What Are Payroll Compliance Laws for Small Businesses?
Payroll compliance requirements are laws created by the federal government and your state government. They come into play whenever you run payroll, as well as when you pay business taxes on a quarterly and annual basis. Thus, payroll compliance is an ongoing responsibility that continues even after an employee leaves your business.
Your business’s payroll compliance requirements depend on a variety of factors. Some regulations, however, must be followed by virtually all companies located in the US.
Here they are:
Federal Income Tax
The most crucial payroll compliance requirement is tax deductions from employee paychecks. At the top of that list is the federal income tax. This is withheld from every paycheck, and the employee’s wage bracket usually determines the amount. You must also factor in the exemptions that each employee claims when filling out their W-4 form.
On average, employees should expect federal income taxes to eat up anywhere from 10% to 37% of their paychecks. This amount is reported to the IRS and the employee when they receive their W-2 form to file their tax returns.
FICA and FUTA Taxes
Federal Insurance Contributions Act taxes, a.k.a. FICA taxes, are a combination of two taxes: social security and Medicare. They are paid by both the employer and the employee.
So, you must not only withhold FICA taxes from your employees’ paychecks but also report and pay additional FICA taxes to the IRS on your own. Most businesses pay FICA taxes bi-weekly or monthly and report to the IRS every quarter.
Federal Unemployment taxes, a.k.a. FUTA taxes, are paid only by the employer. Though it technically counts as a “payroll tax,” FUTA doesn’t get deducted from your employees’ paychecks. Confusing, right?
The FUTA rate is 6% of the first $7,000 in wages paid to an employee each year. However, businesses that pay their state unemployment taxes on time typically receive a credit of 5.4%. Your new FUTA tax rate would, therefore, be 0.6%.
You must file and pay FUTA taxes each quarter.
Which Employee Benefits Are Taxable?
Certain benefits that you offer employees are actually taxable and must be withheld from employee paychecks. These benefits are excessive mileage reimbursements, moving expense reimbursements, and clothing. Excessive mileage reimbursements are payments to an employee for using a personal vehicle for business purposes. Moving expense reimbursements are expenses the employee incurs from relocating for work purposes. Lastly, clothing expenses refer to clothing given to an employee that they can also wear outside of work.
If you offer these benefits, you must include them on your employees’ W-2s.
Earlier, we established that payroll compliance refers to the legal classification of employees in addition to payroll taxes. There are two types of workers: 1099 independent contractors and W-2 employees.
Independent contractors technically work for themselves. Hence, you do not have to withhold payroll taxes from their paychecks, and they cannot receive benefits. Instead, these workers must pay taxes on a quarterly or annual basis and obtain their own health insurance and retirement plans. 1099 is the form independent contractors receive from their employers to report income on their personal tax returns.
W-2 employees are traditional full-time employees. They are eligible for benefits, and payroll taxes must be withheld from their paychecks.
The Fair Labor Standards Act (FSLA) ensures that all businesses adhere to federal laws concerning overtime, minimum wage, and child labor. When you hire a new employee, you must determine whether that employee is eligible for overtime pay according to FSLA law. In most cases, employees who work more than 40 hours per week are paid time and a half for each extra hour they put in.
However, FLSA law also states that certain types of employees are not eligible for overtime pay. Therefore, these employees must be identified as “exempt” upon being hired, compared to “non-exempt” for employees who are paid for overtime. Examples of exempt employees include certain types of executive and administrative employees, farmworkers, and employees of seasonal amusement or recreational businesses.
Payroll Compliance: State Requirements
As if federal payroll requirements weren’t hard enough to keep track of, you must also adhere to several state payroll requirements. These requirements vary tremendously from state-to-state, though most states have the same types of laws. It’s the specifics of the laws that differ. Your state will likely require you to withhold state income taxes, report new hires, pay the minimum wage, and provide overtime pay for eligible employees.
What Are the Most Common Payroll Compliance Mistakes?
