Payroll in the U.S. is more than simply issuing paychecks at the end of a pay period. From a risk standpoint, U.S. payroll involves compliance with multiple federal, state, and local laws and regulations, as well as collaboration across business operations, including human resources (HR), finance, benefits, and tax. In fact, payroll can comprise one of the largest tax burdens for employers, even compared with income and sales taxes. Looking at payroll through an operational lens, it’s crucial to remember that employees who keep the business running rely on their employers to provide accurate compensation.
Errors in the payroll function can create a ripple effect across the organization and, when unresolved, can result in fines, penalties, financial losses, and disruption of major business events such as IPOs, mergers, and acquisitions. This article helps U.S. employers identify common payroll-related errors and mitigate the associated risks, including noncompliance with the IRS, Department of Labor (DOL), and state and local legal requirements.
Understanding Worker Misclassification
Classifying workers — for example, as employees versus independent contractors or exempt versus non-exempt under the federal Fair Labor Standards Act (FLSA) — has long been a crucial part of payroll and benefits and a focal point for tax and labor agency audits. For workers, the nature of their compensation and benefits depends on their classification status; for employers, an error here can trickle down to other areas within the finance and accounting function.
But making these determinations is far from simple. Compliance requires employers to adhere to numerous standards that view the employer-employee relationship differently, including the following:
- IRS: The IRS considers how classifying a worker as an employee versus an independent contractor affects payroll taxes and income tax withholding. The IRS uses various common law factors that assess the behavioral, financial, and other relationship characteristics between the worker and the employer, largely focusing on whether (and to what extent) the employer has a right to direct and control the services performed by the worker.
- DOL: The DOL takes a different perspective and focuses on wages and minimum wage, particularly under the FLSA.
- State and local agencies: Laws and regulations related to employees can vary from state to state — and among local jurisdictions such as counties, cities, or other municipalities — especially with respect to unemployment benefits and minimum wages. Some states and localities apply tests similar or identical to those used by the IRS, while others apply more rigid tests.
As for classification itself, employers face several common issues:
- Employee vs. independent contractor: Several key distinctions separate employees from independent contractors. This determination largely depends on the employer’s level of direction and control over the employee, dictating how the individual is paid (e.g., hourly, salaried, or by project), whether taxes are withheld, and whether compensation is reported on Form W-2 or Form 1099.
- Salaried vs. hourly: What’s important here is the pay type. Salaried workers are paid a fixed amount per pay period with overtime eligibility depending on exempt status. Employers pay hourly workers based on the number of hours worked, and overtime pay is usually required by law.
- Exempt vs. non-exempt: Overtime is one of the biggest issues here. Employers must pay overtime to nonexempt employees but not to exempt employees. It’s important for employers to understand that job duties are more important than job titles when determining exempt or nonexempt status. Employers sometimes are confused by pay type: Exempt employees are always salaried while nonexempt employees may be hourly or salaried.
It is important for employers to establish a consistent classification decision framework that evaluates the levels of direction and control involved in each role. Preparing documented job descriptions before hiring gives the employer time to assess the job and classify it appropriately. Specifically, employers should consider whether the work is project-based or hourly, the degree of independence related to the role, and the applicable tax and benefits implications. It’s also important to consider the specific classification factors applicable in the jurisdiction(s) where the worker will be providing services. As noted, classification factors may vary by jurisdiction and by specific government authority. Finally, periodic reviews of payroll and HR processes can help quickly identify errors and mitigate compliance risk.
Addressing Issues With Payroll Earnings and Deductions
An employee’s paycheck represents the amount the employer has agreed to pay, less any deductions — a process that may sound deceptively simple. Collaboration with other teams within the organization, such as HR, is crucial to help ensure that employees receive the correct pay and that deductions are timely and accurate.
In addition to the employee classification issues discussed in the previous section, payroll departments must comply with a myriad of complex laws and regulations governing earnings and deductions. Some deductions are mandatory under federal, state, and local tax laws, while others may be mandated by court order, such as garnishments, child support orders, and qualified domestic relations orders (QDROs). Common errors employers make related to payroll earnings and deductions include the following:
- Failing to promptly enroll new hires and update existing employee accounts
- Applying incorrect deduction amounts
- Designating pre- and after-tax deductions incorrectly
- Failing to timely update 401(k) elections
- Applying incorrect garnishments and levies
- Failing to convey deferral percentage updates to payroll providers and third-party administrators
Establish clear payroll codes and review them periodically. In addition, engage third-party providers to help manage the complex nature of payroll processes, laws, and regulations. For example, the One Big Beautiful Bill Act introduced sweeping changes to employee benefits and payroll, including no tax on tips and overtime wages. Employers should keep in mind that while a payroll provider might be effective at processing payroll, it typically is not qualified to offer tax advice.
Sorting Out Taxable vs. Nontaxable Compensation
Compensation in its simplest form means anything an employer provides to an employee in exchange for services. The difficult question is whether the value of that compensation must become part of the employee’s taxable wages, as failing to report or misreporting compensation can result in significant penalties and fines levied against the employer. Confusion is common considering that taxable compensation can take many forms, including:
- Bonuses
- Awards
- Gift cards (no matter how small the value)
- Trips (including spousal or other “plus one” or family members accompanying the employee)
- Presents
- Stock-based compensation
- Commissions
- Fringe benefits (car or housing allowances, stipends for cell phones or internet, moving expenses, etc.)
- Group term life insurance over $50,000 per year or whole life insurance premiums
- Disability insurance premiums
- Education assistance for employees or their children
- Forgivable loans, including paying for education on the condition the employee will work for the employer for a specified period after graduation
Nontaxable compensation, which must meet strict IRS rules, includes qualified benefits such as employer-paid health insurance and retirement plan contributions. However, these and other fringe benefits may become taxable if the employer fails to comply with applicable laws or regulations.
Sometimes the greatest pitfall is overlooking how the additional compensation originated. In some organizations, the payroll department does not oversee all compensation programs: HR, managers, and other groups within the organization offer awards, gift cards, and bonuses to employees without notifying payroll. When payroll is not given the chance to evaluate whether compensation is taxable or nontaxable, organizations face the risk of unpleasant surprises with equally unpleasant consequences.
Employers should establish a cross-functional intake process so that all departments — including HR, finance, equity, operations, and administration — route all compensation events through payroll before distribution to employees. It’s also important to foster collaboration across the organization but with the clear expectation that payroll reviews anything of value before it reaches an employee.
Mitigating Potential Payroll Risks and Noncompliance
Payroll systems are not “set it and forget it.” As organizations evolve, certain business events should trigger a payroll review, such as:
- Preparing for a sale, merger, acquisition, or IPO
- Considering new compensation and benefit offerings
- Transitioning to a new payroll provider
- Implementing a new payroll platform or enterprise resource planning (ERP) system
- Responding to new laws and regulations
Taking a proactive approach to payroll can help prevent noncompliance, reduce the need for administrative corrective action, and promote a positive employee experience.
Both our Global Employer Services and Outsourced Finance & Accounting teams work with clients to mitigate payroll risks. Please contact us to learn more about how our professionals can help promote long-term business stability through processes and controls that strengthen finance and accounting functions and manage compliance, as well as advise on employment-related tax issues.