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Learn the Ins and Outs of Paying Small Business Employees

Simone Johnson
Simone Johnson

When you're a small business owner, there's a lot to be aware of when paying your employees.

  • 93% of American workers are paid using direct deposit. 
  • Stock options are a payment option that isn't restricted to consultants or investors. Through a contract, your company can provide this opportunity to employees and contractors.
  • When deciding how much to pay your employees, research the role and investigate what your competitors offer. 

When you're starting a new business, setting up your office and training staff aren't the only things you should be concerned with. As an employer, it is also your job to decide how much your employees should be paid and how they should be paid. You need to make sure you're paid, too, and you need to implement a payroll process for your business

In this guide, we'll walk you through all the important decisions you need to make, the options available to you and how to set up payroll so it's a breeze for your small business. 

Let's get started.

How to pay employees in your small business

Compensating your employees sounds simple enough, but there is more to it than writing a check every two weeks. Let's start with the factors you have to take into account. 

First, you must choose the type of employees you want. Do you want independent contractors or full-time employees? Once you've made that determination, next you can decide the best way to pay that individual.


Wages are the salary or amount of compensation you pay employees. It is a fixed regular payment given on a daily or weekly basis, depending on your pay period schedule. According to the Fair Labor Standards Act (the federal law that sets the minimum wage, overtime pay eligibility, record-keeping, and child labor standards for full and part-time workers), you must pay employees the federal or state minimum wage, whichever is higher.


Commissions offer a less fixed rate, because the amount you pay to an employee is determined based on the completion of work, and it can be given in addition to or instead of a salary. Commissions can be based on a percentage of a certain number of orders or sales. Payment of commission isn't required by the FLSA. 


Who doesn't love extra money? That is essentially what a bonus is. Money awarded to you that is more than your salary or typical amount of specified pay. As an employer, you can distribute bonuses based on performance or randomly. 

Stock options

Stock options aren't just for consultants or investors. Through a contract, your company can provide this opportunity to employees and contractors. Your staff can buy shares of the company's stock at a grant price, which is a specified cost.


Sometimes a good insurance package can compensate for a lackluster salary. Employers can help employees pay for their healthcare by giving them money for their insurance. There are two ways to do this: a tax stipend and a tax-free reimbursement arrangement. 

A tax stipend is when employees receive money, regardless of whether they buy health insurance, from their employer. The employer's monthly contributions are added to workers' paychecks. When the year ends, employees must fill out a form that reports the amount of their stipend, which they should classify as income on their personal income tax return.  

A tax-free reimbursement arrangement is when employees are given a fixed amount by their employer to repay themselves for health insurance and medical charges they have incurred. Once employees incur a qualified expense, they're given the money. 

Workers' compensation is also insurance paid by an employer for injured employees. Should an employee be injured on the job, worker's compensation covers the employee's medical treatments. Employers put money into their state and federal workers' compensation funds to cover these costs. You cannot deduct workers' compensation insurance from employees' wages.

How to set pay rates

Deciding what amount you should pay your workers shouldn't be a guessing game. Job roles differ as do the skills of candidates, but by considering certain factors and doing some research, you'll make an educated and fair decision.  

Before you sit down with a prospective employee, write a clear job description that lists the specific skills the candidate should possess and the experience you're looking for. Explain what tasks are relevant to the role. Avoid using generic job titles.  

Charles Read, president and CEO of GetPayroll suggests researching the role in the industry to better understand pay rates. Look at what other companies pay for the position, and research market-rate sites that break down average compensation by location. Check that the data you find is up to date.  

Also, check on your competitors. See what they're giving, not just with pay but the health plans and benefits they offer, too, said Matt Venuto, regional sales manager at ConnectPay

When meeting with a candidate, note the amount they're requesting, then compare it to the average salary for the role. Weigh the average pay against your candidate's experience and worth to your company, and consider what's in your budget and how much you can pay them. 

You do this by calculating how much money you believe the employee could bring in for the year. Consider how much time they will save you and the status of their job within your company. Ask yourself, "Am I financially prepared to give my employee a raise in a year or two?" Keep in mind the amount you want to invest in your company, too.

How to calculate compensation

There are several instruments you can use to calculate how much to pay your staff.

A payroll tax calculator helps you compute payroll deductions and withholdings for employees quickly. It also lowers the chance for mistakes while helping you determine how much to remit from their paycheck.  

A paycheck calculator considers federal, state and local taxes to help you calculate your employee's take-home pay per paycheck.  

A total compensation package calculator helps you understand all the benefits you're paying your employee, boiled down to a dollar value. This includes holidays, paid and sick days, bonuses, commissions and profit-sharing distributions.  

Read also recommends using timeclocks to calculate honest and accurate pay for your employees.   

"If you don't have them, studies show 10% of your payroll is wasted," Read told "Buy two or three, because buddy punching and ghost punching are huge problems, which is when employees have someone else clock in for them [buddy punching] or people who aren't on the payroll [but who] are collecting funds."

Editor's note: Looking for the right payroll service for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs.

Payroll methods available to you

How you compensate your staff is just as important as how much you pay them. It's important to know your options as some may be more convenient for your staff than other methods. You must choose the type of employees you want. Do you want an independent contractor a full-time employee?


Although some believe that paychecks are outdated, many employers still compensate employees with a paycheck. A paycheck is a printed check that is sent weekly, biweekly, monthly or based on the arrangement agreed on by you and your staff. 