If the primary requirements for payroll compliance sound confusing, it’s because they are. Every year, tons of businesses unknowingly fall out of compliance with payroll laws. Most of these businesses make very similar mistakes regarding tax paperwork, reporting deadlines, or employee classification. Fortunately, you can steer clear of them by simply making sure to fill out the correct paperwork by the correct date.
Here are the most common mistakes businesses make with payroll compliance:
Forgetting to Report Taxes and Missing Deadlines
Payroll taxes are a major headache for entrepreneurs. This is because staying compliant doesn’t just mean withholding the correct amounts from employee paychecks and paying the correct amounts on your own. You must also report the right amounts to the IRS via Form 940 and Form 941. Failing to fill out and submit these forms by the required date can result in steep fines or penalties from the IRS.
Missing tax deadlines is a prevalent payroll compliance mistake. In addition to specific due dates, you must remember whether to file certain documents quarterly or annually. The former second mistake is often attributed to the fact that most payroll compliance documents are filed annually. This makes it very easy to forget quarterly documents.
For example, Form 940 for FUTA taxes is filed quarterly even though Form 941 for FICA taxes and employee W-2s are only filed once per year.
Business owners might also forget that W-2s and 1099s must be provided to employees along with the IRS for year-end tax reporting. The fines or penalties for missing tax deadlines might not be as extreme as the punishment for failing to report taxes at all. But they are definitely severe enough to be taken seriously.
Missing Tax Deposit Deadlines
When you consider the number of business owners who miss deadlines for filing tax forms, it’s no surprise that another widespread payroll compliance mistake is missing due dates for paying the actual taxes to the IRS. FUTA taxes are due every quarter. On the other hand, you can pay FICA and income taxes bi-weekly or monthly. This decision usually comes down to the size of your business’s payroll tax liability.
Thankfully, it’s very easy to avoid missing due dates for tax payments. All you have to do is set up a schedule, make the payments online using the electronic federal tax payment system, or EFTPS.
Confusing W-2 Employees and 1099 Contractors
An independent contractor’s original definition is someone who is contracted to work on individual projects with previously established due dates. Legally speaking, independent contractors cannot take on the same workload as W-2 employees. Someone who works 40 hours per week should fill out the necessary forms to receive benefits and tax deductions.
Over the past decade or so, however, an increasing amount of business owners have realized they can save a lot of money by classifying workers as independent contractors even though they are working 40 hours per week. This money-saving scheme has become so rampant that it finally caught the attention of the IRS. If the IRS finds out you’ve been classifying W-2 employees as independent contractors, you may have to pay the taxes you should have been withholding that year, with interest and penalties.
You can expect the IRS to crack down on the misclassification of workers even further in the coming years.
Confusing Exempt and Non-Exempt Employees
Earlier, we noted that employees who meet the FSLA requirements for overtime pay must be classified as “non-exempt,” while employees who don’t meet the requirements must be classified as “exempt.” Many business owners make incorrect classifications due to the complexities of the FSLA criteria for both types.
For example, an administrative employee must meet three specific requirements to be exempt from overtime pay. One of them is being paid via a traditional salary instead of being paid by the hour. It’s natural to assume that overtime pay is only meant for employees who belong to the latter group. This is not the case.
The business owner might also incorrectly assume that meeting just one of the three requirements automatically makes the employee exempt. If the IRS finds out that you’ve classified a non-exempt employee as exempt, you might have to pay the employees the overtime wages he or she should have received that year. Your business could also face an IRS audit and even a lawsuit by the misclassified employee.
Most business owners with non-exempt employees are aware of the rate for overtime pay. What these business owners often forget, however, is that an employee’s overtime rate must also account for bonuses, stipends, commissions, and other forms of compensation. Some business owners might not even know how to calculate an employee’s regular hourly pay rate in the first place. Can you determine this rate from the employee’s annual salary alone, or do you need to figure out the employee’s weekly pay beforehand?
