Small Business Owners: Beware of Common Payroll Blunders

Managing payroll can be a major challenge for small business owners, especially as state and federal payroll tax regulations continue to evolve. Missteps in this area aren't just minor hiccups — they can lead to significant financial penalties and operational disruptions. Below are some common payroll compliance pitfalls and ways to avoid them.

Misclassifying Workers

Businesses often prefer to treat workers as independent contractors (rather than employees) to lower costs and administrative burdens. However, the IRS, the U.S. Department of Labor, various state agencies and even workers themselves may challenge worker classifications.

Properly classifying a worker as an independent contractor is beneficial because the business doesn't have to worry about employment tax issues or provide expensive fringe benefits. However, when a business mistakenly treats an employee as an independent contractor, the employer could owe unpaid employment taxes, penalties and interest. The employer also may be liable for employee benefits, such as health insurance and retirement plan contributions, that should have been provided but weren't. So, it's important to get worker classification right.

Beware: IRS and DOL rules can differ from state and local rules. That said, worker classification is generally based on the degree of control the employer has over the person and their work product.

Another misclassification error happens when an employer misinterprets an exemption from overtime pay. Most salaried executives and many other employers are exempt from overtime pay requirements under the Fair Labor Standards Act (FLSA). However, the FLSA includes several key exceptions reflecting earnings thresholds.

Miscalculating Pay

Inaccurate earnings calculations can cause headaches for employers and hardship for workers. For instance, shorted employees may have to scramble to pay their bills. Examples of mistakes involving employee compensation include:

• Overpayment or underpayment,
• Errors relating to new hires and employees on disability or leave,
• Inaccurate retroactive payments, and
• Incorrect deductions for fringe benefits.

If you make a mistake when compensating an employee, resolve the issue immediately and take steps to prevent it from happening again. Being transparent and responsive helps retain valued workers and maintain morale and productivity.  

Tracking Time Improperly

Accurately tracking time for hourly employees can be challenging. Employers may unintentionally overlook compensable time, such as meal or rest breaks, travel to off-site assignments, or participation in company-sponsored events.

Under the FLSA, nonexempt employees — typically paid hourly — must receive overtime pay at 1.5 times their regular rate for any hours worked beyond 40 in a workweek. Improper time tracking can lead to two unfavorable outcomes: 1) underpayment, where employees aren't properly compensated for overtime, or 2) overpayment, which may require repayment or adjustments to future wages. Either scenario can cause frustration, damage morale, and potentially expose the employer to legal risk.

Failing to Report All Sources of Income

Compensation includes more than just salaries and hourly pay. Examples of alternative pay sources are:

• Overtime,
• Bonuses, and
• Commissions.

Some lesser-known income items may also come into play. For instance, some employers may offer incentive stock options (ISOs) or other rights, gift cards, employee awards, and other fringe benefits, such as the use of company-owned vehicles.

Payroll and income taxes must be paid on these items, too. Failing to include the value of awards, bonuses and fringe benefits (when required) in employees' taxable incomes can lead to substantial underreporting penalties for employers.

Missing Deadlines

The IRS and state tax agencies expect your business to deposit federal payroll taxes on time. That means your organization must deposit amounts withheld for income tax, Social Security and Medicare taxes (FICA) and Federal Unemployment Tax Act taxes (FUTA) throughout the year. It's critical to follow the IRS schedule for depositing payroll payments. Deposit frequency depends on your total tax liability. Most small businesses must deposit payroll taxes by the 15^th of the following month. However, some may be required to make semiweekly deposits.

In addition, small businesses must generally report wages and tax withholding quarterly. The due dates for calendar-year businesses' quarterly reports are as follows:

Note: If a due date falls on a weekend or legal holiday, the deadline moves to the next business day.

When cash is tight, business owners may be tempted to borrow money from withheld payroll taxes. This is never a good idea. Missed deadlines or underpaying the IRS could cost more taxes (plus penalties and interest). Additionally, an officer, business owner and/or other employee responsible for meeting payroll tax obligations on behalf of your organization could be held personally liable for the full amount of the unpaid taxes under Section 6672 of the Internal Revenue Code.

Issuing Inaccurate W-2s

Form W-2, "Wage and Tax Statement," is the only payroll tax form that goes directly from an employer to its employees. It provides the following tax information:

• Gross income,
• Taxable income, and
• Payroll withholding for fringe benefits and retirement account contributions.

Reporting these items correctly is critical. Mistakes on an employee's W-2 can have a domino effect throughout the company. It can lead to penalties for errors, extra paperwork and disgruntled employees.

Relying on Manual Recordkeeping

It might be relatively easy for a small business owner to handle payroll matters for a handful of employees. But as your business grows, payroll tasks become more complicated. Reliance on paper processes, manual data entries and spreadsheets to track employees' hours can lead to miscalculations in pay. For example, manual processes can lead to misplaced worksheets and missed payments.

Furthermore, when the person in charge of processing payroll is out of the office, his or her designated replacement may not be fully prepared for the responsibilities. This situation can cause payroll entries to fall through the cracks or be misrepresented.

Consider investing in an automated payroll system integrates with your accounting system and other digital tools, such as customer relationship management platforms, project management tools, cloud storage and communication apps. Potential benefits include simplified payroll processing, improved oversight and fewer payroll errors.

Get It Right

Payroll-related laws and regulations aren't written in stone. Payroll practices should take into account any changes applicable to your business and government requirements. For example, some procedures were paused or postponed during the pandemic, and new laws and rulings may require updates to your payroll management system. This requires continuous vigilance.

If you feel overwhelmed by payroll tasks, it may be time to shift payroll management responsibilities to an external payroll provider. Professionals who specialize in payroll processing can help you avoid costly mistakes. Contact your professional advisors for more information.