Paychecks have gone down in popularity; today, nearly 93% of American workers are paid using direct deposit. Paper checks are very vulnerable to fraud, according to an Association of Finance's Payments Fraud and Control Survey.  

Despite its unpopularity, one benefit of paper paychecks is that you can put a stop on a payment – something you can't do with automated payments like direct deposit. This feature can come in handy if you miscalculate employee hours.

Direct deposit

Direct deposit, or an automated clearing house (ACH) transaction, is the electronic evolution of a paycheck. You can transfer funds from your business bank account to an employee's bank or credit union account. 

In addition to being a green alternative, direct deposit saves your business money. It costs, on average, $3 for a business to print and distribute paper paychecks. According to Nacha, 83% of employees believe that direct deposit is more secure versus printed checks. [Learn more about direct deposit and small businesses.]

Payroll cards

A payroll card is a prepaid card you load your employee's wages onto every pay period. These cards function in the same way as debit cards when it comes to accessing money. Some payroll cards charge you a monthly maintenance fee or for specific transactions. 


Last, you can pay workers with money out of your pocket. With cash, there's no paper or digital trail like there is with payroll cards, direct deposit and paper checks. However, it's harder to organize your payroll records, and if you're not keeping proper records, you may raise the IRS' suspicion that you aren't deducting the correct amount of taxes.

How to set up a payroll process for your small business

Once you know how you want to pay your employees and how much you want to pay them, you then want to implement a system for processing payroll. Here is what you need to set up that process: 

  • If you don't have an Employer Identification Number (EIN) already, get one. You can apply for an EIN through the IRS. This number allows you to file your business's tax returns and compensate employees. It is also extremely difficult to get a business bank account without an EIN.

  • Make sure your employees have completed their W-4. It will streamline the payroll process significantly.

  • When setting up your pay periods, synchronize them with tax withholdings for the IRS.

  • Have a compensation plan in place for holidays, sick time and vacation.

  • Decide whether payroll will be processed in-house with HR software, or outsourced to a payroll service.  

  • Consult a certified public accountant or visit to familiarize yourself with deadlines, which documents you should keep and for how long. Make sure you are aware of payroll tax deadlines so you're reporting on time. And stay on top of the tax laws in your state to ensure you're compliant.

How small business owners pay themselves

Last but not least, you have to pay yourself. Make sure you're added to the payroll so you're paid regularly, just like your staff. Also, how much you pay yourself should be based on your business operation needs. Your compensation is influenced by the kind of business you own, the stage of your business and personal expenses. 

You can pay yourself using one of these two methods: by paying yourself a salary or by taking an owner's draw.


Some business owners pay themselves through a salary, because tax withholdings and benefit payments are deducted from wages automatically. A salary is better suited for S and C corporations. 

S corporations

S corporations are like a sole proprietorship or partnership in that the tax liability belongs to members or shareholders, which is determined by the percentage of ownership. If you perform essential functions for the S-corp, you must pay yourself a salary, and one that is reasonable compared with your duties and what other similar professionals (e.g., bookkeeper, accountant, CEO) are paid. Shareholders in S-corps are subject to taxes (income, Social Security, etc.), the same as they would be as if they worked for a nonshareholder company. 

In addition to a reasonable salary, you can receive a distribution on the profits, which is based on your ownership in the S-corp. Distributions are not subject to withholding, but if you're drawing no or a very low salary and taking large distributions, the IRS is likely to notice and can reclassify distributions as wages, which means you're subject to taxes as well as penalties and interest. 

C corporations

If your business is a C corporation, you can pay yourself a salary and/or a distribution. As in an S-corp, if you are heavily involved in the day-to-day management of the C-corp, you're considered an employee, so you must pay yourself a reasonable salary. Owners can pay themselves a distribution, but you are subject to income taxes on those distributions.  


A draw is when an owner takes money out of the company for personal use. The IRS views the owners of sole proprietorships and partnerships as self-employed individuals, so they aren't compensated through regular wages. (Any profits from sole proprietorships and partnerships pass through the business and are reported on the business owner's personal tax return.)

A draw is best suited for sole proprietors, partnerships and limited liability companies (LLCs), a business structure where the owners aren't liable for a business's debts or liabilities.  

Sole proprietorships

Sole proprietors are organized through an LLC. All of the business's profit is considered the income of the owner, which is then reported on the owner's personal tax return. A sole proprietor, however, cannot deduct payment from their company as business expenses. They take their payments from earnings through draws. Sole proprietors are taxed on the draws they take. As a sole proprietor, you can allocate a percentage of your income to a savings account set aside for taxes, which reduces the risk (and pain) of surprise tax bills.  


As a partner, you can take money through a distributive share. If your business is a partnership, the partners can't be paid a salary, but they can receive a share of the profits. Partners are taxed on the full profits in the business, which are divided according to the partnership agreement.

Image Credit: Ralwel / Getty Images
Simone Johnson
Simone Johnson Staff
Simone Johnson is a and Business News Daily writer who has covered a range of financial topics for small businesses, including on how to obtain critical startup funding and best practices for processing payroll. Simone has researched and analyzed many products designed to help small businesses properly manage their finances, including accounting software and small business loans. In addition to her financial writing for and Business News Daily, Simone has written previously on personal finance topics for HerMoney Media.