Employees running a cash roll machine and following payroll compliance

The Employers Payroll Compliance Handbook

Paying employees in a small business isn’t as easy as cutting a check. Payroll compliance is the meticulous art of following state and federal wage regulations. These laws are in place to protect workers and employers. This is your handbook for payroll policies and procedures if you are paying an employee for the first time. 

In this article:

  • What is payroll compliance?
  • Why HR is so important?
  • Top 5 Benefits of PEO’s
  • How to pay an employee in a small business
  • Classification of employees: full time vs contract workers
  • Payroll tax compliance
  • How to calculate and pay Federal payroll taxes
  • Employee Benefits: state-mandated and fringe benefits

What Is Payroll Compliance?

Payroll compliance is an umbrella term for paying employees according to state and federal labor laws. These requirements guarantee certain rights to employees, so they are treated fairly. All employers in the U.S. are required by law to comply with these items: 

  • Fair compensation for services, meeting minimum wage standards.  
  • Time to vote, serve on a jury, or perform military service.
  • Comply with all workers’ compensation requirements.
  • Withhold FICA taxes from employee wages, and pay FICA taxes for retirement and disability benefits.
  • Pay state and Federal unemployment taxes, providing aid to unemployed workers.
  • Contribute to respective state-run disability programs where applicable.
  • Comply with the Federal Family and Medical Leave (FMLA).

What Is FLSA And How Does It Affect My Business?

During the industrial age in America, workers had very little rights. They performed hard labor, for long hours, in horrible conditions. The conditions caused severe illness, injuries, disabilities, and sadly death. Employers weren’t held accountable for the poor treatment of workers.

In 1938, the Fair Labor Standards Act (FLSA) turned America’s dismal work scene around. Since its inception, FLSA has been ratified to its current regulation, affecting all businesses with hourly workers: 

  • The federal minimum wage is $7.25/hr (subject to change).
  • 40-hour workweek: if an hourly worker goes over they must be paid overtime.
  • Equal Pay Act (EPA): stating that men and women in the workplace receive equal pay for equal work, based on job content, NOT title. The jobs don’t have to be 100% alike but similar. 
  • Child Labor: Ensures that children are working in safe conditions, and does not interfere with their health and education.

Why HR Is So Important?

Human Resources (HR) is the people department. Large companies have bonafide HR functionality to streamline all employee matters. As a small business, you should mirror this with good employee housekeeping. Most non-compliance issues arise because companies have incomplete records or employee files that are hard to understand. 

Having a dedicated person to manage HR, whether it is you or another employee is advised. Since most actionable items are dealing with government and tax agencies. It is standard for a company starting out to pass this role to an accountant. HR and payroll reporting compliance for each employee should look like this: 

Employee Records for HR and payroll compliance

What Can Happen If I Am Non-Compliant?

Lawsuits happen when a company is non-compliant. Non-payment and ignorance of labor laws can bring legal action at the federal and state level. Depending on your business entity, liability could fall on you personally. Dedicating time for internal compliance audits, and employee welfare checks. Follow the tips sprinkled throughout the article to avoid penalties.

Top 5 Benefits Of A PEO

Small businesses could benefit from a Professional Employer Organization (PEO) aka third-party benefits administrator. They are a co-employment organization that acts as an employer to your workers, but they only support HR and Payroll processes. By grouping together with a network of thousands of companies, you gain access to valuable benefits for your employee. PEO’s help mitigate liability risks while offering coverage in: medical, dental, vision, retirement, life insurance, disability insurance. We recommend Justworks and TriNet.

Here are the top 5 benefits of a PEO:

  1. Certified PEO’s can run payroll processes for you. They will pay your employees and act as a third party tax administrator, for payroll tax compliance.
  2. Reduced premiums and great coverage because you are pooling your resources with a large group.
  3. Bonafide HR department to handle onboarding, compliance, and benefits disbursements.
  4. Liability coverage in the event of employment disputes.
  5. Risk management via internal audits and employee investigations. 

How To Pay Employees In A Small Business?

All small business owners can agree, there are only so many hours in a day. At some point, it may be necessary to take on hired help to achieve your goals. Err on the good side of the law, with these payroll policies and procedures. Here are the ducks you need to get in a row, to pay employees in a small business.

