Payroll is just one of several essential aspects when it comes to HR for your small business. However, like many procedures involved in your business operations, payroll in itself is multifaceted. Overall, payroll means paying your employees—and yet—it also means choosing a payroll schedule, calculating employee checks and taxes, and making sure everything is done accurately and on time. With all of these factors involved in running payroll, it can be easy to glance over your compliance responsibilities, those parts of payroll that are governed by federal and state law.
These requirements, covering everything from overtime to income tax, ensure that employees are treated fairly and that the government is receiving taxes to maintain federal programs, therefore, making payroll compliance all the more significant. Moreover, payroll compliance is also necessary to prevent fines and penalties that could negatively impact your business operations.
To help you sort through this complex business procedure, we’ve compiled this payroll compliance guide. We’ll discuss the various regulations that will dictate your payroll compliance requirements, break down common payroll compliance mistakes business owners often make, and offer tips to streamline your payroll processes.
Compliance Requirements for Payroll
As we mentioned, as part of your payroll processes, you’re subject to the employer payroll compliance requirements laid out by both federal and state laws. In essence, this means that there are considerations you need to take every time you run payroll, as well as on quarterly and annual bases for business tax purposes. Payroll compliance, therefore, is a continuous part of the employee life cycle—from the day you hire someone until even after they’ve stopped working at your business.
Ultimately, your payroll compliance responsibility will be specific to your business, but there are relatively universal regulations to keep in mind:
Payroll Compliance Guide: Federal Income Tax
As part of your employer compliance requirements for payroll, you must withhold a variety of different taxes from your employee’s paychecks. One of these taxes is federal income tax, which is withheld from every paycheck and determined based on the IRS-specified methods, either by wage bracket or percentage. Federal income tax withholding is also based on the exemptions that each of your employees designated on their W-4 form. The amount withheld for federal income tax can range from 10% to 37% and is reported to both the IRS and the employee using the annual W-2 form.
Payroll Compliance Guide: FICA and FUTA Taxes
Federal Insurance Contributions Act taxes, known as FICA taxes, are also federally required for payroll tax compliance. FICA taxes consist of social security and Medicare taxes and, like federal income taxes, must be withheld from your employees’ paychecks. In addition to the FICA taxes you withhold for your employees’ paychecks, you’re responsible for paying these taxes as an employer. FICA taxes should be deposited on a semiweekly or monthly schedule, depending on your business, and reported to the IRS on a quarterly basis using IRS Form 941.
On the other hand, unlike these first two taxes, federal unemployment taxes, or FUTA taxes, are paid for solely by you as an employer. The federal FUTA tax is 6% and applies to the first $7,000 you pay to an employee each year. FUTA taxes must be paid quarterly and filed using IRS Form 940.
Payroll Compliance Guide: Employee Benefits
Depending on the fringe benefits you offer your employees, you may be responsible for withholding taxes for these benefits as well. Generally, the IRS says that “any fringe benefit you provide is taxable and must be included in the recipient’s pay unless the law specifically excludes it.” Moving expense reimbursements, clothing, and excessive mileage reimbursements are common examples of taxable fringe benefits. For these kinds of benefits, therefore, you would be responsible for withholding taxes from your employees’ paychecks and report doing so on their W-2s.
Payroll Compliance Guide: Employee Classification
In addition to these payroll tax compliance requirements, you’re also responsible for adhering to other important regulations, like correctly classifying the people you hire. If you hire independent contractors vs. employees, your responsibilities will be different and therefore, it’s important to classify your workers accurately. Although there is no 100% official determination of what makes someone an independent contractor versus an employee, generally, you control what work an employee will do, you provide them with work equipment and benefits, you reimburse particular expenses, and you designate a specific schedule for them to work.
This classification is important with regard to payroll because you must withhold taxes and pay the employer portion for your employees. Independent contractors, on the other hand, are responsible for their own taxes.
