Paying employees in any business is a difficult task.
And it could be extremely stressful if you don’t know what you’re doing. Mostly because there are 3 sides to paying your employees:
1. Determining how much to pay your employees.
2. Designing your comp plan to actually motivate them to work hard for you and retain them.
3. Compliance, which is making sure you’re paying your employees correctly to avoid big hefty penalties from the government.
We’ve been through it all, from trying to figure out how to do payroll for our very first employee, to figuring out how much should we pay our employees.
And, we’ve suffered the consequences of getting this wrong. We’ve paid thousands of dollars in payroll tax penalties. We’ve lost employees. And we’ve lost a lot of money.
Luckily, we’ve flipped this around and created systems to not only hire employees but also incentivize them to work as well.
That’s why in today’s post, we’re going to help you understand how to do this in your business, so you don’t make the same mistakes we made.
In this post, we are going to go over employee compensation, the types of employee compensation, and the easiest way to start paying your employees if you’re doing it for the first time.
If you’re looking for ways to pay your employees, or you’re hiring an employee for the first time and just don’t know where to start, this post is for you.
Alright, now let’s talk about how to pay your employees.
Small Business Mistakes We Made
When we hired our first employee, well, at least we thought they were an employee anyway.
It was when we first started our first company, LYFE Marketing.
When we first started our business, we couldn’t hire any employees just like most bootstrapped small businesses.
When we did start making some money, the first group of people we hired were interns. We hired some college students as interns and paid them a few hundred dollars per month to help us with some of our client projects.
Eventually, this evolved into us needing someone full-time. So, we did away with the internship program and hired a single full-time person to absorb their responsibilities.
At the time, we could only afford to pay that person $10/hour.
Now, with this full-time person, you’re probably thinking that they were a full-time EMPLOYEE. Well, in the beginning, we did as well.
But no, we learned that this person was actually an independent contractor. Because we had no payroll system at the time and was literally paying this person by check, this person was not a W-2 employee.
This meant that their wages were not taxed at all. So if they made $1600/month, that’s the exact amount that went into their bank account.
And while that might sound good in theory, it did not sound good when tax time came.
Because they were a contractor, they received 1099 at the end of the tax year and ultimately, had to pay their taxes all at once to the IRS, instead of piece by piece with W-2 wages.
Obviously, that wasn’t ideal, so we converted this person into a W-2 employee. And then as we grew as a company, we were able to increase our wages to match the market for our employees.
And now, we’re doing much better.
So there are a few things to unpack here that our clients ask us all the time:
- What’s the difference between a contractor and an employee?
- What’s the EASIEST way to set-up a payroll system?
- What is the best way to set up compensation plans for your employees?
So let’s dig in.
Difference Between an Independent Contractor and an Employee?
An independent contractor provides specific services to your company as defined by a written contract.
These independent contractors may be freelancers, consultants, or any company or individual you hire for a specific job.
Now, when you hire an independent contractor, they generally have complete control over how they perform the job that you hired them to do.
The moment you start “controlling” the way they perform work, then technically they are an employee.
According to the IRS, a worker is an employee when the business has the right to direct and control the work performed by the worker.
The worker is also an employee if you have financial control or provide employment-type benefits to the person, such as benefits or tools to perform their job.
An employee, on the other hand, is an individual who works for your business. You provide all the tools, training, benefits, and other items so they can perform their job. But most importantly, you have CONTROL over the end product.
If you hire a contractor, they must complete a W-9 form and receive a 1099 form at the end of the year if you want the expenses you pay them to be tax-deductible.
If you hire an employee, then they must complete a W-4 form, and will receive a W-2 at the end of the year that reports their wages, taxes paid, and other items.
To learn more about this, then check out our post on 1099 vs. W-2 employees.
Now, let’s move on to the next major question.
What’s the Easiest Way to Set-up a Payroll System?
Let us first describe the payroll process.
When you hire an employee, you must pay payroll taxes. The employee is taxed, and the employer.
So, to do this, you have to do a few things:
- You need to have a Federal Identification Number (EIN) for your business. You can do this online with the IRS if you do not have one
- You need a State Income Tax number. You can set this up on your State’s Department of Revenue’s website.
