1. Money

Introduction to Preparing Payroll

Learn About the Circular E and Payroll Taxes

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A frequent question my arts and crafts clients ask me if change their type of business entity to incorporate or want to hire employees for their sole proprietorship is how to prepare a payroll check. You can always hire a payroll service or buy software to prepare checks.

However, if you only a few payroll checks to issue each pay period, it's pretty easy to do it manually. This article gives you an introduction to preparing payroll checks.

Downloading Circular E

I've calculated thousands of payroll checks manually over the last 15 years and trained many clients to do the task themselves. If you have fewer than five employees, using my method won't take but 10 to 15 minutes each pay period.

Your first step is to order or download Circular E, also known as Publication 15, from the IRS. There are tables in Circular E that tell you the exact federal income tax amount you should withhold from each paycheck. The W-4 form you or your employees fill out when starting employment has the info you use to figure out how much federal withholding tax you need to deduct from each check.

The W-4 form asks for the employee's name, address and social security number. This is crucial information you need to prepare a W-2 for them at year end. It also asks for the employee's marital status and number of exemptions for tax purposes.

Please note: I could write an entire book on payroll. The information in this article is only an introduction to manually calculating and running payroll checks. It doesn't cover any paperwork requirements, such as the W-4 or I-9 form, or the legal requirements of payroll tax reporting or depositing.

Figuring Out the Difference Between Gross and Net Wages

These taxes make up the difference between gross and net wages:

  • Federal Income Tax: You need the Circular E to figure how much federal income tax to withhold from each employee's paycheck. Inside the Circular E you will find tables. These tables are broken out by how often you run payroll - for example, monthly, bi-monthly and weekly. There are also separate tables if the employee is claiming single or married or married for tax purposes.

    You might be wondering why a married person might opt to be single for tax purposes. It doesn't have anything to do with filing a joint tax return. It is merely a way to have more taxes if needed deducted from the paychecks via the tables. Looking at the tables, you'll see that a single person with 1 dependent has more taken out of their check than a married person with one dependent.

    Going down the side of the table are wage amounts. Going across are columns for the number of dependency exemptions. Find the tax by going to the correct intersection of wages and dependents.

  • FICA: Social Security Tax - There are two components to FICA (Federal Insurance Contributions Act): Social Security and Medicare. The Social Security tax rate is 6.2%. This percentage has been the same for decades. This tax is limited to a certain dollar amount each year. After employees have been paid in that amount, they no longer have an FICA obligation for the rest of the year. (Circular E has the yearly limitations.)

    Please note: for 2011 only, FICA tax is subject to a reduced rate.

  • FICA: Medicare Tax is 1.45%. This percentage has been the same for years too. At present, there is no limit to this tax.
Most states will have income taxes, too. You'll have to check for your applicable state employment tax percentage and dollar limit. Depending on where you live, there might be a city employment tax as well.

I won't cover any other optional employee deductions, such as 401(k) retirement plans and flexible spending accounts, because I want you to learn the basics here. Once you understand how payroll works, you can add other deductions appropriate to your business. Also, your accountant can help you with any other payroll deductions.

The next page in this series of articles discusses a practical example of figuring net wages on $1,000 gross.

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