How to Setup Payroll

What businesses need to know about setting up payroll.

Please note that this article is intended for educational purposes only and should not be deemed to be or used as legal, employment, or health & safety advice. For guidance or advice specific to your business, consult with a qualified professional.

Taking on your first employee often feels like a major achievement. It turns you from a solopreneur to an employer. Getting the right employees on board can really boost the success of your business. It does, however, bring additional responsibilities. One of the most important of these is the responsibility to manage payroll.

What is payroll?

Payroll is the term commonly used to describe the financial aspects of managing employees. The foundation of payroll is the employee’s salary or wage. This is rarely paid at the exact rate specified in the employee’s employment contract.

Usually, an employee’s gross pay has various adjustments to it. The main ones are likely to be downwards. These include deductions mandated by HMRC (e.g. Income Tax, National Insurance), pension contributions and student loan repayments. You may also be required to garnish wages to ensure that employees fulfil legal obligations such as child-support payments.

Some adjustments may be upward, such as overtime payments and productivity bonuses. Even so, these upward adjustments are probably going to be subject to standard deductions for Income Tax, National Insurance and pensions. This means that an employee’s net pay can end up being very different to their stated gross pay.

Who does payroll apply to?

Payroll only applies to people directly employed by the company: people engaged through a contract of employment. Payroll does not apply to people employed through a contract of service: non-executive company directors, agency staff and freelancers.

It does, however, apply to company directors engaged through a contract of employment. This is probably the key distinction between company directors and freelancers. Even if a company director effectively acts as a freelancer, they are not. If they have a contract of employment with the limited company, they are an employee. This means that the company is an employer and needs to act as such.

Is it in your best interests to become an employer?

Before taking steps to implement payroll, it is worthwhile thinking about whether or not you actually want or need to become an employer in the first place.

Many businesses could in principle get all the services they need to be performed under contracts for service. In fact, it’s now essentially standard practice for companies to have non-core services performed under contracts for service (outsourced). For example, these days, very few companies run their own cleaning and maintenance departments. Of these, even fewer are small businesses.

It’s also becoming less and less unusual for businesses to outsource even core functions. Using freelancers gives businesses massive flexibility and scalability with minimal commitment. There are, however, two reasons why businesses might become employers.

The first is that employers have a far higher level of control over how work is performed. For example, if a business hires a freelancer to perform a service, it’s entirely up to the freelancer how this is done. As long as the freelancer meets the stated outcomes, they have the right to be paid.

The second is that the nature of a relationship between a business and an individual could be such that it is effectively an employment relationship. If that is the case, then legally it is treated as an employment relationship with everything that implies.

Are you an employer already?

If you have any third party performing any sort of service for you, then you could potentially have become an employer without realising it. The UK currently recognises three legal categories of working relationships:

  • Employer–employee
  • Employer–worker
  • Hirer–service-provider

Which relationship applies is determined by the practicalities of how the business and the individual work together, not by what the applicable contract says.

This means that it is advisable to check whether the individual is actually on the correct type of contract. If they’re not, take steps to correct the situation immediately.

Employers and IR35

In a nutshell, the IR35 rules obligate businesses to assess their relationships with independent contractors working through limited companies, in the same way as they do with individuals.

If the nature of the working relationship indicates that the individuals working for the limited company are acting as employees or workers, they must be treated as employees or workers. That means among other things that they must be put on the payroll.

The IR35 rules are massively complex. HMRC does provide some guidance on how to assess limited companies for IR35 compliance. However, it is very debatable how much use this is in the real world. Also, IR35 has become something of a legal battleground. It’s therefore very possible that the rules or guidance on them will be updated over the coming years in the light of court judgements.

Realistically, if you are a small business owner, the fine details of IR35 are likely to be too complex for you to handle on your own. So make sure any service contracts are checked by a lawyer or an accountant. Then follow the advice they give you for that particular situation.

What costs should you consider before hiring?

Your intended salary or wage is just a starting point for your costs. Keep in mind that the UK has a minimum wage, which varies by age.

Also calculate the impact of the employer’s National Insurance contributions and pension contributions. Remember that some employees have the right to request to be included in a workplace pension scheme, even if they do not qualify for auto-enrolment.

Additionally, plan for the cost of covering absences, both planned and unplanned. For example, how much sick pay are you going to offer before switching the employee to Statutory Sick Pay (SSP)? You may want insurance to minimise your potential liability here.

Finally, think about the costs of training or equipping the employee to do their job. This needs to include running costs (e.g. electricity for computers) and any insurance they require.

Employers have a duty of care to their employees. This means that they must take all reasonable steps to keep them healthy and safe at work. This includes preventing discrimination (both direct and indirect) and, insofar as possible, respecting and protecting their privacy. You must also ensure that anyone you employ has the right to work in the UK.

You also need to ensure that your employees follow the law themselves. For example, if they have access to personal data, they must fulfil their responsibilities under GDPR.

How to set up payroll

Most of the work of setting up payroll goes into the planning. The actual process of setting up payroll is fairly simple, only consisting of two main steps: register with HMRC and choose your payroll software.

Registering as an employer for PAYE

Register with HMRC via PAYE online. Do this before your first employee’s first pay date. You cannot do this more than two months before your employee’s first pay date.

In principle, it should only take five working days to get your PAYE reference number. So if you register as soon as you have your first hire, everything will be in place before they complete their first pay period.

If not (e.g. if there are delays at HMRC), there is a process you can use so you can pay your employees. This is explained when you register. Reputable payroll software should be able to cope with this.

Only register with HMRC once. Your PAYE reference number is valid for as long as you continue to trade. You can therefore use it for all new hires.

Using payroll software

By far the easiest way for small businesses to manage payroll is just to invest in reputable payroll software. Input the details, and have the payroll software take care of all the maths and the admin (e.g. issuing payslips). You can have an accountant oversee this as part of their general oversight of the business.

Useful resources

  • Does your small business need an EORI number? Find out here.

  • Register as an employer for PAYE here.

  • Learn more about IR35 here.

  • See if a contractor would come under IR35 here.

  • Learn about the differences between employees, workers and the self-employed here.

  • Get detailed information about workplace pension rules here.

  • Learn more about health and safety at work here.

  • Learn about the Equality Act 2010 here.

  • Learn more about GDPR here.

  • Learn more about right-to-work checks here.

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