Miscalculating overtime pay can result in the same outcomes as confusing non-exempt and exempt employees. You may have to make up for the portion of overtime wages the employee did not receive. The underpaid employee may also have grounds to take legal action, even after receiving the owed wages.
Forgetting That Some Benefits are Taxable
Most fringe benefits like paid vacation, retirement plans, stock options, and commuter plans are not taxable. This causes some business owners to assume that all fringe benefits are not taxable, which is not true. Does your business offer excessive mileage reimbursements, moving expense reimbursements, or casual clothing? Then you must withhold the correct amount from your employee’s paychecks and report this amount on the employees’ W-2 forms.
Forgetting to Distribute I-9 and W-4 Forms
Whenever you hire a W-2 employee, he or she must complete the I-9 and W-4 forms. This confirms that the individual is eligible for employment and tax deductions. It’s the business owner’s job to ensure that each new W-2 employee completes these forms. The quicker this happens, the quicker you can add the information to your payroll processing system. If a new employee does not complete the required paperwork, the business could face fines, penalties, and an IRS audit.
Before the invention of payroll compliance software and small business payroll services, it was very easy to misplace payroll and tax documents. This could be very problematic if federal and tax agencies ask to see your records. Most states have requirements for the length of records that small businesses must keep on-hand.
Accountants and tax professionals usually recommend maintaining at least three years’ worth of payroll and tax documents. You should even save documents from employees who have left the company in that time frame.
In summary, it’s absolutely vital to purchase payroll compliance software or a small business payroll service once you begin hiring W-2 employees. Most options feature a portal that allows you to store and maintain employee payroll and tax records easily.
How To Streamline the Payroll Process:
It’s completely understandable to feel overwhelmed by the number of responsibilities associated with payroll compliance. Fortunately, remembering and performing these tasks is much easier with the help of just a few resources. This way, maintaining payroll compliance will require just a small amount of your time. You can continue spending your days running your business.
Here are a few ways to streamline your payroll processes:
1. Make Checklists For Payroll Compliance Tasks
Step one for maintaining payroll compliance is making a series of checklists. The first should outline every payroll-related task you must perform whenever you hire a new employee. These tasks include determining if the employee is eligible for overtime, asking the employee to complete I-9 and W-4 forms, adding the employee to your payroll processing system, and reporting the new hire to the state.
Your second checklist could outline every task you must complete towards the end of the quarter, like filing and depositing certain payroll taxes. A third checklist would do the same thing for annual payroll tasks.
Payroll compliance checklists will certainly come in handy when you’re working with your accountant to complete tax forms at the end of each quarter and during tax season.
2. Invest In Payroll Software
Payroll software allows you to automate your payroll processes, calculate deductions, and store all payroll-related information in one place. You can even use payroll software to file and pay taxes throughout the year.
Some of the more popular payroll software solutions are Gusto and Patriot. In addition to the features described above, both services offer direct deposit and benefits management (health insurance, paid time off, etc.). It’s also much easier to remember to give new employees their I-9s and W-4s when you can distribute and sign them electronically.
3. Work with a Payroll Professional
Despite the myriad of features offered by payroll software, payroll compliance is still too important to leave in the hands of an online service. Only after working with a professional can you be 100% sure that your calculations and documents are correct. Odds are, there’s going to be at least a few aspects of payroll compliance that you find particularly confusing or tedious.
That’s where your accountant, tax advisor, or payroll specialist comes into play. Any one of these individuals can help you keep track of deadlines, stay informed about new policies, and show you how to use your payroll software’s key features. If anything, you should definitely consult a professional as you begin building your team as well as when you wish to start offering benefits.
What Can Businesses Do If They Can’t Make Payroll?
For many small businesses, payroll is their largest monthly expense. The size of this expense makes it increasingly difficult to cover during cash flow crunches. Thankfully, there are several solutions for covering payroll when your usual revenue stream grows unexpectedly thin.
