How to Do Payroll for a Small Contractor Business (Step by Step)

Most small contractors do not put off payroll because it is hard — they put it off because it is easy to get wrong quietly. Misclassify a worker, miss an overtime hour, or skip a tax deposit, and the problem does not show up until an audit or a disgruntled ex-employee finds a lawyer. This guide walks through running payroll for a small crew the right way, in the order the decisions actually happen.

Step 1: Decide employee (W-2) or independent contractor (1099)

Before you calculate a single paycheck, you have to know what the worker legally is — and this is the single most common payroll mistake in the trades. The IRS and Department of Labor look at behavioral control, financial control, and the relationship, not what you call the arrangement on paper.

• Likely an employee (W-2) if you set their schedule, tell them how to do the work (not just what the end result should be), provide the tools and materials, and they work only for you.
• Likely a 1099 contractor if they set their own hours, use their own tools and equipment, carry their own insurance, can send a substitute, and work for other clients too — a subcontracted plumber or electrician you bring in for a specific scope, for example.

Calling a full-time helper a “1099 sub” to skip payroll taxes and workers’ comp is one of the most common trade-business audit triggers, and back taxes plus penalties on a misclassified employee can run into thousands of dollars per worker per year. When in doubt, treat them as an employee, or get a written opinion from your accountant. For the full breakdown of the differences, see 1099 vs. W-2 for trades.

Step 2: Get an EIN (Employer Identification Number)

If you are going to have even one W-2 employee, you need a federal Employer Identification Number (EIN) — it is free and takes about ten minutes directly on the IRS website (irs.gov), and you get the number immediately online. Your EIN is what goes on payroll tax deposits, W-2s, and your business bank account if you have not opened one yet. You will also likely need a state employer account for state income tax withholding and unemployment insurance — check your state department of revenue and department of labor sites, since the process and required accounts vary by state.

Step 3: Pick a pay period and stick to it

Common options for small contractor crews:

Many states set a minimum pay frequency by law (often at least monthly, sometimes semi-monthly for hourly workers) — check your state’s requirement before you pick one. Whatever you choose, keep it consistent; switching pay periods mid-year creates confusion and record-keeping headaches.

Step 4: Calculate gross pay, including overtime (FLSA basics)

Gross pay is the starting point for every other calculation, and this is where errors compound fastest on job-costing crews with variable weekly hours.

Regular pay = hourly rate × regular hours. Overtime pay, under the federal Fair Labor Standards Act (FLSA), applies to non-exempt employees for hours worked over 40 in a single workweek, generally at 1.5× the regular rate:

Salaried-exempt employees (typically supervisors or managers meeting specific duties and salary tests) are generally not owed overtime under federal law; 1099 subcontractors are not covered by overtime rules at all since they are not employees. Some states layer stricter rules on top — a handful require daily overtime after 8 hours in a single day, not just 40 in a week. Run these numbers yourself with the overtime pay calculator before you cut a check.

Step 5: Withhold the right taxes and pay your employer share

This is general information, not tax advice — withholding depends on each employee’s W-4, filing status, and location, and you should confirm exact figures with the IRS withholding tables, your state, or a payroll professional. At a high level, every paycheck involves two sides:

Taxes withheld from the employee’s paycheck

• Federal income tax — based on the employee’s W-4 and the IRS withholding tables.
• State (and sometimes local) income tax — where applicable; a few states have no income tax at all.
• FICA — Social Security (6.2%) and Medicare (1.45%), 7.65% of gross combined.

Taxes the employer pays on top (not withheld from the employee)

• Matching FICA — you owe the same 7.65% the employee does, as the employer share.
• FUTA (federal unemployment) and SUTA (state unemployment) — employer-paid, rates vary by state and your claims history.
• Workers’ compensation insurance — required in nearly every state for employees doing physical trade work, priced per $100 of payroll by job classification.

Withheld taxes generally have to be deposited with the IRS and your state on a schedule (monthly or semi-weekly for most small employers, based on your total tax liability) — missing a deposit deadline triggers penalties even if you eventually pay the full amount. This is the area small contractors most often outsource, for good reason.

Step 6: Issue pay stubs and keep records

Every pay period, give the employee a stub showing: employer name, employee name, pay period and pay date, hours and rate (regular and overtime, itemized separately), gross pay, each deduction on its own line, and net pay. Many states require this by law. Use the free pay stub generator to produce one instantly from the hours and deduction amounts.

Keep records for at least the periods your state and the IRS require — commonly 3–4 years for payroll records, longer for some tax filings. At minimum, retain: timesheets, pay stubs, tax deposit confirmations, W-4s and I-9s, and any workers’ comp or unemployment filings. A missing timesheet during a wage dispute puts the burden of proof on you, not the employee.

Step 7: DIY, software, or a payroll service?

Once you have more than one or two W-2 employees, weigh the real trade-off:

• DIY with spreadsheets — free, but you own every deposit deadline, tax table update, and form filing yourself. Workable for a single employee with steady hours; risky once you have several employees with overtime and shift variation.
• Payroll software (Gusto, QuickBooks Payroll, and similar) — automates tax calculation, deposits, and filings for a monthly fee per employee. The most common choice once you cross 2–3 employees.
• Full-service payroll or a bookkeeper/CPA — hands off compliance entirely for a higher fee; makes sense once payroll errors would cost more than the service.

Whichever route you pick, the calculators and templates above still apply — they are the numbers you are checking software against, or the tools you use before you are ready to pay for one.

Frequently asked questions