Startup payroll basics: What every founder should know

Payroll is the back-office system most likely to bite you. The IRS is more patient with income-tax mistakes than payroll mistakes — late payroll-tax deposits trigger automatic penalties that compound fast. Here's the founder's primer on doing it right.

W-2 vs 1099: get classification right

Every person you pay is either a W-2 employee or a 1099 contractor. The distinction isn't optional — it's a legal test the IRS, your state, and (in places like California) state attorneys general all enforce.

The short version

• W-2 employee: you control how, when, and where they work. They use your equipment, follow your processes, and the work is core to your business.
• 1099 contractor: they decide how to do the work, use their own tools, work for multiple clients, and are engaged for a defined deliverable.

Setting up payroll the first time

Before you can cut a paycheck, you need the following in place. Allow 2–4 weeks total, longer if you're hiring across multiple states.

1. 1Federal Employer Identification Number (EIN) — free from the IRS, immediate online.
2. 2State employer registrations — withholding tax account and unemployment insurance account in every state where employees live. Some states take 1–3 weeks.
3. 3Workers' comp insurance — required in nearly every state for any W-2 employee.
4. 4Payroll provider — Gusto, Rippling, ADP, EazePayroll. Skip the spreadsheet; you will mess it up.
5. 5I-9, W-4, state withholding form, and direct-deposit info on file for every employee.

Payroll taxes you owe

Payroll tax has two halves: what you withhold from the employee, and what you (the employer) pay on top. A modern payroll provider handles the math, the filings, and the deposits — you just need to fund it.

What you withhold (from the employee)

• Federal income tax (per W-4)
• Social Security tax — 6.2% up to the annual wage base (~$176k for 2026)
• Medicare tax — 1.45% on all wages (+0.9% additional Medicare over $200k)
• State income tax (where applicable)
• Local taxes (some cities)

What you pay on top (employer share)

• Social Security — 6.2% matching
• Medicare — 1.45% matching
• Federal Unemployment Tax (FUTA) — 0.6% effective on first $7k of wages per employee
• State Unemployment Tax (SUTA) — varies 0.5%–6.0% by state and experience rating
• State disability / paid leave in some states (CA SDI, NY PFL, etc.)

Rough rule of thumb: total cost to employ a W-2 employee is salary × 1.10 to 1.15 once you factor in employer-side payroll tax. Benefits (health, 401k, equipment, software) push that to 1.20–1.35.

Year-end forms

• W-2 to every employee by Jan 31. Copy to SSA.
• 1099-NEC to every U.S. contractor who earned $600+. Due Jan 31.
• Form 941 (or 944 for smallest employers) — quarterly federal payroll tax return.
• Form 940 — annual FUTA return.
• State equivalents on each state's schedule.

Founder pay: salary, draws, S-corp

How you pay yourself depends on your entity:

• Sole prop / single-member LLC: you don't run payroll. You take owner's draws and pay self-employment tax on net profit at year end.
• Multi-member LLC: same idea, but profits are allocated per the operating agreement. Each member pays SE tax on their share.
• S-corp (or LLC w/ S-corp election): you must run W-2 payroll for yourself at a "reasonable salary" before taking distributions. Distributions above salary are not subject to SE tax — that's the whole point.
• C-corp: founders are W-2 employees, period. Distributions are dividends and double-taxed.

Common payroll mistakes

1. 1Misclassifying employees as 1099 contractors. The penalties are eye-watering.
2. 2Running payroll from a personal bank account or your operating account without a payroll provider. Inevitable mistakes; inevitable IRS notices.
3. 3Missing state registrations when you hire in a new state. You can hire someone in a new state immediately — but the state expects to be registered before their first paycheck.
4. 4Skipping the S-corp reasonable salary. The IRS audits this; back-pay-plus-penalty is painful.
5. 5Forgetting to file 1099s by Jan 31. Penalties up to $310 per 1099 if not filed within 30 days of the deadline.

What to do next

Pick a payroll provider before you make your first hire. Get an EIN and state registrations in place 2–4 weeks ahead of the first paycheck. If you don't want to think about any of this, hand it to us — we run payroll for clients monthly and the only thing you see is the funding email.