Payroll Compliance Guide: FLSA Law
One of the other important federal laws governing payroll compliance is the Fair Labor Standards Act (FLSA). The FLSA regulates overtime, minimum wage, child labor standards, and recordkeeping. As an employer, you must adhere to the applicable statues under the FLSA—including but not limited to paying minimum wage, paying overtime as necessary, and following the age and hours restrictions for workers under 18. Employee overtime pay, however, is particularly important to payroll compliance, as you must determine which of your employees, if any, are eligible for overtime, and for those who are, pay them for that overtime according to FLSA law. Generally, you must pay any eligible employee who works over 40 hours in a given workweek time-and-half for the overtime hours they work.
Some employees, however, are exempt from overtime—meaning they are not entitled to overtime pay under FLSA law. These employees include executive, administrative, and professional employees who meet certain requirements, employees of certain small newspapers, seasonal amusement or recreational businesses, farmworkers, and more. When you hire an employee, therefore, you’ll need to correctly identify them as “exempt” or non-exempt” with regard to these regulations.
Payroll Compliance Guide: State Requirements
On top of the federal regulations you must follow in order to remain compliant with your payroll practices, there are also state payroll compliance requirements to adhere to as well. As you may imagine, your state obligations will depend on the state where your business is located and will vary from state to state. More than likely, however, you’ll be responsible for withholding state income taxes, reporting new hires, and following any other minimum wage, overtime, or employee pay laws your state may have.
Payroll Compliance Guide: Common Mistakes
Now that we’ve discussed several of the most important payroll compliance requirements, let’s go through some common mistakes business owners make when it comes to their payroll processes. By examining these payroll compliance mistakes and how they happen, you’ll have the information you need to avoid them in your business operations.
Forgetting to Report Taxes
As we mentioned, a large portion of your payroll compliance responsibilities relates directly to payroll taxes—which means not only remembering to take out the appropriate taxes from your employees’ paychecks but reporting them as well. A common payroll compliance mistake that business owners make, therefore, is overlooking or forgetting tax paperwork. Although every business is different, generally, you’ll need to complete Form 940 and Form 941, as well as W-2s and 1099s for each employee and contractor. If you forget to complete and submit the necessary payroll tax forms, your business can face fines or penalties from the IRS.
Missing Tax Deadlines
Similarly to what we just discussed above, another common payroll compliance mistake is missing tax filing deadlines. Although businesses may remember all of the appropriate forms they need to complete, they may neglect to file them on time. Different forms have different filing dates, but it’s important to remember that some forms, like Form 941, must be submitted quarterly. Other forms, like Form 940 and W-2s, are only filed once a year. However, with year-end tax reporting, like W-2s and 1099s, you must submit the appropriate forms to the IRS, as well as to your employees and contractors. Missing any of these tax reporting deadlines can once again subject your business to IRS fines and penalties.
As we explained earlier, it’s important to accurately classify your employees vs. contractors because of the different tax implications of each. Once again, although there’s no authoritative definition to indicate the difference, you should make sure that you carefully consider this distinction with each individual you hire. Some employers try to lessen their tax responsibility by wrongfully classifying their staff as independent contractors.
Not only is this illegal, but in recent years, there has been more attention to this particular issue, with even the IRS highlighting the significance of the two different classifications. If you incorrectly classify your workers, you can be held liable for additional taxes, as well as interest and penalties. Therefore, you’ll want to avoid this payroll compliance mistake by thoroughly considering the differences between contractor and employee to complete new hire paperwork and reevaluating the classifications of everyone you employ on a semi-regular basis.
Confusing Exempt and Non-Exempt Employees
Another misclassification employers often make with regard to payroll compliance is confusing exempt vs. non-exempt employees. As we discussed above, exempt employees are those not covered under the FLSA for overtime pay, while non-exempt employees are covered. This means, then, you must pay your non-exempt employees overtime pay for any overtime hours they work. Many employers face issues here by categorizing non-exempt employees as exempt. This can occur, for example, when an employer classifies an administrative employee as exempt simply because they’re salaried. This could easily be a misclassification because, in order to qualify as exempt as an administrative employee, you must meet three tests, with salary only being a part of the first one.
