From Jean Murray,
Your Guide to US Business Law / Taxes.
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Setting up Your Payroll System

As an employer, you are responsible for

• Paying your employees as agreed for the work they have done, and paying overtime appropriately.
  
• Filing payroll tax reports with the IRS and state agencies at the correct times.
  
• Withholding appropriate taxes from employees and paying these taxes.
  
• Setting aside funds to pay your portion of payroll taxes and paying these taxes.

That is a lot to consider, but if you set up a system for filing and paying, you will stay within the law. Here are the payroll taxes you need to include in your system:

• Federal and State Income Tax Withholding
  This tax is withheld from employees each pay, as designated on the W-4 form each employee fills out when hired, along with a state form (if that state collects income tax). You collect the withholding amounts from each employee and pay those amounts to the IRS and state governments as required.
  
  
• Social Security (OASDI) and Medicare
  Two funds are included: (1) the Old Age, Survivors, and Disability Fund (OASDI), better known as Social Security, and (2) Medicare. As an employer, you share the cost with employees by withholding a percentage of each person's gross pay (before deductions). There is a limit on OASDI deductions, which changes each year. There is no limit on Medicare deductions. These taxes are collected by the IRS and sent on to the Social Security Administration.
  
  
• Federal Unemployment Taxes (FUTA)
  This tax is paid by employers to subsidize payments to employees who have been terminated. The deduction amount is determined by the gross earnings of your employees, up to a certain limit.
  
  
• State Unemployment Taxes
  Most states have their own unemployment tax funds, to which you must contribute. The amount you must pay is based on the category of business you are in (businesses with higher turnover pay more unemployment taxes).
  
  
• Worker's Compensation Tax
  In most states, employers are required to pay into a fund which provides health care and other expenses for employees who suffer work-related illnesses and injuries. The payment and reporting requirements vary by state.

Now that you know the taxes involved, here is the process for setting up your payroll system:

1. Obtain Your Employer ID Number To obtain this number (EIN), go to the IRS website and fill out the SS-4 Form to request this number. You can get the number immediately, either by phone or online.
   
   
2. Determine Your State's Requirements
   Contact your state employment office (online or by phone) and learn about your state requirements unemployment compensation and worker's compensation. Contact your state department of revenue for information about state income tax deduction, reporting, and payment requirements.
   
   
3. Make Pay Decisions
   Make decisions on how you will categorize and pay employees.
   
   
4. Decide How You Will Process Payroll
   Decide whether you will use your accounting software to pay and report payroll, or if you will use a local bookkeeping service, or an online payroll system. The type of system you use will probably depend on the complexity of your payroll. If you have only a few employees, and all employees are working within the same staate, you can probably use any of these systems. For more complex payrolls, you may want to use a payroll processing service.
   
   
5. Set up Your Payroll Filing System
   Find a secure and private place to store payroll information. You will need a file for each employee, with records of all deductions and all pay calculations and payments. If you are audited, you will need to show these records, and they must be complete and accurate.