manager, she is expected to work at the restaurant and follow the protocol you have set up. 

In addition to her role as a manager at the restaurant, Amy also provides graphic design services for menus and advertising. This work would be classified as independent contractor labor. 

You, the owner of the restaurant, provide input on how you want the deliverables to look, but Amy is in charge of deciding how to execute your input. She decides when, where, and how she creates the graphics.

If you’re unsure about whether someone is an employee or independent contractor, it’s best to consult legal counsel who can clarify how federal laws from the Department of Labor apply to your company. To avoid any potential lawsuits or legal issues, you need to be sure you are complying with the FLSA when paying your employees.

Final Thoughts: How to Pay an Employee in a Small Business

There’s a lot to know when it comes to paying your staff. 

First, you must determine how much they’ll make and how you’ll pay them. Then, you have to determine whether your staff are W-2 employees or 1099 contractors to figure out whether or not you are responsible for withholding their taxes. Finally, you must run payroll correctly (and on a regular schedule) to make sure everyone is happy on payday.

The process seems complicated. Fortunately, there are payroll services like Hourly that take the stress of payroll off your plate by automating it. They can help with your payroll recordkeeping, since everything is stored in the app, as well as your tax returns, which they'll file automatically for you. Hourly also offers time tracking and workers' compensation insurance, so you can keep everything streamlined. Learn how you can free yourself from payroll with Hourly.