Managing payroll is one of the most important functions for a growing business. But it’s also surprisingly complex, and it’s easy to make mistakes that may have costly and painful consequences.
Common payroll errors include misclassifying workers, incorrectly calculating wages, taxes or deductions, and mishandling compensation for training or work-related injuries. This article will cover some of the mistakes small businesses often make—and how to avoid them.
What Happens if You Make a Payroll Mistake?
Payroll mistakes can result in substantial financial penalties, as well as lawsuits and audits. You may face investigation by the IRS or U.S. Department of Labor, as well as state and local agencies. And if your mistakes involve incorrectly calculating wages or otherwise negatively impacting employees, they can damage workforce morale that leads to further problems such as lower productivity.
These could be innocent oversights. Small businesses face many payroll-related challenges. But that doesn’t change the fact that payroll errors are disruptive to business and cause lasting harm, so organizations need to do everything they can to avoid them. And to do that, they need to be aware of the most common mistakes they’re likely to make.
Top Payroll Issues and Mistakes
Here are 13 of the most common small business payroll errors and how your business can avoid them.
Not classifying workers properly. There are two main classifications to consider with your staff: whether workers are independent contractors or employees, and whether employees are exempt or nonexempt under the Fair Labor Standards Act (FLSA).
It can sometimes be difficult to determine whether worker should be classified as an employee or a contractor. The Department of Labor (DOL) offers a six-step guide to help you determine the correct designation, but among the deciding factors are the length of time someone works for the company, whether they use their own equipment and who determines their schedule. Alternatively, you can file Form SS-8 to ask the IRS to determine it for you. It’s important to get the classification right: employees may be entitled to minimum wage and overtime, while contractors are not. If someone is an employee, you need to pay the employer’s share of payroll taxes and withhold income tax from their paychecks. Misclassification could result in penalties in addition to the need to repay any taxes with interest.
Workers who are exempt from the FLSA are not entitled to some of the Act’s protections. For example, they are not legally required to receive overtime pay. Exempt employees typically include executives and some other salaried employees, but you should review the DOL’s guidelines closely before making a determination.
Miscalculating overtime wages. In general, the FLSA requires businesses to compensate nonexempt employees at 1.5 times (time and a half) their standard pay rate if they work more than 40 hours in a week. But some states impose additional requirements that may supersede federal law. In Alaska, California and Nevada, for example, employers must pay overtime if employees work more than eight hours in a day. Understanding your local laws is crucial to avoid penalties, interest, backpay and potential lawsuits.
Paying incorrect tax rates. Tax errors are one of the most common payroll mistakes. That’s because payroll taxes are complicated and they change frequently. Your business may be subject to local, state, and federal taxes, and you need to keep track of changes at each level. Furthermore, the tax liabilities may differ for employees who live in different jurisdictions.
Running payroll late. Employees rely on getting their paychecks on time so they can pay their own bills. Paying late may erode employees’ trust and result in problems with state authorities. So it’s important to monitor cash flow so that you have enough funds to pay employees promptly on payday. Automating payroll with software or an outsourced service may help. If issues do arise, let employees know as soon possible so they can plan accordingly.
Paying incorrect amounts. Underpaying employees may be more common than you think: in 2019, the DOL collected $322 million in wages owed to workers. If you find that you’ve underpaid a worker, it’s best to rectify errors immediately to maintain a positive relationship and avoid potential claims and reputational damage. It’s important to maintain clear documentation of the issue and its resolution.
Overpaying an employee can be a more complicated problem to address. Again, clear and comprehensive records are key. No one wants to hear that they need to repay their employer but showing employees clear proof of the error can help. If the overpayment is substantial, it’s advisable to work out an agreement with the employee for reclaiming the money via a lump sum or small installments.
Poor holiday planning. It’s crucial to plan for holidays—and to do so well in advance. You’ll need to notify employees of any closures beforehand. Under federal law, you’re not required to provide paid holidays or pay employees overtime if they work those federal days, although many companies choose to do so. But in any case, it’s a good idea to post holiday schedules well in advance and be clear about any associated changes to payroll.
