A Basic Guide to Understanding American Payroll

There are many different factors to consider when expanding to the US market.

Everything a business needs to know when it comes to the complex world of US payroll. Learn key terms and concepts, and the processes you need to follow to ensure complete compliance. 

Unlike many countries, payroll in the United States involves a highly regulated three-tiered compliance structure: federal, state, and often local laws. These make accuracy and timeliness crucial for business success and legal compliance, but add additional layers of complexity, especially for the first-timer. 

This guide is intended for general informational purposes only and does not constitute legal, tax, or financial advice. Payroll regulations vary by jurisdiction and change frequently. We recommend consulting with qualified legal, tax, or human resources professionals to address your specific business needs and ensure compliance with all applicable laws.

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1. Payroll Fundamentals: Key Terms and Concepts

Before processing a single paycheck, it’s essential to understand the language of US payroll.

Term	Definition
Gross Pay	The total compensation earned by an employee before any deductions or taxes are withheld.
Deductions	Amounts subtracted from gross pay. These can be mandatory (taxes, garnishments) or voluntary (health insurance, 401(k) contributions).
Net Pay (Take-Home Pay)	The final amount an employee receives after all deductions and taxes are subtracted from gross pay.
FLSA	The Fair Labor Standards Act, a federal law establishing minimum wage, overtime pay eligibility, record-keeping, and child labor standards.
FICA Taxes	Taxes required under the Federal Insurance Contributions Act; this includes Social Security and Medicare taxes.
EIN	The Employer Identification Number, a unique nine-digit number assigned by the IRS to business entities for tax reporting.

2. The US Payroll Process: A 5-Step Compliance Cycle

Running payroll effectively in the US is a recurring cycle that requires precision at every stage.

Step 1: Pre-Payroll Setup and Data Gathering

Before every pay run, you must ensure all foundational and employee data is accurate and up-to-date.

1. Establish Employer IDs: Obtain your EIN (Employer Identification Number) from the IRS, which is necessary for all federal tax filings. You must also register for any required State and Local Tax IDs (e.g., state income tax withholding, state unemployment).
2. Collect Employee Paperwork: Every new hire must complete specific forms to determine their tax withholding and eligibility to work:
   • Form I-9 (Employment Eligibility Verification): Documents the employee’s identity and right to work in the US.
   • Form W-4 (Employee’s Withholding Certificate): Used to determine the amount of Federal Income Tax (FIT) that should be withheld from their pay.
3. Define Your Pay Schedule: State laws often dictate the minimum frequency an employer must pay. Common schedules include biweekly (26 pay periods per year), weekly (52 pay periods per year), and semimonthly (24 pay periods per year).

Step 2: Calculate Gross Pay

Calculating the correct gross pay is the starting point for every paycheck.

• Hourly Employees: Calculate by multiplying the time recorded (regular hours + overtime hours) by the employee’s regular and overtime pay rates.
• Salaried Employees: Calculate by dividing the annual salary by the number of pay periods per year.
• Overtime Compliance: The FLSA mandates that non-exempt employees must be paid 1.5 times their regular rate of pay for all hours worked over 40 in a single workweek. You must ensure you correctly classify employees as exempt or non-exempt to avoid severe penalties.

Step 3: Calculate and Withhold Deductions

This step determines the final net pay by subtracting all mandatory and voluntary deductions.

A. Statutory (Mandatory) Deductions:

These taxes must be withheld from the employee’s gross pay:

• Federal Income Tax (FIT): The amount is based on the information provided on the employee’s Form W-4 and IRS tax tables.
• FICA Taxes (Social Security and Medicare): These are mandatory taxes shared between the employer and the employee.
  • Social Security Tax: Employees contribute 6.2% of gross wages (up to the annual wage base limit).
  • Medicare Tax: Employees contribute 1.45% of all gross wages.
• State and Local Income Taxes (SIT/LIT): Applicable only in jurisdictions that impose these taxes.