Therefore, just as you consider the difference between contractors and employees, you’ll also want to carefully consider whether each of your new employees is exempt or non-exempt under FLSA law. If you miscategorize a non-exempt employee as exempt, your business will have to pay back wages and can also face penalties, as well as the possibility of an audit or lawsuit.
Although this may seem like an easily avoidable mistake, in fact, overtime is often miscalculated. It is well-known that overtime pay is one-and-a-half times an employee’s regular rate, however, employers often forget to include other forms of compensation—bonuses, stipends, commissions, etc.—when calculating this rate for overtime purposes. Additionally, some employers miscalculate when determining the hourly rate to use to calculate overtime pay based on an employee’s salary or weekly pay. As with all of these payroll compliance mistakes, miscalculating overtime can be problematic, especially if you’re underpaying your employees. In this case, not only are you subject to back pay and fines but you also can be subject to legal action from the underpaid employees.
Missing Deposit Dates
It’s important to remember that in addition to filing all of the right IRS tax forms by the deadline, as an employer, you’re also responsible for making payroll tax deposits—accounting for FICA taxes, FUTA taxes, and income taxes throughout the year. FICA and income taxes are typically deposited on a semiweekly or monthly schedule, depending on your business’s payroll tax liability. FUTA taxes, on the other hand, must be deposited on a quarterly basis. A common payroll compliance mistake, however, is missing these deposit dates. Therefore, we recommend setting up a schedule and making these payments online using the EFTPS, or electronic federal tax payment system.
Failing to Take Out Taxes for Benefits
Although many common benefits, like health-savings accounts and commuter plans, are pre-tax, there are other benefits that are subject to tax withholding. If your business offers any of these applicable fringe benefits, therefore, you’re responsible for withholding the appropriate amount from your employees’ paychecks and reporting this information on the respective tax forms. To ensure that your business follows payroll tax compliance regulations in this respect, you’ll want to pay close attention to the benefits you offer employees and any associated tax obligations they may have.
Forgetting New Hire Paperwork and Reporting
An important part of bringing on a new hire is completing all of their paperwork, especially those like the I-9 form and W-4, that are related to employment eligibility and tax deductions. As an employer, you’re responsible for ensuring that your new employees complete the required paperwork (and adding the relevant information to your payroll system), as well as reporting new hire information to your state directory. Unfortunately, many employers miss one of the pieces of documentation involved in the new hire process. As with all of the payroll compliance mistakes we’ve discussed thus far, falling trap to this mistake can also cause lead to penalties or problems during a potential audit.
Failing to Maintain Records
Although seemingly simple, with all of the paperwork involved with payroll compliance, it can be easy to forget or lose important documents. However, failing to maintain payroll and tax records can be extremely problematic for your business, especially if federal and state tax agencies ask to see them. This being said, you’ll want to ensure that you maintain your payroll records for all active employees, as well as anyone who has left within the last three years. Furthermore, some states have longer-term requirements for keeping payroll records. You will want to keep these documents organized, secure, and yet, still accessible if necessary. A great option for online storage is using payroll compliance software or a small business payroll service—as they typically include a portal for you to house and maintain employee information, documents, and payroll records.
Payroll Compliance Guide: Tips and Best Practices
With all of the payroll compliance requirements you must adhere to as a small business owner, it’s easy to feel overwhelmed. Luckily, there a number of simple ways you can streamline your payroll processes and set yourself up for success.
