The Comprehensive Guide to Payroll Compliance
Everything you need to know to ensure payroll compliance in your organization, presented by Replicon, the Time Intelligence® platform.
At the surface level, it may seem that a good payroll system is all about paying employees on time. However, there is a lot more to consider behind the scenes. From choosing a payroll schedule, to calculating wages and taxes, to ensuring payroll compliance with labor laws, organizations must ensure every aspect of their payroll is accurate and completed on time.
Of these, payroll compliance is easily the most important. A failure to comply with regulatory standards can result in significant legal and financial penalties. After all, these regulations, such as overtime, meal breaks and tax policies, exist to support employees.
However, payroll laws and regulations vary among regions, states and, of course, countries. Depending on how the organization operates, there can be several sets of regulations to follow, making payroll compliance a complex endeavor. This guide will help illustrate the fundamentals of payroll compliance and provide you with the information you need to remain compliant.
What Is Payroll Compliance?
Payroll compliance is all about meeting the relevant laws and regulations that govern how your employees are paid. These laws can be at the local, state or federal level and cover a wide range of duties that the employer must perform. A few examples include:
- Employee classification
- Employee benefits
- Social security taxes
- Unemployment taxes
- Periodic tax deposits
- Deductions and withholdings on wages
Payroll compliance is a continuous process. No matter what industry they operate in, organizations must always comply with the various applicable regulations. If an issue arises, it can put the organization at risk of legal action and costly penalties. In many cases, this can also have an impact on the tax credit eligibility of the organization, which may jeopardize its bottom line.
The Importance of Payroll Compliance
For any organization, irrespective of its size and business, ensuring payroll compliance should be a priority. Of course, being compliant helps the organization avoid costly litigation, fines and penalties. However, that is not the only reason to meet compliance requirements.
Payroll laws and regulations were introduced to ensure the fair treatment of all employees. They guarantee that employees receive fair compensation for the work they perform. Companies cannot force employees to work in inhumane conditions or for long periods of time, thanks to these regulations. Therefore, for employees, payroll compliance is of vital importance.
If your organization wants to hire the best talent, you cannot ignore payroll compliance. Therefore, good corporate governance dictates that you comply with all relevant payroll laws.
The Basics of Payroll Tax Compliance
All organizations, no matter their size or industry, are subject to the requirements of federal laws, as well as the laws of the state in which they operate. It is imperative to comply with those requirements whenever you process payroll. Therefore, payroll compliance is an ongoing process that starts from the moment you employ a person and continues even after they have left the organization.
Of course, the exact range of compliance requirements varies among businesses. The size of your organization, its location, how it operates and several other factors can affect which laws you must follow. If your organization operates in multiple jurisdictions and states, you’ll need to follow all applicable laws in those regions. In some cases, organizations may also need to adhere to regulations under union contracts for complete payroll statutory compliance.
Irrespective of those factors, most non-federal payroll regulations cover issues such as overtime, minimum wage, new employment reporting, and taxes. Of course, there are a few federal regulations that apply to all organizations operating in the United States.
Federal Income Tax
The employer requirements for payroll compliance obligate organizations to withhold a range of taxes from their employees’ paychecks, one of which is federal income tax. This tax is determined by methods specified by the Internal Revenue Service (IRS), either by percentage or by wage bracket. It is withheld from all paychecks. The withholding also depends on the exemptions designated on the employees’ W-4 Form. This amount can range between 10% to 37% and is reported to the employee and the IRS using the W-2 Form.
Employee Classification Rules
Payroll compliance starts the moment you hire someone. It is imperative that you classify the new hire correctly to prevent hassles down the line. Your responsibilities as an employer will vary, depending on whether you hire an independent contractor or an employee. Therefore, accurate classification is a must. There is no official guide to determining the classification of your hires. However, with an employee, the employer has a greater degree of control over their work, schedules, benefits and reimbursements. The classification also plays an important role in payroll compliance. In case of employees, employers are required to withhold taxes and pay the employer-specific part of taxes. On the other hand, independent contractors are required to pay their own taxes.
Fair Labor Standards Act (FLSA)
The FLSA is one of the most important federal regulations on payroll compliance. This law governs minimum wage, overtime, recordkeeping and child labor standards. Organizations must adhere to these regulations wherever applicable. This includes ensuring minimum wages for all employees and paying overtime as needed. If the organization is allowed to hire workers under 18, they must follow the applicable hours and age restrictions.