Note that if a regularly scheduled payday is a bank holiday, employees paid through direct deposit won’t receive payment until the next day. To ensure employees are paid on time and have the money they need when they need it, you’ll need to schedule payment one business day earlier.
Not paying within the minimum pay period. Most states have laws that determine the minimum frequency for paying employees, such as weekly, semi-monthly or monthly; in some states, such as California, the minimum frequency depends on the occupation. Failing to adhere to your state’s requirements can lead to fines and possibly employee lawsuits. The DOL provides a chart that clearly lays out the requirements in each state.
Mistaking gross vs. net payroll. It’s important to distinguish between gross and net payroll—and to calculate your business costs accordingly. Gross payroll refers to the wages earned by all employees before taxes and deductions. To determine the total payroll costs for your business, you’ll also need to factor in the employer’s contribution to payroll taxes and any benefits. Net payroll is the amount received by employees, after deductions for federal, state, and local taxes, as well as any other required or optional withholdings.
Failing to pay nonexempt employees for things like training. In general, you have to pay nonexempt employees for the hours they spend attending work-related training or other activities such as attending lectures and meetings. This includes time spent on online training related to the job, even if it’s conducted outside normal work hours. Under the FLSA, in order for an activity not to be considered part of hours worked, it must be voluntary, not job-related, not performed concurrently with other work and take place outside of normal hours.
Not maintaining payroll records. Failing to maintain accurate employee and payroll records can lead to audits and substantial fines—note that the IRS fined companies a total of $13.7 billion in 2019 for not adhering to payroll tax laws. The IRS requires that you keep records for all employees, including information such as the amounts and dates of all wages and copies of W-4 tax withholding forms. In addition, the FLSA requires that you maintain even more detailed information for all nonexempt employees, including hours worked. To comply with the FLSA, you need to keep those records for at least three years.
Not paying for time spent recovering from injuries. Most employers are required by state law to carry workers’ compensation insurance, which pays part of an employee’s regular wages if they’re absent from work while they’re recovering from a work-related injury or illness. In addition, under the FLSA an employer is responsible for compensating employees for the time they spend waiting for and receiving medical attention at their work premises or at the direction of the employer.
Failing to stay up to date on payroll laws. Many laws—at the federal, state and local level—set rules for how you employ people and pay them. In addition to the FLSA, key federal laws include:
- The Family and Medical Leave Act (FMLA), which entitles eligible employees to up to 12 weeks of unpaid leave for family and medical needs.
- Equal employment opportunity laws such as the Civil Rights Act, which bars many forms of discrimination, and the Equal Pay Act, which requires that women are paid equal wages as men for equal work.
- The Occupational Safety and Health Act (OSHA), which is designed to ensure workplace safety.
When you’re running a small company, it can be hard to stay up to date with all relevant laws, especially if you don’t have dedicated HR and legal expertise. It may be helpful to join professional associations that track laws related to your industry.
Forgetting to post labor law signage. By law, you have to post notices that inform employees of their rights. For example, the DOL requires the employer to post the provisions of the FMLA and FLSA and the steps an employee must follow to file a complaint. To assist with this, the DOL advises which posters you’ll need and lets you order them for free.
Avoid Payroll Errors and Issues with Payroll Software
Payroll software can greatly reduce the chance of payroll mistakes by automating complex calculations, tax filings and employee payments. It should automatically apply the latest federal, state and local taxes, relieving you of the headaches and risks of trying to track changes in tax and labor regulations. It can automate the process of maintaining payroll records as required by law.
Selecting payroll software that’s part of an integrated suite of business applications can simplify accounting by automatically updating the general ledger and handling reconciliations. This connectivity also enables faster reporting and analytics that’s based on real-time data. It also allows companies to avoid integrations, which are costly and pose additional risks, and gives them a single support resource if they run into any issues.
The complex task of managing payroll has numerous potential pitfalls. For many small businesses, it’s hard to keep tabs on the changing requirements and make sure you handle every aspect of payroll correctly, every time. Payroll software can relieve much of the burden by automatically staying abreast of changing regulations and ensuring that you pay employees accurately and on time.