Make a Payroll Compliance Checklist
The first way you can put your best foot forward in regards to payroll compliance is by making a variety of payroll checklists specific to your business. You can create a payroll compliance checklist to consult for each new employee or contractor, for each time you run payroll, as well as one to consult on a quarterly and annual basis. On each of these checklists, you can specify the steps you need to take as well as any points you need to remember to stay in compliance with the various payroll-related laws. For example, a checklist for new hires might include:
- Determine exempt or non-exempt
- Complete I-9 and W-4
- Add employee to payroll system
- Set up direct deposit
- Report new hire information to the state
- Add records to business database
With these payroll compliance checklists, you’ll not only have a point of reference to help you through your processes, but you’ll also be able to use them to train your HR team or other employees to manage and set up payroll. Moreover, laying out the specific parts of your process will also be helpful to consult when you’re working with an accountant or tax advisor to complete quarterly or annual tax forms.
Utilize Payroll Software
Perhaps one of the best ways to simplify your payroll procedures and monitor your compliance is by using payroll software. A payroll software solution can allow you to automate your processes, store information in one place, calculate employee paychecks and withholdings, and even file taxes on your behalf. There are a variety of different offerings on the market, each with specific features and price points. Although the right payroll service for your business will ultimately depend on your particular needs, here are a few you might consider:
With Gusto, business owners can choose from three payroll plans, each with an increasing number of features. On the whole, though, the Gusto payroll software includes tax filings and payments, employee check calculations, direct deposits, and a customizable payroll schedule. Gusto also gives your employees access to their payroll information via a self-service portal. Additionally, you can use Gusto to develop employee profiles containing essential information, as well as allow employees to electronically sign their I-9s and W-4s. Gusto can also help you manage health benefits, workers’ comp, PTO, and more. The Gusto plans start at $39 per month, plus $6 per employee per month. For a limited time, you can get the Core plan for a discounted price of a monthly $19 base cost for the first 6 months. Gusto also has a new option for contractor-only employers, who simply pay the $6/employee rate and no base price.
Patriot is another popular payroll software option that is highly reviewed and known as both easy to use and affordable. Patriot offers two plans, the first of which mostly deals with the actual payment part of payroll. The second plan, however, can offer business owners payroll and tax assistance to maximize your efficiency and compliance success. With Patriot Payroll Full Service, you receive tax filings and deposits in addition to payroll management capabilities. With Patriot Payroll, you’ll also have access to an employee portal, free direct deposit, unlimited payroll runs, time off management, and payroll documents and reporting. Patriot Payroll Full Service costs $30 per month, plus $4 per employee per month.
Work with a Professional
In addition to utilizing a payroll software to help you with the calculations, forms, and tax requirements for compliance, another way to streamline your processes is by working with a professional. There are many professionals out there—from accountants to tax advisors to payroll specialists—who can help your business with payroll compliance in various ways. If you need assistance setting up and managing your payroll systems, a payroll or HR specialist will be able to walk you through the steps and answer any questions you may have.
When it comes to withholdings, paycheck calculations, and tax responsibilities, consulting an accountant or tax advisor can be a great way to supplement the benefits of using payroll software. These professionals can check your calculations, inform you on tax forms and deadlines, and help you complete any necessary paperwork. Additionally, an accountant or tax advisor can answer questions, offer advice, and generally serve as a point of reference for these kinds of complex processes.
Payroll Compliance Guide: The Bottom Line
At the end of the day, although payroll compliance may seem overwhelming at first, the pieces involved can be broken down (as you’ve seen in this payroll compliance guide) and made easier with time and practice. As your business grows and changes, continuing to take the necessary time and attention to consider payroll compliance requirements and monitor your processes will help you avoid any penalties, fines, or issues with the IRS or state authorities.
Moreover, if you want to truly optimize your payroll processes and save yourself time, money, and hassle, we’d recommend creating payroll compliance checklists, utilizing payroll software, and consulting with a professional when necessary. Without a doubt, by investing in these payroll tools now, you’ll be helping your business—and yourself—in the long run.