One of the most important payroll compliance requirements outlined in FLSA is that of overtime pay. In general, all eligible employees are given extra pay for the overtime hours they work beyond the regular 40 hours in a workweek. However, not all employees are automatically eligible for overtime. It falls upon the employer to determine based on FLSA law which employees are exempt and which are non-exempt from overtime pay.
Employees who are exempt from any overtime pay typically include administrative, professional, and executive employees whose work meets certain specified standards under FLSA. Other exempt employee types include those that work for small newspapers, recreational businesses, seasonal amusement businesses or are farmworkers.
Employee Fringe Benefits
Employers who choose to offer fringe benefits to employees must keep in mind that those benefits are also subject to payroll compliance. However, benefits can greatly vary among organizations. As such, employers must carefully evaluate the applicable laws and regulations to ensure compliance. Broadly speaking, all fringe benefits are taxable. They must be included in the employee’s wages unless otherwise excluded by law. A few examples of taxable benefits include reimbursements for moving expenses and mileage reimbursements. For these fringe benefits, the employer must withhold taxes and report it through the Form W-2.
Federal Insurance Contributions Act (FICA) Taxes
The taxes under social security and Medicare are known as the FICA taxes and are taken from employees’ wages. The employer is responsible for withholding these taxes, and paying them to the federal government. Depending on the business, the organization must deposit these taxes on a monthly or semi-weekly basis. Additionally, the organization needs to report them to the IRS every quarter with the IRS Form 941.
Federal Unemployment Tax Act (FUTA)
Under FUTA, organizations pay taxes for funding unemployment benefits at the federal level. However, unlike FICA, taxes under FUTA are paid solely by the employer. As of 2022, the tax rate under FUTA is fixed at 6% and it is only applicable to the first $7,000 that you pay to each employee every year. Employers must pay FUTA taxes every quarter with the IRS Form 940.
Equal Pay Act (EPA)
The Equal Pay Act was put into effect to abolish wage disparity. Under EPA, employers are legally prohibited from making discriminatory decisions around wage rates. If employees are performing work that is substantially similar, they must be paid equally, regardless of their sex, race or ethnitcity. To ensure compliance with EPA, organizations must implement systematic wage rate factors and maintain proper documentation for all wage rate decisions.
In addition to the federal regulations, employers must also be aware of state regulations for payroll compliance. As one would expect, these requirements can vary from state to state. If your organization operates in multiple states, you must fulfill the payroll compliance requirements for each state individually. Typically, state laws require organizations to withhold income taxes for the state, report new hires, and follow minimum wage and overtime regulations.
How to Comply With Federal and State Labor Laws
Navigating the labyrinth of labor laws can be a challenge for the unprepared. Federal and state laws on payroll compliance can be tricky and even a small mistake can open up the organization to costly litigation and penalties. Additionally, there are local laws and union contracts that add to the complexity of ensuring compliance.
Therefore, your payroll team must constantly monitor US employment laws using the right tools. An integrated time platform that supports out-of-the-box payroll compliance can go a long way in overcoming those challenges.
The Cost of Payroll Compliance Failures
As stated previously, organizations must enforce payroll compliance or risk expensive litigation. In fact, there were 20,279 complaints related to wage and hour settlements alone registered with the Department of Labor in the fiscal year 2021. Nearly $234 million was paid out in back wages with 193,349 employees being affected.
With wage and hour settlements continuing to be the major risk for organizations, it is essential that employers focus on ensuring payroll compliance. It is better for organizations to spend time, effort and money to ensure compliance, as the cost of lawsuits is far greater.
Common Mistakes With Payroll Compliance
There are a few common payroll compliance mistakes that employers are known to make. Examining these mistakes and understanding how they occur is a necessary step to avoid repeating the same errors in your organization. Due to the importance of payroll compliance, organizations must remain on the lookout for the mistakes outlined below.
Misclassification of Independent Contractors and Freelancers
A major challenge for employers is the misclassification of their hires. In several industries, organizations are known to hire freelancers and independent contractors to support their existing workforce. Moreover, hiring contractors helps reduce the burden on the employer’s payroll since these workers are not entitled to employment benefits like overtime pay. However, it is crucial that these hires are clearly classified as contractors or freelancers, as the case may be.
