Payroll compliance: everything founders need to know
In this guide we cover everything business owners need to know to stay in compliance with their payroll.
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1 minute
October 8, 2024
Kevin Flynn is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.
Getting payroll right is critical for small businesses. Ensuring employees receive the amount due to them is one part of that. Payroll compliance with state, federal, and IRS regulations is another. This article will explain how compliance works and provide tips on avoiding non-compliance with payroll tax and employment laws. Some of the key takeaways are:
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Payroll laws governing how wages and salaries are processed and distributed come from several different sources. The Fair Labor Standards Act (FLSA) is a federal law protecting employees. States have minimum wage laws, and the IRS has tax withholding requirements. Conformity with these and other payroll laws is called payroll compliance.
Business owners should check with their local department of labor about payroll compliance requirements in the state where their business is located. Many states run webinars explaining state laws and how to process an employee’s wages. Look for those and information on payroll regulations and wage rates. You don’t want to run afoul of either of those.
Another key element of payroll compliance is employee classification. Your payroll records must declare new hires exempt or non-exempt employees for federal tax purposes. That should be listed as part of the onboarding process on your payroll compliance checklist. State laws may also have clauses for tax exemptions.
Human resources is responsible for benefits administration, the accountant will handle your tax filing, but the business owner is ultimately responsible for payroll compliance. Business owners pay the fines when compliance requirements are not followed.
That doesn’t mean you need to do the payroll yourself.
Many businesses hire third-party payroll services like Gusto to handle payroll processing and tax withholding. These companies can work in several jurisdictions and know how to do payroll for independent contractors. A payroll company typically uses payroll software and tools to automate payroll processing.
The United States uses a progressive tax system that starts with a marginal rate of 10% and ranges through seven tax brackets to 37%. Your withholding is based on the tax brackets your employees are in and the information provided to you on their W-4 form. Read IRS Publication 15-T, Federal Income Tax Withholding Methods to learn more about this.
Please consult with a tax professional for more guidance on your specific situation.
Several federal laws affect payroll. The federal government enacted these laws to protect employees. They include labor laws, tax laws, and laws that govern wage rates. If you own a business with employees, your company must adhere to these laws to remain in payroll compliance. Read them carefully to avoid non-compliance fines and penalties.
The Fair Labor Standards Act was enacted in 1938 to set a minimum wage and eliminate child labor in the manufacturing industry. It also governs overtime pay and payroll reports or recordkeeping. State laws may cover some components of the FLSA. For example, the state minimum wage may be higher than the federal minimum.
The Federal Insurance Contributions Act (FICA) covers the Social Security and Medicare taxes portion of your federal income tax. It has been an intrinsic part of our payroll system since 1935, when President Theodore Roosevelt established it to fund the new Social Security program. Businesses are required to deduct FICA from employees’ paychecks.
The Federal Unemployment Tax Act (FUTA) was enacted to pay employees when they’re unemployed for an extended period of time due to no fault of their own. The business, not the employee, pays this tax, which does not exempt you from paying state unemployment taxes. Local governments (towns and cities) don’t have unemployment taxes.
The Equal Pay Act (EPA) was enacted in 1963 by the John F. Kennedy administration to ensure equal pay for women performing the same jobs as men. This law was designed to target specific workplaces, hoping that individual changes could lead to industry-wide evolutions.
If you’re a contractor or subcontractor, the Davis-Bacon Act (DBA) mandates that you pay your workers at least the prevailing wages and minimum fringe benefits for the area where you’re doing a federal project. Non-compliance with this law could lead to the loss of the construction project, fines for each violation, and potential lawsuits from employees.
The Internal Revenue Service (IRS) has a Payroll Page on its website with links to several topics related to payroll tax compliance. These include workers’ compensation for full-time employees, how to file Form 945 so employees can do tax returns, tax rates based on income brackets, audits, and penalties for misclassifying employees.
IRS tax laws are complicated and change frequently, so it’s best to have an accountant or payroll company help you to remain compliant. Another option is to use an Employer of Record (EOR) for third-party legal and administrative responsibilities or a Professional Employer Organization (PEO) to handle employee HR tasks.
You do not want to violate IRS payroll regulations. The fines and penalties can be excessive, making life difficult for small business owners. The best way to avoid that is to do your homework on tax laws and hire professionals when needed. You might also need a lawyer if you run into a misclassification issue. Try to avoid that if possible.
Please consult with a tax professional for more guidance on your specific situation.
Businesses operating in multiple states may already be familiar with multi-entity accounting. You should also be well-versed in state income tax laws. The states typically ask for a smaller percentage than the IRS, but their enforcement procedures can be more intense. Research the local rules before you expand. Here are some examples:
State Unemployment Tax Act (SUTA) taxes fund state unemployment insurance (SUI) programs that offer compensation and other benefits to unemployed individuals. SUTA taxes are different from FUTA taxes, which are federal. Businesses must pay both to comply with federal and state tax regulations. FUTA and SUTA are both typically paid by the employer.
Unemployment taxes are usually not included on employee paystubs. They are calculated based on the state’s wage base and tax rates, so the tax won’t be the same if you have offices in multiple states. Your payroll software should have updated charts for each state to help with this calculation. We’ll provide a list of payroll software later in this article.
Some circumstances require extended time off, but employees don’t want to lose their health insurance or jobs while out. That’s why the Clinton administration enacted the Family and Medical Leave Act (FMLA) in 1993. With this protection, employees can keep their health insurance when they leave their jobs on unpaid leave for up to twelve weeks per year.
