Payroll is an essential business function, not unlike sales and customer service, it isn’t just a bookkeeping annoyance. Because it’s the primary way employees are rewarded, late or incorrect paychecks can lead to a dissatisfied, unmotivated workforce, and perhaps even worse since it can be difficult to retain people when their payroll is always messed-up.
The relationship between employers and employees is highly regulated, and many of the rules are reflected in payroll. There are hundreds of regulations, and just as many mistakes you can make.
Since almost all of us have done payroll, most probably using a program like Intuit's Enhanced Payroll for QuickBooks or ZenPayroll, or something similar, it obviously won’t surprise you that payroll is one of the original computer applications. Way back in 1954, General Electric Corporation bought the first UNIVAC-I computer ever sold to a private company, and promptly programmed it to process the payroll for their employees.
The computer sitting on your desk today has a processing power thousands of times greater than that 60-year-old UNIVAC-I. Even your 'iPad tablet' has thousands of times the storage capacity of that huge old computer, despite all the tape drives shown in this picture. But even with the capabilities of today’s personal computers, the challenges of payroll have not really changed because they are not so much computational as they are procedural and compliance based issues upon which the processing of payroll remains dependent on constantly changing rules and regulations, that's why almost all 'payroll programs' offer a tax compliance (update) service.
With that said, we must also recognize that the consequences of some payroll mistakes can be much more serious than the paychecks simply being wrong. While some mistakes result in us getting a hard time from our employees or colleagues when there is a mistake in their paycheck, other mistakes can result in regulatory audit and enforcement from people we don’t want to become acquainted with. I mean, absolutely none of us, want to ever have to meet the federal and state government tax enforcement officers who perform payroll and/or employment audits.
In this series of 3 articles we will examine 15 of the most frequent myths and mistakes in payroll and how to start avoiding them today. But before we start with these 15, we should recognize that the most significant myth results when a small business thinks that the various rules, regulations and requirements related to payroll and employment don’t apply to them because they believe their business is “just a proprietorship rather than a corporation”, or that they “are too small since we only have 1 or 2 employees”, or that “those burdensome rules are for ‘the other guy.”
The rules apply to everyone, small or large, proprietorship or corporation, you and the other guy. The extent to which the rules apply may change according to circumstance, but the worst thing that can happen is for a small business to simply ignore the rules with the mistaken believe that they either don’t apply, or that ‘they don’t know’ the rules. Because as enforcement personnel will tell you, “ignorance of the law is, no excuse.”
Myth # 1 – “They’re Not Employees, they’re Independent Contractors!”
I wonder how many times the IRS auditors have heard that one? But the odds are that if the IRS is at your place of business listening to you make that statement, they already know that the individuals in question are not ‘Independent Contractors’ at all, rather they are YOUR employees.
There is one sure way to avoid doing payroll, that is by not having any employees. Far too many small businesses attempt to avoid the extra expenses of having employees such as the costs of Social Security employer matching, Workers’ Compensation premiums, and State Unemployment taxes) by classifying workers as ‘independent contractors’ and paying them with a regular check (rather than a paycheck). A business can certain reduce their tax payments by applying this misclassification, but in the long run it will almost certain catch up with them and cost them more than if they had followed the rules in the first place.
In recent years, about 25% of all Internal Revenue Service employment audits have focused on the issue of determining the status of independent contractors or employees. The consequences of an incorrect classification by a small business can be monumental in terms of back taxes, penalties and interest.
There are a few simple questions a business can use to quickly determine if an individual is truly an independent employee or an employee. If a business controls the work or hours of an individual they are an employee, not an independent contractor. In these days when more and more workers are on ‘flex time’ or ‘work from home’ it may seem that they are more akin to being independent contractors, than regular employees, but if you set the minimum number of hours they work for any pay period, or you set the regularity of their pay frequency, or you require them to be available at designated times, then they are employees.
Independent contractors generally have ‘their own employees’, and they assign those employees to perform tasks related to work they have contracted to perform. You would probably complain if ‘Sam’ showed up to do the work for which you had hired ‘Jim’ to do, as an employee Jim has a responsibility to do his own work, but as an independent contractor Jim has the freedom to assign anyone to do the work he has agreed to do.
A service provider who believes they are an Independent Contractor can in fact obtain an IRS determination to establish if the services they perform are those of a contractor or an employee by submitting form SS-8 Determination of Workers Status for Purposes of Federal Employment Taxes.
The IRS has their own tests that include things like: Instructions (do you tell them what to do, or do they perform their services based upon standards they establish), Training (do you train them, or do they train you), Integration (is the work incorporated into your overall work-flow, or does it stand apart), and nature of Service Delivery (self or substitutes).