- You need a State Unemployment Number. You can set this up on your State’s Department of Labor’s website.
Each department will require monthly or quarterly tax payments and tax filings at a specific frequency.
You should be familiar with them to make sure you comply with those requirements. If you don’t, you can end up paying big tax penalties.
Now, in the old days, employers had to do this entire process manually.
Imagine keeping up with all of the tax payments, tax filings, and mailing this into each department separately.
Or you could hire an accountant to do it for you. But if that accountant is anything like us, they probably wouldn’t want anything to do with it.
Not because we don’t want to help, but it’s not necessary. Because now there are payroll tools that do all of this for you, automatically.
All you’d have to do is have the correct accounts setup with each department you’re liable to, and connect your account numbers to a specific payroll system.
Then, if you choose the right payroll provider, they will automatically calculate your payroll taxes, pay them on your behalf, and file your payroll taxes each month.
When we first started doing payroll, we tried to do everything by ourselves. We logged into each department’s website to try to file them electronically. And, we did our best to stay on top of it.
Well, one-time, we were late by one day. And we have received a penalty for over $1,000. And ever since that day, we completely automated our payroll process so that we did not have to worry about this ever again.
There are several different full-service payroll providers out there like:
- QuickBooks full-service payroll
…to name the most popular ones.
If you want to know which one we use, we have been using QuickBooks full-service payroll, which has been working perfectly well for us and automatically syncs with our accounting system.
Anyway, choose whichever works best for you and your business, but make sure you automate this process so it doesn’t cost you an arm and a leg down the line.
Alright, now let’s move on to the last but possibly most important aspect you need to consider.
How to Create Compensation Plans for Your Employees
How you pay your employees will determine how much of your talent you retain in your company.
So to do this correctly, you need to determine the best methods to pay your employees, whether that be with hourly pay or salary pay, or with commissions, bonuses, or profit-sharing.
Let’s quickly discuss the difference and things to consider.
Hourly pay is one of the simplest ways to pay your employees. They log-time, and you pay them a flat-rate per hour to perform the job.
With hourly pay, you have to keep overtime in mind. When you hire full-time employees, they may take longer to do their job to try to rack up their pay.
Also, many highly skilled workers don’t love hourly pay. They’d rather receive a fixed salary to deliver specific results to your company, regardless of it it takes 35 hours or 45 hours per week.
Regardless, hourly pay does have its place for many straightforward jobs that are not super complicated.
Salaries are fixed payments to your employees for performing their job.
Salaries are normally used to hire for highly-skilled jobs.
It’s also a simple way to pay your employees. And you don’t have to keep track of employee hours and time logs to do this.
Now, there is a fundamental flaw with salary pay.
And that is motivation.
In the words of Dave Ramsey, salary is the most boring way to pay people.
Paying your employees by salary could result in your employees becoming unmotivated, lazy, or just doing the bare minimum to receive their paycheck.
With that said, a hybrid model is normally recommended.
You should try to pay your salary-based employees with not just a fixed salary payment, but also with some bonuses or commissions that will motivate them to work harder to reach your business objectives.
Commissions and Bonuses
Think about the sales profession.
Most sales jobs are a blend of salary and commission or just flat-out commission-based.
This makes sense for the sales rep because you’re ultimately paying them to generate sales. And if they aren’t generating sales for you, then they are effectively useless in your company.
Now, with this example in mind, you may design commissions or bonuses to incentivize your full-time employees as well.
You should design incentive plans around the KPIs, or key performance indicators, that drive your business.
If you do not know what your business KPIs are, then check out our post on small business KPIs.
But in short, every single job in your business should be connected to a quantifiable result.
Then, you can create bonus-based pay for your employees to hit that quantifiable result, which is also contributing to your business growth.
For example, if you’re hiring a customer service representative, then that might be customer satisfaction.
If your employee hits a certain level of customer satisfaction, then you might have a bonus for them hitting that target.
Now let’s move on to the ultimate incentive to unify your company which is profit-sharing.
Profit-sharing, or revenue-sharing, is a single incentive that can unify and motivate your entire company to work towards your business goals.
The purpose of profit-sharing plans is to get everyone in your company to feel like a partner in your business.