The FMLA applies to public agencies and private sector employers with fifty or more employees, including local, state, and federal employers. Employees can take FMLA leave if they’re caring for a newborn, adopted child, foster child, or family member. They can also leave to take care of their own medical condition if longer-term treatment is required.
One of the most pressing compliance issues is payroll tax compliance. Violating state or federal tax laws can have serious consequences. Doing your corporate tax filings incorrectly can result in expensive fines, interest, and penalties. There are also withholding rules and deposit deadlines that need to be followed. Here are a few examples of those:
The employer is responsible for paying 1.45% of an employee’s paycheck to Medicare and 6.2% to Social Security. That’s 7.65% of all wages paid to mandatory programs for employers and employees. Your company cannot, under any circumstances, omit these deductions or fail to make required deposits to the Medicare and Social Security funds.
FUTA taxes can be tricky. Your company must pay 6% of the employee’s tax base, which is $7,000, but you may be exempt from most of that if you pay state unemployment taxes (SUTA). The maximum credit is 5.4%, leaving your business responsible for paying 0.6% of the tax base to FUTA. Your payroll software should be able to calculate this for you.
Employees not exempt from the Fair Labor Standards Act (FLSA) must be paid at least the federal minimum wage ($7.25 per hour) for their first forty hours of work per week and 1.5 times that amount for overtime. Common exemptions to this rule include salaried executives and sales reps working for commissions. State minimum wage laws take precedence over this rule.
Each state has its own tax laws. Some mirror federal regulations, while others are entirely different. For example, twelve states charge a single tax rate for all income, while twenty-nine states use graduated income tax brackets. You can use this ADP reference guide to research the rates in any state you do business in.
Payroll non-compliance can be expensive and detrimental to your business reputation. Making mistakes when compensating your employees is not a good look. It can lead to morale issues, turnover, and additional costs for new hires and training. That’s on top of the fines, penalties, interest, audits, and legal fees you might have to deal with. Here’s what that looks like:
The IRS charges penalties for not making payroll tax deposits on time. They start at 2% for deposits 1-5 days late and escalate quickly to 5% for deposits 6-15 days late, 10% for deposits 16 days late, and 15% for deposits made ten days after a first IRS notice. There’s also a Trust Fund Recovery Penalty (TFRP) if you withhold payroll taxes and don’t send them in.
That’s just the tip of the iceberg. The IRS charges a failure-to-file penalty of 5% for every month you fail to file taxes, up to a maximum of 25%. You could also be subject to a negligence penalty if the government feels you intentionally or recklessly disregarded tax rules.
Payroll non-compliance can result in legal actions initiated by the IRS or by employees who have been unfairly treated. Examples of this include non-payment of overtime, failure to comply with the Equal Pay Act, or intentionally not making deposits of funds withheld from your employees. The severity of the judgments in these cases varies by jurisdiction.
Mistakes happen. Anyone can miskey information or neglect to update documentation. When those things happen repeatedly, your company can get in trouble. Failing to recognize non-compliance can also create unmanageability. You can avoid that by paying close attention to your payroll processes. Here are some examples of the mistakes to watch out for:
Employees need to fill out a W-4 form and receive a W-2 at the end of the year. Contractors submit a W-9 form and receive a 1099 at the end of the year. Misclassifying either can lead to fines, penalties, and possible litigation. The most important distinction is that you must withhold employee tax dollars. Contractors handle their own taxes.
Employees can declare their exemption status on a W-4 form, but the IRS is not obligated to accept that. Tax exemptions are available if an employee has no tax liability from the previous year or expects none in the current year. This typically happens with students, part-time employees, seasonal workers, or individuals over sixty-five years old.
Two key variables in calculating worker’s compensation are payroll and hours worked. Unemployment benefits come from the state, so audits are done at the direction of the State Department of Revenue. To avoid potential penalties, your business should do internal audits to catch mistakes before the state auditors come in.
The most obvious way to remain compliant with your payroll is to pay close attention to how the payroll process is done. You can learn how to manage a payroll or hire people to do that for you. Using the right tools and doing internal audits can also help. Here are our top three tips for achieving successful payroll compliance:
ADP provides a free payroll compliance checklist if you’re looking for a tool to help your team stay on point. It covers payroll processing, taxes, time and attendance, mobile access, compliance, hiring, online employee self-service, reporting, and integration. You can use the checklist to monitor payroll activities or create new processes.
An internal payroll audit should not be viewed as an attempt to “trip up” your employees. Think of it as a self-care exercise. Regular audits can help everyone, including you. They improve accuracy and efficiency, eliminate costly mistakes, and help your company avoid fines and penalties for payroll non-compliance. Explain that to your team whenever you do audits.
There are several good payroll software programs on the market. They can help you with everything from payroll compliance to scheduling ACH deposits for your employees. ADP and Gusto are two of the more popular payroll software programs for small business owners.
Payroll compliance is complicated, even for small businesses. IRS regulations, federal and state tax withholdings, and several national and local laws govern how you should pay your employees. Those include the Equal Pay Act and local minimum wage laws. Hiring compliance professionals and using the right payroll software can help you keep it all organized.
When considering a dedicated payroll provider to help keep you in compliance, keep in mind that Rho offers direct integration with several popular options: Gusto, Workday, and Bamboo HR to streamline your processes. This helps you speed up your month-end book closing and sync and reconcile transactions as they happen, saving you precious time.
Learn more about Rho’s integrations today.
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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.