Classifying Employees On Payroll

Classifying your workers is one of the very first steps when adding a worker to payroll. As an employer, you can incur fines if you misclassify employees. States are constantly updating the rules determining a worker’s classification. So you must designate an employee, freelancer, or intern accordingly

Full Time Vs Contract Workers

A salaried, full time worker is valuable for their loyalty. Recruiting and training new people is a disruption to the day-to-day dealings. Benefits also show employees that they are a valuable part of the company, leading to better productivity. Overall going with salaried employees, and staying compliant will increase the chances of long-term business prosperity. Bonus, some sizable tax credits, and deductions are available to employers offering benefits plans.

Employers can indeed save on overhead costs by hiring 1099 contract workers. There are no income tax withholdings, employment taxes, liability, and benefits plans. A small company benefits from the flat contract fees. That being said, the IRS has a strict description of what constitutes an employee and an independent contractor.

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If you have the right to control or direct not only what is to be done but also how it is to be done, then your workers are most likely employees…If you can direct or control only the result of the work done—and not the means and methods of accomplishing the result—your workers are probably independent contractors. —IRS

Trouble could arise if you misclassify an independent contractor and they suffer a work-related injury. Without workers’ compensation insurance, you would be liable if this contract should have been described as an employee. Pay close attention to regulations in your state. Some states treat contractors as employees if they get injured on the job.

Switching Employee Classification

Employee classification is not set in stone. Should certain job parameters change, you can switch an employee to an independent contractor, and vice versa. Immediately submit the proper tax forms to the IRS, and state governing agencies. Then, be sure to note changes to pay structure and benefits in your internal employee records. 

What To Do In The Event Of Employee Misclassification?

Sometimes it is not immediately apparent how to classify your employee. So, perform internal audits of employee records as due diligence. Should you find a misclassified worker, immediately change their classification in your records, and submit the proper tax forms. If you are having difficulty with the classification process you can submit Form SS-8 to the IRS for clarification. They will probe for information from both you and your employee to decide worker status.

What Is The Difference Between Exempt And Non-exempt Employees?

Federal laws dictate workweek hours and require overtime compensation for hourly workers. However, some salaried employees are exempt from overtime pay. As an employer, you could face wage disputes if you don’t comply with FLSA overtime rules. Here is how you determine overtime eligibility based on pay structure:

  • Exempt Employee: also coined “white-collar exemptions,” these are salaried employees in executive roles, that don’t receive overtime compensation. Each state has a minimum salary threshold that qualifies overtime exemptions. Usually, exempt employees are paid more and supplemented with competitive benefits. A plus for owners because these workers sign on for a 40+ hour workweek. 
  • Non-Exempt Employee: these employees are typically part-time or in entry-level positions. They are eligible for overtime compensation if their workweek exceeds 40 hours. They are given time and half of their wage rate. 

Payroll Tax Compliance

Moving right along into payroll taxes. Payroll tax compliance means you are accurately paying your people and government tax agencies. As well as accurately reporting employee wages, withholdings, and employment taxes. In this section, are the tax forms to file for each type of worker. Plus how to calculate and submit payroll taxes to the federal government.

Tax Forms To File For Full Time Vs Contract Workers

During onboarding, you need to gather tax information from your new hire. To pay your worker and formally classify them you submit their information federal and state tax agencies. Not to mention add them in employee records for HR compliance. Here are the forms to use for full time vs contract worker classifications: 

W-9 

This form classify’s a U.S. resident as an independent contractor. You send this form to contractors to gather personal information. At the start of the contract, they fill this out and return it to you. When you dispense 1099 forms at the end of the year you use this information.

W-8BEN 

This form is similar to a W-9 but is used for an international contractor’s tax information.