B. Employer Tax Obligations:

In addition to withholding employee taxes, employers must pay their share of payroll taxes:

• FICA Matching: Employers must match the employee contribution for Social Security (6.2%) and Medicare (1.45%).
• FUTA (Federal Unemployment Tax Act): Paid exclusively by the employer to fund unemployment benefits.
• SUTA (State Unemployment Tax Act): Paid exclusively by the employer (except in a few states that require a small employee contribution).

C. Voluntary Deductions:

• Pre-Tax Deductions: Contributions to insurance premiums, FSAs, HSAs, or traditional 401(k) plans. These reduce the amount of income subject to tax.
• Post-Tax Deductions: Roth 401(k) contributions, wage garnishments, or union dues.

Step 4: Pay Employees and Deposit Taxes

Once the net pay is calculated, the payment process begins, followed immediately by tax deposits.

1. Distribute Payments: Issue the net pay to employees via direct deposit (the most secure and common method), paper checks, or pay cards.
2. Deposit Withheld Taxes: This is a crucial compliance step. The employer must remit all withheld employee taxes (FIT and FICA) along with their employer-matching contributions (FICA, FUTA, SUTA) to the IRS and state tax authorities by their required deadlines. Failure to deposit on time can result in significant penalties.

Step 5: Filing and Record-Keeping

Compliance continues well beyond the payday. Employers must report wages and taxes to the government quarterly and annually.

• Quarterly Filings: Most employers file Form 941 (Employer’s Quarterly Federal Tax Return) to report income tax, Social Security, and Medicare taxes withheld.
• Annual Filings:
  • Form W-2 (Wage and Tax Statement): Provided to each employee and filed with the Social Security Administration (SSA) by January 31 each year, summarizing their compensation and withheld taxes.
  • Form W-3: A summary form for all W-2s.
  • Form 1099-NEC (Nonemployee Compensation): Required for any independent contractor paid $600 or more during the year.
• Record Retention: The FLSA requires employers to maintain all payroll records, including timecards, wage rates, and tax forms, for a minimum of three years.

Payroll and compliance don’t stop at borders. Learn how People2.0 simplifies workforce expansion and compliance in the United States and beyond.

3. Advanced Compliance: Avoiding Costly Pitfalls

Two areas are common sources of costly mistakes for US businesses: worker classification and federal labor law.

Worker Misclassification (Employee vs. Contractor)

This is one of the biggest risks in payroll. Misclassifying an employee (W-2) as an independent contractor (1099) can lead to severe IRS fines, back taxes, and penalties. The IRS applies a strict test focused on the degree of control and independence:

• Behavioral: Does the company control how the work is done?
• Financial: Does the company control the business aspects of the worker’s job?
• Type of Relationship: Are there written contracts or employee benefits?

FLSA Compliance: Exempt vs. Non-Exempt

• Non-Exempt Employees: Are protected by the FLSA and must be paid at least minimum wage and overtime (1.5x regular pay over 40 hours). These include most hourly workers.
• Exempt Employees: Are not entitled to overtime. To qualify for exemption, the employee must generally:
  1. Be paid a minimum salary threshold (the Salary Basis Test).
  2. Be paid on a salary basis (the Salary Level Test).
  3. Perform exempt job duties (the Duties Test), typically in executive, administrative, or professional roles.

4. Payroll Management Options

Choosing the right system is vital for accuracy and compliance.

A. In-House Management

This involves using dedicated payroll software or accounting programs and managing all calculations, deposits, and filings yourself.

• Pros: Complete control over the process; can be cost-effective for very small, simple payrolls.
• Cons: High risk of error and non-compliance; requires deep expertise and constant monitoring of changing federal and state laws; time-consuming.

B. Outsourcing to a Payroll Service Provider

This involves using a specialized firm (like ADP, Gusto, or Paychex) to handle all payroll functions.

• Pros: Nearly guaranteed compliance (the provider handles all tax calculations and filings); significant time savings; reduced administrative burden; access to expertise.
• Cons: Higher recurring cost.

The choice largely depends on your company’s size, budget, and appetite for compliance risk. For most growing businesses, the security and efficiency of an outsourced solution offer the best value.

Understanding the U.S. payroll landscape is just the first step. The next is ensuring your operations are compliant, efficient, and ready to scale. See how People2.0 supports global businesses operating in the United States.