Small business owners striving for cost-efficiencies may choose to do payroll themselves. However, this seemingly straightforward task of processing payroll holds many potential pitfalls. Payroll is time-consuming and highly detailed. As company leaders cope with shifting tax laws, staff turnover and changing market demands, in addition to the many other responsibilities of running a business, it is easy to make payroll mistakes that can damage a small firm.
Complex tax laws
Running a company means complying with various tax laws. The five general types of business levies are:
- Income tax: All businesses except partnerships must file annual income tax returns. Partnerships file an information return. The form you use depends on the organizational structure of your business. The IRS requires companies to pay federal tax as they earn or receive income during the year.
- Estimated tax: Those in business for themselves generally need to make estimated tax payments to cover income tax and other levies such as self-employment tax and alternative minimum tax. The IRS may impose penalties for not paying enough tax through withholding and estimated tax payments, or for late estimated tax payments.
- Self-employment tax: Self-employment tax is a Social Security and Medicare tax primarily for individuals who work for themselves.
- Employment tax: Businesses with employees have certain employment taxes and forms to file, including Social Security and Medicare taxes, federal income tax withholding, and federal unemployment tax.
- Excise tax: Excises apply to certain types of businesses that make or sell particular products, use certain types of equipment or facilities, or receive payment for specific services.
Businesses must submit taxes to federal, state, and local authorities, at specified times and in designated forms. Such demands greatly amplify fiscal compliance and payroll administration obligations.
Common payroll mistakes
Given the tax challenges described, those who handle payroll on their own face myriad risks. Here are 10 potential payroll mistakes that are important to navigate:
- Filing late: The IRS stipulates a due date for depositing taxes. Failing to file on time could bring a 15 percent failure-to-deposit penalty. A late payroll tax return also incurs fines. For each partial or total month that a return is not filed, you can receive a 5 percent penalty, based on your unpaid tax bill.
- Errors on tax forms: Slip-ups on tax forms may cause you to remit too much or too little in payroll taxes. Mistakes will also impact reconcilement of W-2s with year-end tax returns. Before you submit your return, double-check your figures, re-verify totals, ensure amounts are entered on the correct lines, make certain each line item coincides with your financial statements and payroll reports, and be sure to sign your return.
- Submitting incorrect amounts: The IRS can penalize you for submitting the wrong amount of payroll tax. However, the agency forgives firms for first-time mistakes, or for errors arising from a reasonable cause rather than willful neglect. Penalties — ranging from 2 percent to 10 percent of total payroll — start accruing on the due date of your payroll taxes.
- Misclassifying employees: Your workers can be categorized as employees or contract workers. Misclassifying employees as independent contractors will incur retroactive payroll taxes. Remember, employees must fill out a Form W-2 so that you can deduct money for taxes; contractors paid $600 or more in a year must complete and submit a Form 1099, making them responsible for federal and state taxes. The determination of a worker's status as an employee or an independent contractor relies on common-law rules, which weigh the relationship between the worker and the business, taking into account control and independence.
- Getting employee details wrong: When processing payroll, inaccurate or outdated employee information may cause trouble with the IRS. Ensure you have the right data on your workforce such as:
- Full names;
- Employment start/termination dates;
- Tax file numbers;
- Dates of birth;
- Current addresses; and
- Payroll details, including hourly rates, gross wages, and employment periods.
- Processing payroll late or not at all: It happens, and it has consequences. Employees will be unhappy, and you may affect the bottom line if you inadvertently overpay or underpay workers. Employee departures pose particular risks, as some states set time limits on employers to provide final paychecks or incur penalties.
- Paying the wrong amount: If faulty information is initially entered in the payroll database, problems are bound to occur. Establish safeguards on your payroll system and double-check all employee information, tax withholding amounts, and payment information.
- Overlooking bank holidays: Bank holidays aren't counted as business days for payroll processing. Know the holidays for which your bank closes and adjust your payroll-processing timelines accordingly.
- Depositing and reporting employment taxes incorrectly: After collecting payroll taxes from your employees and contributing your share, you must submit those taxes to federal, state, and local tax authorities. The IRS allows you to choose between two schedules.
- Not maintaining adequate payroll records: State and federal regulations call for businesses to maintain specific employee records for former hires. Some local and state jurisdictions may have recordkeeping requirements that vary from federal regulations, so it's imperative that you're familiar with such requirements in the location(s) in which you do business.
IRS penalties for submitting the wrong payroll tax amount can range from 2-10% of total payroll, and start accruing on the due date of your payroll taxes.
Hidden costs of doing payroll yourself
As a business owner, your time is especially valuable. A recent survey by the National Small Business Association examined the time spent doing in-house payroll each month. Results showed that small business owners spent:
- 1 - 2 hours: 27 percent
- 3 - 5 hours: 20 percent
- 6 - 10 hours: 14 percent
- 11+ hours: 9 percent
- No time at all: 31 percent
One-third of small U.S. firms spend $1,000 to $5,000 annually to do their own payroll. More than another third of companies spend more than $5,000 a year, with some companies reaching expenses as high as $40,000 or more.
There are still other pitfalls to avoid:
- Complex administration: You must ensure that all employees complete a Form W-4 and any appropriate state forms, establish a payroll schedule, calculate and withhold taxes, remit payments to appropriate tax agencies, prepare and file tax forms, send Form W-2 to all employees, process checks, maintain payroll records, and know all taxes and laws that apply to your company. If you have contractors, you will also need to prepare and issue Form 1099s.
- Potential fines for tax errors: As many as a third of all employers make payroll errors, and roughly 40 percent of small businesses incur an average of $845 each year in IRS penalties. More than half of all employment civil tax penalties at year-end occur because of failure to pay.
- Salaries for payroll staff: Those responsible for payroll and time-keeping in small companies can cost their firms about $43,000 a year, exclusive of additional benefits or compensation.
About 40% of small businesses incur an average of $845 each year in IRS penalties.
Evaluating the long-term costs of keeping payroll in-house can shed light on the possible efficiencies of using a payroll service provider. While the IRS publication Circular E as well as state-level resources can help you avoid some errors, professional help could save your business thousands of dollars in administrative costs, recouped time, and improved accuracy.
Reputable payroll providers also offer various add-on packages, so you only need to pay for the services relevant to your organization. Learn more about making the transition from in-house to outsourced payroll functions.