1099 

If you pay an independent contractor to perform work for your company, you will need to complete Form 1099-NEC. Put simply it states how much money was paid to your contractor. This is a form you submit to your contractors and the government. No deductions need to be included, independent contractors pay self-employment taxes. Important notes about this form:

  • 1099’s are only required if you pay the contractor $600 or more in a year.
  • These are for cash paid to the contractor, you submit this form when you pay not when payment is accrued. For example: you have a contract that will last two years, but you pay the contractor one lump sum in the first year. You send out a 1099 for that year only. 
  • This form is due to the IRS and contractors on February 1st of each year.
  • With multiple 1099’s, you can file Form 1096 with the IRS. It is an annual independent contractor summary

W-4

This is an information collection form, for employee withholdings. It determines how much will be withheld from an employee’s check based on marital status, the number of allowances, and additional deduction amounts. It needs to be completed before the first payroll disbursement. Things to know about this form:

  • If employees fail to provide a correct W-4, employers need to withhold federal income taxes, from their wages, as if they are Single with no other adjustments. 
  • Employees may update this form at any time during their employment. The change will go into effect on the 30th day after the revision has been submitted.  
  • Most states also require their version of a W-4 for state taxes.

W-2

Is a multipart form to track employee wages, garnishments, social security, and Medicare tax withholdings. This is issued to employees and the IRS by January 31st of each year. 

What Are Payroll Taxes?

Governing agencies collect tax on total compensation for W-2 employees. Total compensation includes wages, overtime pay, benefits, bonuses, and any other perks. There are 3 types of payroll taxes: taxes paid by an employer; an employee; and both. As an employer, you are responsible for withholding, filing, and paying taxes on behalf of your business and your employees.

For Employers: Employers are solely responsible for unemployment at the Federal and state level.

  • Federal Unemployment Tax (FUTA): collected from employers annually to aid state unemployment programs. You pay 6% on the first $7000 you pay to an employee
  • State Unemployment Tax (SUTA): paid by the employer on behalf of each employee. This program provides compensation to an employee in the event they are laid off.

For Employees: You must withhold income tax from each salaried or hourly worker. The amount withheld is based on wages and their W-4. You will file and pay these taxes to Federal and state agencies.

For Both:
Both you and your employees are responsible for paying Federal Insurance Contributions Act (FICA) taxes. These taxes are split 50/50 by employers and employees to fund Social Security and Medicare. An employer collects an employee’s contribution of  6.2% for Social Security and 1.45% for Medicare, totaling 7.65%. Employers match this rate for a total of 15.3%.

Additional withholding taxes (if imposed) are due because of special circumstances. One common Federal event is the Additional Medicare Tax withholding. If an employee makes over $200,000 in a calendar year, they owe the federal government an extra .9% on top of the 1.45% standard withholding. This is taken in the pay period they make wages over the threshold. Employers are NOT required to match this contribution. You should always consult your tax advisor about additional withholdings.

How To Calculate Income Tax Withholdings

Employers must calculate and file payroll taxes and withholdings. Federal income tax withholdings are based on W-4 tax deductions. As stated before all hourly employees should have a W-4 on file. Encourage your employees to update their W-4’s annually.

How To Calculate FICA Taxes

To calculate an employee’s FICA tax contribution, you take their gross wages by their portion of Social Security and Medicare. Since employers are responsible for the other half of FICA, the portion owed by your employees is doubled. See the example below:

FICA Tax Calculation Example

An employee earns $1000 in wages for the pay period. They need to pay 6.2% to Social Security and 1.45% to Medicare.

Social Security Contribution
$1000 x .062 = $62

Medicare Contribution
$1000 x .0145 = $14.5

Total Employee FICA Taxes $62 + 14.5 = $76.50

Total FICA Taxes Owed $76.50 x 2 = $153

How To Calculate Unemployment (FUTA)

An employer pays a 6% unemployment tax rate on the first $7000 in wages for each employee. The Federal government extends a FUTA tax credit of up to 5.4% to employers. You can redeem this credit by paying SUTA on time, and in full. When you get the tax credit you actually pay .6% for FUTA.

Note: A Title XII advance, is when a state borrows money from the Federal government to pay for their unemployment program. When Federal loans aren’t paid back promptly, with interest, employers cannot redeem the standard FUTA credit. This is a credit reduction state because the tax credit is reduced by .3% for every year the loans aren’t repaid. Employers should check announcements about credit reduction states every November.