They essentially have some skin in the game to be able to look at your business from your eyes, and not as someone who’s just coming to work to pick-up a check.
Now, while a profit-sharing plan is a great incentive, you need to design it in a way that your employees do not feel entitled to it.
And there are many ways to set-up profit-sharing plans that we’ll have to create another post for it.
For many businesses just starting, you probably won’t be able to afford a profit-sharing plan.
But as you grow and start hiring IRREPLACEABLE executives or managers in your company, you’ll probably want to consider having this in place as a way to motivate and retain them for their loyalty to your company.
So that’s the various types of compensation – hourly pay, salary, bonuses, commissions, and profit-sharing.
The last thing we need to discuss is how much to actually pay your employees.
How Much to Pay Your Employees?
They say to be rich, you need to always have 3x more money than what you have today.
And while we don’t know if this is true or not, what we do know is as a business owner, your employees will demand more money from you.
And no matter how much you pay them, they will want more as they grow in their career path.
Especially your top-talent – if they don’t feel like they have the ability to grow, they might jump back into the job market to find growth opportunities elsewhere.
So what can you do?
The best thing you can do is to find-out the market-rate for the employees you are seeking to hire.
That way, if an employee is demanding more money than anyone else is willing to pay them to do the same job, you can confidently reject your employee’s demand for more money.
And even if they don’t like it and go into the job market, they’ll be met with similar or lower payment options than they thought they were worth.
On the flip side, you also need to make sure you are paying your employees the market-rate.
Because if you are paying them below the market, then it’ll be very easy for someone to message your employees on LinkedIn and them leaving your company the next day.
We can’t count how many times it happened to us. We’ve just come into work and heard,
“Hey, I’m putting in my 2-week notice”, and then when we ask what’s going on it’s normally something like, “I wasn’t looking on the market, someone contacted me with an amazing opportunity that I couldn’t reject”.
And trust us, you’d rather lose your best employees to anything else other than money.
Now, for some people, we know what you’re thinking – you’re probably wondering – as a small business, how in the world are you going to be able to pay what the market is paying?
As small business owners, we’ve been there. And we used to think the exact same thing.
But, you actually have more options than you think.
First and foremost, if you can’t afford to hire a single employee for what the market is demanding, what makes you think that’ll change when you have 10 employees? Or 100?
You see, finding the money to hire good employees is normally not a business stage issue, it’s normally a budget or pricing issue.
When you decide on the prices for your products and services, and the budget for how you will allocate the money you receive, you should have already considered the cost of labor.
If you haven’t, then stop what you’re doing right now and read our post on small business budgeting.
But in short, you need to plan for growth in advance.
We made this mistake with one of our businesses.
We grew quickly to over 30 employees, but we still did not have the money to pay each employee what the market was paying.
And as a result, we ended up having to reorganize our entire company and layoff most of our staff to rebuild back the right way.
And we don’t wish that task upon any business owner – laying off our employees was one of the darkest days of our entrepreneurial life.
So on a more positive note, make sure you pay attention to the market when it comes to determining how to pay your employees.
You can easily do this by using tools like Glassdoor to get a general idea of what the market is paying.
And be sure to filter it down to your exact business size, area, and the years of experience you’re seeking for your job to get the most accurate results.
So there you have it!
This is how you pay your employees from A-Z.
Now, let’s quickly recap.
Today we answered 3 big questions:
- What’s the difference between a Contractor and an Employee?
- What’s the EASIEST way to set-up a payroll system?
- What is the best way to set up compensation plans for your employees?
The difference between an employee and a contractor all came down to control. If you exercise full control over any individual working for you, then they are an employee.
Next, we discussed the easiest way to set up a payroll system. You need to set up the correct accounts with the appropriate federal and state departments. Then, we recommended that you automate the payroll process with a platform like QuickBooks or Gusto, for example.
Finally, we discussed the compensation plans and how much to pay your employees. The best compensation plan is a hybrid model that includes salary and additional bonuses to incentivize behavior towards your business results.
And in terms of how much to pay your employees, we recommend that you study your market to make sure you’re not underpaying your employees, and also not getting taken advantage of by overpaying your employees.
If you want more guidance with your business financial management, then consider working with the experts in this industry. Call us today at 470-240-1437.