But before we outline the most sensible options, let’s first establish what not to do in this highly common situation.
Should You Use a Business Credit Card to Cover Payroll?
Business credit cards are designed to cover smaller recurring expenses, like utilities or supplies. Thus, using credit cards to cover more considerable costs like payroll presents a slew of negative consequences. Your high balance will result in high interest and high monthly payments. The card will essentially become more of a burden than a tool. This defeats the entire purpose of business credit cards, which is having extra funds available when you need it.
You might assume that business credit cards are your only option since you can’t qualify for a traditional business loan. That’s what makes credit cards so dangerous. It’s usually not difficult to get approved, even with poor or little credit history.
But as we mentioned earlier, issues with covering payroll are prevalent. Hence, the business financing industry created a solution in the form of a business line of credit.
How Can a Business Line of Credit Help You Make Payroll?
A business line of credit is similar to a business credit card in that it is designed to cover occasional “hiccups” in cash flow. However, several attributes of a business line of credit make it much more appropriate for covering larger recurring expenses.
First, business lines of credit typically have higher spending limits and lower APRs than business credit cards. Your interest rate won’t skyrocket when you borrow tens of thousands of dollars to cover payroll. And unless you’re looking for a credit line over $250,00, you probably won’t need collateral.
Also, most business lines of credit are revolving. This means that once you pay back what you owe that month, that money becomes available again. So, if you needed to cover payroll again in the future, you wouldn’t have to take the time to apply for more funding.
Other Options: Short-Term Financing
Another popular solution for covering payroll is short-term financing. But unlike a business line of credit, short-term financing is usually only recommended for isolated incidents. In other words, short-term financing works best when cash flow crunches are relatively rare.
Compared to a business line of credit, short-term financing has higher interest rates and higher monthly payments.
But if that is the case, why would someone choose short-term financing? Well, for one thing, short-term financing carries some of the loosest requirements of any financing option on the market. Payment frequencies may also have room for flexibility. For example, instead of monthly payments, you could elect for payments to be collected daily, weekly, bi-weekly, etc.
Additionally, it’s important to note that borrowing power for lines of credit depends on your business’s financial health. For this reason, it is recommended to apply for a line of credit well before you actually need the money. If your cash flow isn’t in the best shape, your approved credit line might not be large enough to meet your obligations.
On the other hand, short-term financing is geared towards businesses in cash flow crunches. Due to the higher interest, financial institutions will be less hesitant to approve your requested amount.
Other Options: Accounts Receivables Factoring
If your business model revolves around invoices, your cash flow crunch may be attributed to late-paying clients or longer payment terms. Businesses facing this dilemma should definitely consider accounts receivable factoring or invoice financing. The borrower sells the unpaid invoice to a financial institution for a discount price, which the institution pays right away. Yes, you lose a small percentage of income. But you’d have money to pay employees in just a few days, and you wouldn’t owe any money to the institution.
You’d also be off the hook from collecting from the client. This responsibility goes to the institution. Once they collect from your client, the institution pays you the remainder of the invoice’s total cost, minus a second discount. Unlike short-term financing, accounts receivable factoring is highly recommended and not technically classified as a “loan.” It will not show up as “debt” on your balance sheet. This allows borrowers to use accounts receivable factoring many times, possibly even once a month, without ruining their business credit.
How Will You Prevent This From Happening Again?
Regardless of which financing option you choose, institutions will want to hear that you know how you got into this situation and are taking measures to prevent it from happening again. This may include keeping a closer eye on profits, cutting certain expenses, or creating additional revenue streams. Many smaller businesses have decreased the likelihood of payroll issues by hiring full-time employees when necessary.
While making payroll can definitely cause a lot of stress, this reflects how beneficial it is to have this element under control. Once you’re out of the woods in regards to payroll, every other obstacle that comes your way will seem much less threatening.
If only it weren’t so difficult to get to this position.