FUTA Tax Calculation Examples

An employer is paying annual unemployment, for 2 employees, with the max FUTA Tax Credit of 5.4%.

Total FUTA Taxes Owed = ($7,000 x 2) x .006 = $84

An employer is paying annual unemployment, for 2 employees, in a credit reduction state, with a .3% credit reduction.

FUTA Tax Credit = 5.4% – .3% = 5.1% 

($7000 x 2) x .009 = $126

How To Pay Federal Payroll Taxes

Employers pay all Federal payroll taxes using the Electronic Federal Tax Payment System (EFTPS). This is a free electronic payment system that you need to enroll in. Note: deposit payroll taxes timely, otherwise you face exorbitant penalties. The Federal late penalty is 2-15% of the total deposit. The fine will depend on how late the payment is made. All payments made using EFTPS, need to be received by 8 pm EST the day before your due date. If the website is down, you need to make the payment via the phone system. Late payments will NOT be excused.

Pay Schedule For Income Tax Withholdings

The pay schedule for income tax withholdings is semi-weekly or monthly depending on the total taxes of the previous 4 quarters: 

  • Monthly Schedule: for new businesses in their first calendar year OR a business whose total taxes are less than $50,000.
  • Semi-Weekly: For any business that owed more than $50,000 in total taxes. 

The $100,000 Next Day Deposit Rule is a fun twist. Any company that accumulates $100K in tax liability, immediately ends the payment schedule. They pay withholding taxes to the IRS the next day. This starts the pay schedule over, on the following day. Plus if said business was previously on a monthly schedule, they will resume payments on a semi-weekly schedule.

How To Pay FUTA Taxes

Employers carry over FUTA tax liability from quarter to quarter until taxes owed reach more than $500. Businesses with a larger FUTA tax liability, need to make quarterly payments when taxes exceed $500. In this case, you make your deposit by the last day of the month, following the end of the quarter. 

Payroll Reporting Compliance

Federal income withholdings and FICA taxes are reported on Form 941 quarterly. New businesses file this form in the first quarter wages, subject to withholdings, are paid. Here are the quarterly due dates of Form 941:

  • April 30th
  • July 31st
  • October 31st
  • January 31st

Some small businesses are permitted to make annual filings with Form 944. This is true for companies with annual FICA and income tax liability less than $1000. This form is due by February 1st every year. 

Unemployment (FUTA) taxes are reported on Form 940 annually.  Here are the due dates for Form 940:

  • File by January 31st
  • If you deposited all FUTA taxes when due, you have until February 10th to file

How To Pay State Payroll Taxes?

You need to be informed about state income and unemployment taxes. Each state differs in tax rates, what taxes are owed and the method of payment. These 9 states have no income tax:

  1. Alaska
  2. Florida
  3. Nevada
  4. New Hampshire
  5. South Dakota
  6. Tennessee
  7. Texas
  8. Washington
  9. Wyoming

These 3 states require employee contributions to unemployment (SUTA):

  1. Alaska
  2. New Jersey
  3. Pennsylvania
How to pay state payroll tax maze

Payroll Compliance for Foreign Owners

The same payroll regulations that apply to U.S. companies, apply to foreign owners. Foreign owners are subject to Federal and State tax laws if they have Permanent Establishment (PE). If a foreign owner is conducting business and has contractors working within the U.S then Permanent Establishment (PE) is recognized. Foreign owners must register in the state they are paying employees in, with a valid U.S. working permit and an Employer Identification Number (EIN)

Tax treaties from the employer and employee’s home country could reduce or exempt income tax withholdings. Publication 901 helps you determine if there is a tax treaty between the United States and the home country. Additionally, nonresident aliens, with a certain status, are not subject to FICA and FUTA taxes. Consult your home country’s tax professional for additional information.

Payroll Tax Compliance For Remote Workers?

All the same payroll policies and procedures apply to remote workers, except if they are salaried. You must comply with all labor and tax laws in the locality that the remote worker lives and/or works in. Withholdings are generally based on the address on their W-4. However, you will want to confirm that the employee works in their resident state

Typically when your remote employee works in one state but lives in another, you comply with the tax laws of the nonresident state. Some states have reciprocal tax withholding agreements with surrounding states. So if they are working in a reciprocal state, payroll withholdings are based on tax rates in their resident state.