Areas like Hiring, and Control and payment of assistants are big indicators as far as the IRS is concerned. Another area is What is the nature of your relationship, is it an on-going relationship (the IRS tends to think that contractors are always temporary). How about hours of work, setting-own-hours, working only when the business is open, etc.?
The IRS will almost always inquire about the Nature of reporting by the contractor, is it formal or informal, etc. Payment methods and expenses – contractors should be invoicing for services (invoices may be ‘progressive’ but should represent specific phases of work completed and not just ‘hours spent’. Unless there are specific contract provisions for expenses, a contractor should absorb their own expenses and not bill those back directly to the party with whom they have contracted.
Areas like furnishing of tools or equipment, Requirements to do the work, a Contractor’s investment in their own business (including at risk status), and Business profit and loss all help determine a ‘contractors true status as a business’ eligible to perform contract work.
The IRS further refines this by looking at a contractor as Performing multiple jobs at the same time, Public offering of services, Responsibility for completion of work, and Finished product factor.
Many states use this same, or variations of this list, to determine requirements for unemployment, workers’ compensation or state employee taxes.
Myth # 2 – “I don’t need W-4 forms, do I?”
I once went to help a new QuickBooks user set-up their Payroll. My first question was, ‘where are the W-4 forms for the employees?’ Of course the answer was, ‘we don’t have our people fill those out.’
All employees MUST have a completed Form W-4 on file at their employers’ place of business, and all NEW employees must complete a Form W-4 prior to starting work. The IRS requires every employee at the time of hire to complete a Form W-4, Employee's Withholding Allowance Certificate. The form indicates the employee's marital status and number of allowances, so you can determine the amount of federal income tax to withhold from the employee's paycheck. Existing employees should complete a new W-4 every time they have a status change; for example, get married, fill out a new W-4; get divorced fill out a new W-4; or have a baby, fill out a new W-4; or any other time an employees’ earnings and/or withholding status changes, fill out a new W-4.
Employers MUST maintain a W-4 on every current employee and keep it for 4 years after an employee leaves or is terminated. Don’t discard any prior W-4 forms just because an employee completes a new one, you must keep them all on file.
I know this sounds pretty simple to those of us who have done payroll a long time, but as ProAdvisors we need to set the example and help enforce these rules with our clients, so that we don’t contribute to any penalties, because the IRS can levy a fine of as much as $1000 for each ‘missing’ W-4 form if they perform an audit and the records are incomplete.
Of course the IRS is not the only agency wanting W-4 type information; all states require the reporting of new hires, because this aids in the collection of child support and the monitoring of unemployment compensation, workers' compensation and other public programs. In most states, you can meet this requirement by submitting a copy of the employee's W-4; however, many states either require or allow you to submit new hire documentation electronically. Employers need to insure they are aware of their state's policy since laws differ from state to state.
Myth # 3 – “Can late or wrong ‘tax deposits’ trigger an IRS employment tax audit?”
A lot of things can trigger an employment audit from the Internal Revenue Service including late or underpaid tax deposits, or late or underpaid Quarterly Tax Returns. Besides risking an IRS employment audit, a small business can be subjected to considerable penalties for missing the deadlines for depositing payroll taxes and/or filing required tax returns.
Most businesses keep a ‘tax calendar’ which lists all the various filing deadlines for federal, state, county and municipal tax obligations (payments or filings) for the entire year. Even with a calendar and reminder system, it is easy to miss a deadline unintentionally. For example a small business owner goes on vacation and fails to prepare the filings prior to departure; his mind is on the vacation, not the tax returns due 5 days later.
Of course there is also the illegal practice of ‘borrowing’ against tax liabilities. A lot of small businesses get into trouble by failing to pay their payroll tax liabilities due to cash-flow issues. They think to themselves, “I can’t pay this right now, I will pay it a little late when some revenue comes in.” Unfortunately that is a short path to a deep hole. Far too many businesses that take that first step find themselves deeply in debt to governmental authorities very quickly, when the penalties, interest and fines are levied they can’t even begin to ‘catch-up’ with their past due obligations and they pattern just gets worse. Anyone involved in the ‘payroll process’ can in fact become liable in terms of both civil and/or criminal penalties in these cases, not just a business owner.
Years ago, it seems more like eons, we use to take a Number-2 lead pencil and carefully color in the little dots, and then print in the blocks, our tax deposit information on payment coupons, but now EFTPS is the name of the game for almost every business. The IRS requires you to use the Electronic Federal Tax Payment System to make tax deposits with the exception of very small employers with such limited tax liability that they are permitted to ‘mail-in’ their tax deposit at the same time as their Form-941 Quarterly Tax Returns.
Stay tuned for Parts 2 and 3 of this series covering the remainder of our 15 Myths and Mistakes of Payroll.