A cafe owner is seated at a table in his establishment. He has his laptop open. He is reading employee timesheets and reviewing them before he processes his restaurant's payroll.
Because of its complexity and federal and state rules governing payroll, many small business owners use software or a provider to process their payroll. — Getty Images/andresr

Payroll errors plague a significant number of small businesses each year. IRS penalties average $845 for roughly 40% of these businesses. What may seem like a straightforward task — paying your employees regularly and on time — is actually far more complex. It includes distributing wages, managing deductions, and complying with labor and tax regulations. Here's how to make this task as efficient and accurate as possible.

Payroll checklist: What you need to process payroll

According to ADP payroll expert Stephanie Monaco, if you're processing payroll for the first time or completing a payroll audit, these are the things you need to gather:

  • Your employer identification number.
  • Your state and local tax ID numbers.
  • Your state unemployment ID number.
  • Your employee's addresses and Social Security numbers.
  • Form I-9 (showing that new employees are legally allowed to work in the United States).
  • Form W-4 (to figure out how much to withhold for federal income tax).
  • If applicable, a state withholding allowance certificate.
  • Any applicble U.S. Department of Labor records.

If you live in Washington, Wyoming, or New Mexico, you also need to register for a state ID number before you can purchase workers' compensation insurance.

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And if you plan to manage payroll yourself rather than outsourcing it, you should review IRS Publication 15 (Circular E) to understand your tax responsibilities.

How to set up payroll

There are three ways to set up payroll: do it yourself, outsource it to a professional employer organization (PEO), or find a payroll software provider. Each option comes with unique challenges and benefits.

[Read more: Decoding PEO vs. Payroll Services: A Small Business Guide]

"Before you commit to one system over another, consider factors like business growth, employee benefits, and the complexity of your state’s payroll taxes and laws," wrote QuickBooks.

Most small businesses opt to use technology to help manage payroll, since manual payroll processing is time-consuming and prone to errors. Payroll software can automatically calculate and file payroll taxes, generate reports, and pay wages to employees' bank accounts. Or an outside payroll provider can handle all of these aspects, plus compliance — though their contracts can be expensive.

Once you figure out what system you're going to use, create a payroll policy to help you comply with labor laws and give employees insight into their pay dates. A payroll policy should cover pay dates, such as the length of each pay period; payment methods, such as check or direct deposit; your overtime policy, if applicable; payroll deductions and withholdings; and payroll benefits that might impact an employee's paycheck.

There are three ways to set up payroll: do it yourself, outsource it to a professional employer organization (PEO), or find a payroll software provider.

6 steps to process and run payroll

Gather the employee information you need. Depending on the method you choose to manage payroll, these are the general steps you will follow each pay period:

  1. Track employee time. If you work with hourly employees, gather their time sheets for the pay period. For full-time employees, make sure you have attendance records that show any sick days or leave.
  2. Calculate gross pay. Determine how much each employee earned during the pay period, plus any overtime.
  3. Deduct tax witholdings. Calculate and deduct federal income tax, Social Security and Medicare taxes, and state and local taxes. Deduct any other authorized withholdings, such as health insurance premiums, retirement contributions, or wage garnishments.
  4. Calculate net pay. Subtract all taxes and withholdings from the employee's gross pay to arrive at their net pay.
  5. Pay employees. Use their chosen method (usually either check or direct deposit).
  6. File payroll taxes and reports. File required payroll tax forms with federal, state, and local agencies and pay applicable payroll taxes.

Make sure you keep accurate records well organized in case the IRS or the U.S. Department of Labor has a question during your tax reporting. Keep in mind that full-time, contract, and hourly employees all have different forms and tax applications. Consult with an expert to make sure you're complying with all reporting requirements.

[Read more: How to Hire and Pay Independent Contractors]

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