While there are no official distinctions made between contractors and employees, there are clear differences in the tax implications of each type. Some employers make the mistake of trying to reduce their tax responsibilities by misclassifying full-time employees as independent contractors. Of course, this is highly illegal and is bound to attract expensive lawsuits. The employer may also be held responsible for additional taxes in addition to penalties and interest.
To avoid accidental misclassification, employers must make extra effort to ensure the accuracy of paperwork when hiring new people. It is also a good idea to reevaluate all employee classifications at regular intervals to ensure accuracy.
Exempt and Non-exempt Classification Errors
Another common classification mistake that organizations make is with regards to the exemption eligibility of their employees. As previously stated, exempt employees are not eligible for overtime pay under FLSA, but non-exempt employees must be paid for overtime hours. However, many organizations confuse these classifications and mistakenly believe that an employee is exempt from overtime if they are salaried.
To help organizations avoid such errors, there are three tests they can perform to determine the exemption eligibility of employees. Salary is just the first of those tests. It is therefore essential to carefully check the eligibility of every new employee for exemption under FLSA law. Misclassifying a non-exempt employee as an exempt one can lead to lawsuits and even audits. Additionally, the organization is liable for paying back wages along with penalties.
Failure to Report Taxes
A significant part of payroll compliance relates to taxes. It is not enough for employers to ensure they are accurately withholding the relevant taxes from their employees. Employers must also ensure they are correctly reporting those taxes to the government. However, perhaps due to the task’s complexity, it is not uncommon for employers to overlook or even forget to file the relevant tax paperwork.
Organizations must submit different tax forms, depending on the nature of their business, though most are required to submit Form 940 and Form 941, at minimum. Employers must also submit Form W-2 and Form 1099 for every employee or contractor they have hired. As with any payroll tax compliance issue, the organization can attract stiff fines and penalties if they fail to report taxes accurately.
Overlooked Tax Deadlines
Organizations sometimes miss tax deadlines, perhaps due to complicated filing processes. An organization will typically have several tax forms to submit and each has a different filing deadline. Also, forms may be due at different intervals; for example, organizations must submit Form 941 each quarter, while Form 940 is only due once a year. Additionally, for some forms, such as Form W-2 and Form 1099, organizations must submit them not only to the IRS, but also to their employees.
This complexity can easily catch an unprepared payroll team off guard. To ensure compliance, the payroll team must plan and strategize their processes for submitting all forms and taxes before their deadlines.
Inaccurate Overtime Calculations
Overtime pay is another process where errors in payroll compliance are common. Mistakes can occur in several ways. While overtime pay is typically at least 1.5 times the regular rate of the employee, organizations often fail to account for other types of compensation while calculating pay. Compensation like commissions, stipends and bonuses also factor into these calculations.
Of course, as discussed earlier, misclassifying non-exempt employees as exempt can also lead organizations to incorrectly account for overtime. It is also common for organizations to use inaccurate hourly rates when calculating overtime pay. This typically occurs when employees receive weekly pay or a salary. Inaccurate overtime pay, particularly if it results in underpaid employees, can attract significant back pay and fines. Employees will also have the right to raise legal action against the employer to resolve the discrepancy.
Failure to Tax Employee Benefits
While organizations have the option of offering various benefits to employees, their tax implications can vary greatly. Benefits such as commuter plans and health-savings accounts do not require employers to withhold taxes, but other fringe benefits do. If you offer these types of taxable benefits, it is your responsibility to withhold the correct amounts from your employees’ pay. Of course, you must also report those amounts on the appropriate tax forms. To ensure payroll compliance, employers must carefully evaluate the tax regulations and obligations applicable to the benefits they are offering.
Missed Paperwork and Reporting for New Hires
When you bring a new hire into your organization, completing all relevant paperwork is important. For example, employees must fill out Form I-9 to verify employment eligibility. However, it is actually the responsibility of the employer to ensure the completion of all requisite paperwork. They must also report all relevant information regarding new hires to the appropriate state department to ensure compliance. While there may be several documents to submit, missing out on any one of those forms can lead to non-compliance.
As you can expect, payroll compliance involves a considerable amount of paperwork. It is not only important to ensure the accuracy of the paperwork, but also to maintain proper documentation and records. Audits can take place at any time. It is also possible for federal or state tax agencies to ask for documentation. As a result, proper recordkeeping is a must to prove that your organization is compliant with payroll regulations and laws.