Employee Benefits

Payroll compliance encompasses employee benefits programs. As an employer, each employee is compensated for their role in the business. Compensation also includes certain mandated benefits, plus perks that you throw in. This section goes through state-mandated and optional fringe benefits.

Workers Compensation

In most states workers’ compensation is a state-mandated benefit. As an employer, you need to have this in the event of an accidental injury on the job. An employee can then file a workers’ compensation claim to cover ⅔ of working wages. Not only does it help the injured worker, but it also prevents you the employer from any lawsuits. Here are the pros of having workers comp insurance:

  • Medical care for injury
  • Retraining a replacement
  • Compensation for any permanent injuries
  • Benefits to survivors in the event of death
  • Wage replacements for money lost while injured
  • Vocational rehabilitation if necessary

Workers Compensation Vs Disability

The difference between workers comp and disability is where the injury event takes place. Workers comp covers all work-related injuries. Disability is coverage if an employee gets hurt outside of the job and is unable to work. The major benefit of both is that the employee suffers minimal wage loss.

Disability Insurance

Certain states require compliance with the Americans with Disabilities Act (ACA) program. This act prevents an employer from discriminating or retaliating against disabled persons. The employer pays and sometimes administers, disability benefits to employees. There are two types of disability insurance:

  1. Short-term: is insurance for a year or less. The employee must go through a waiting period before benefits kick in. This can be 1-2 weeks depending on the plan.
  2. Long-term: insurance for more than one year, capping at the age of retirement. It serves as a 40-60% wage replacement for someone who has been disabled. 

Most state-run disability programs are short-term, and employers withhold a percentage of pay for benefits. The more money a person makes the higher the benefit. The 6 states that mandate disability insurance are California, New Jersey, New York, Rhode Island, Hawaii, and Puerto Rico.

Federal Family And Medical Leave (FMLA)

FMLA is an employee benefits program offering 12 unpaid weeks off for family leave. It can be used to attend the birth or adoption of a baby, or attend to immediate family members with serious health conditions. After 12 weeks, employers must reinstate the employee in the same job or an equivalent one. In most states, FMLA only applies to employers with 50+ employees. However in some states it applies to employers with 5+ employees. Be sure to check your state’s FMLA requirements.

Fringe Benefit Plans

Competitive benefits packages are the driving force for loyalty and retainment. Individual insurance premiums are often unaffordable with sub-par coverage. A healthcare option could make or break a person’s decision to take a job. A company will have the leading edge by incentivizing their labor force.

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Give employees the benefits they value, and they’ll be more satisfied, miss fewer workdays, be less likely to quit, and have a higher commitment to meeting the company’s goals. —Joe Lineberry of Aon Consulting

Medical Insurance

Health coverage is highly sought after and gives employers leverage when recruiting. Contributions make all the difference to an employee, especially if they have a family. However, employee health plans are nuanced for small businesses and premiums/deductibles largely depend on employee health. Although as a small company, premiums will be lower than larger companies. Giving you a much needed break to compete in the big leagues for talent. 

All healthcare plans have to offer the essential health benefit standards. As an employer, you can expect to pay around $3100 a year per employee for health benefits. Plus there are tax credits and deductions offered to businesses helping bring down the overall cost. 

Retirement Plan

A 401(k) is an investment plan that allows employees to contribute a percentage of their salary to a retirement account. For a business, the funds from employees will be reinvested into a portfolio made of mutual funds, stocks, bonds, money market funds, and other investment options. You can offer a percentage to match their contributions. Really all your worker desires is a beach and a margarita. That pipe dream is within reach if you contribute to retirement funds. In return, they will stay with your company longer.  

A man unlocking himself from a job to retire on a beach.

Final Thoughts

Since payroll is a company’s number one expense, it needs attention. We caution CEOs and small business owners against doing payroll. More often than not, details are missed resulting in a completely avoidable fine. Outsource your payroll or hire an expert accountant, so you can focus on the success of the business. You are sure to grow with happy, healthy workers.

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