Employers must certainly maintain payroll records for all employees currently working at their organization. However, they cannot afford to neglect the records once an employee leaves. In fact, most state laws require organizations to maintain records for employees who have left within the previous three years, at minimum. Therefore, organizations must keep all documents organized and securely stored. Storing these records on cloud-based systems is an excellent option for modern organizations.
Best Practices for Payroll Compliance
There is definitely a lot that goes into ensuring payroll compliance. No matter the size of the organization, it is easy to feel overwhelmed with all of the obligations, documentation and deadlines surrounding payroll compliance. However, there are some best practices that employers can adopt to streamline their compliance processes and ensure long-term success.
Create a Payroll Compliance Checklist
One of the most effective strategies for ensuring payroll compliance is to create a series of checklists. Tailor these checklists to your specific business needs, to meet compliance requirements in various scenarios.
For example, you could create one checklist outlining the compliance requirements when hiring a new employee, and another for quarterly payroll requirements, and so on. Ensure that these checklists are as comprehensive as possible to avoid any issues down the road. These checklists will serve as a reference for your payroll team to streamline processes. They are also beneficial in payroll compliance training for new HR and payroll employees.
Create a Payroll Calendar
Another challenge in payroll compliance is meeting the variety of deadlines involved. With different tax forms having different deadlines and submission periods in a financial year, it is a good idea to create a comprehensive calendar to track them all. This calendar can help you avoid legal hassles and financial penalties due to missed deadlines.
Schedule Internal Audits Periodically
As discussed previously, misclassification errors are among the most common payroll compliance mistakes. While the confusion is often understandable, these errors can attract significant penalties. Employers should definitely try to ensure the accuracy of their employee data and payroll information from the very beginning. However, to reinforce the accuracy, organizations should also schedule internal audits periodically such as biannually or even quarterly. By auditing the payroll database regularly, you can reconfirm the classifications and other details of your employees. If you are using payroll software, check if it offers audit trails. Audit trails allow you to track any changes or edits to records to validate information. In turn, this will minimize the risk of penalties.
Considering the complexity of payroll compliance, organizations should definitely look for expert advice to protect themselves. Many small to medium organizations lack the resources needed to hire payroll experts onto their team. In fact, they may not even have a proper payroll team in the first place. Therefore, it can help to seek an expert third parties, such as accountants specializing in payroll compliance.
Invest in a Cloud Platform
Gone are the days when you had no choice but to perform payroll manually. From tracking timesheets to calculating payroll taxes on spreadsheets, ensuring compliance manually is certainly a difficult task. However, that need not be the case any longer. With modern cloud-based solutions at your disposal, you can now automate key payroll processes such as time tracking. Automation can help you meet deadlines by speeding up processing times. Moreover, you can integrate these solutions with other essential tools at your organization, such as accounting and HRMS software, saving you time and effort when administering payroll and benefits. As a result, you can streamline your payroll processes, taking the burden off your payroll team.
While payroll compliance can seem daunting at first, the fact remains that it is a critical business process that organizations must undertake. The good news is that running payroll and staying compliant does become easier with time. All you need to do is give the necessary time and effort to managing compliance requirements and stay on top of updates to the applicable payroll laws. Of course, following best practices and staying aware of the common mistakes mentioned above can also help you tremendously in meeting your compliance obligations.
Frequently Asked Questions
1. What are the laws governing payroll?
There are various laws and regulations governing payroll at the local, state, federal and even international levels. Some of the most common federal payroll laws include the Fair Labor Standards Act (FLSA), Federal Insurance Contributions Acts (FICA) and Federal Unemployment Tax Act (FUTA).
2. Why are payroll compliance laws important?
Payroll compliance laws exist to protect employees by ensuring fair compensation and to prevent organizations from taking advantage of their workforce. Some payroll laws also help in funding essential social service programs such as unemployment benefits and Medicare.
3. How to ensure accuracy of payroll?
There are several steps an organization can take to ensure the accuracy of its payroll. They include classifying employees and contractors correctly, maintaining meticulous employment and pay records, and staying on top of the latest payroll law updates.
4. What is a payroll compliance audit?
A payroll audit helps in determining if an employer is fulfilling the necessary tax obligations under the applicable payroll laws and other related agreements.
How can Replicon help with Global Payroll Compliance?
With Replicon’s powerful Time Intelligence® platform, you can:
- Capture employee time with configurable time sheets to track hours, tasks, activities or projects
- Ensure ALL of your offices are complying with local regulations regardless of which country they are located in
- See a complete, unified picture of your organization’s time data