Payroll is one of the most important administrative responsibilities for any small business, but it can also be one of the easiest places to make costly mistakes. Errors can result in incorrect employee paychecks, frustrated employees, additional administrative work and potentially significant tax penalties.
Payroll mistakes can happen even when you use payroll software or hire an outside payroll provider. Understanding your responsibilities and establishing effective review procedures can help reduce the risk of errors involving withholding, tax deposits and payroll reporting.
Here are some key steps small businesses can take to keep payroll taxes on track.
Withhold and Deposit Payroll Taxes Correctly
Employers generally must withhold federal income tax and employees’ share of Social Security and Medicare taxes from wages. Employers are also responsible for paying their share of Social Security and Medicare taxes.
These amounts must be properly deposited with the IRS and reported on the appropriate employment tax returns. Additional requirements may apply to the 0.9% Additional Medicare Tax, federal unemployment tax and state and local payroll taxes.
One common source of payroll errors is entering information incorrectly from an employee’s Form W-4, Employee’s Withholding Certificate. Changes to an employee’s name, address or immigration status can also affect payroll records and potentially create withholding or reporting problems.
Don’t Miss Payroll Tax Deposit Deadlines
One of the most serious payroll mistakes is failing to deposit federal employment taxes on time.
IRS penalties can increase quickly depending on how long a deposit remains unpaid:
- 1–5 calendar days late: 2% of the unpaid deposit
- 6–15 calendar days late: 5% of the unpaid deposit
- More than 15 calendar days late: 10% of the unpaid deposit
The penalty can increase to 15% if more than 10 calendar days pass after the date of the first IRS notice or letter. A 15% penalty may also apply on the day a notice or letter demanding immediate payment is received.
There is an even more serious consequence when an employer willfully fails to deposit certain withheld taxes. If the IRS determines that the failure to deposit withheld federal income tax and employees’ share of Social Security and Medicare taxes was willful, a 100% penalty may apply.
This penalty can potentially be assessed personally against individuals who are considered responsible for the unpaid taxes.
Create Procedures to Prevent Payroll Tax Errors
A few basic procedures can significantly reduce the risk of payroll mistakes.
Businesses should establish processes for:
- Reviewing employee withholding information
- Monitoring payroll tax deposit deadlines
- Reconciling payroll records with amounts reported and deposited
- Investigating discrepancies promptly
- Reviewing changes to employee compensation and benefits
Using a payroll service provider doesn’t necessarily eliminate your responsibility as an employer. Your business generally remains responsible for ensuring that federal employment taxes are deposited and paid correctly and that required payroll tax returns are filed on time.
Regularly reviewing your payroll records can help identify problems before they become larger compliance issues.
Report All Taxable Compensation
Employee wages and salaries aren’t the only forms of compensation that may be subject to payroll taxes.
Depending on the circumstances, employers may also need to include bonuses, awards and certain fringe benefits in employees’ taxable income.
Failing to account for taxable compensation can result in insufficient withholding and may create additional payroll tax problems. It can also lead to penalties related to incorrect information returns, including Forms W-2, Wage and Tax Statement.
For this reason, review the tax treatment of bonuses, awards and fringe benefits before processing them through payroll.
This is particularly important when introducing a new employee benefit or changing an existing compensation arrangement. The rules for federal income tax withholding aren’t always identical to the rules governing Social Security and Medicare taxes.
Review New Compensation and Benefits Before Payroll
A new benefit or compensation arrangement can create unexpected payroll tax consequences if its tax treatment isn’t reviewed in advance.
Before adding a new benefit, bonus or other form of compensation, determine:
- Whether it is taxable to the employee
- Whether federal income tax withholding is required
- Whether Social Security and Medicare taxes apply
- Whether the amount must be reported on Form W-2
- Whether state or local payroll taxes also apply
Addressing these questions before the payment is processed is generally much easier than correcting an error afterward.
Correct Payroll Mistakes as Soon as Possible
Even businesses with strong payroll procedures can make mistakes. When an error is discovered, the first step is to determine exactly what happened.
Identify:
- What went wrong
- Which employees are affected
- Which payroll periods are involved
- Whether taxable wages were affected
- Whether withholding or tax deposits were affected
- Whether previously filed information returns or payroll tax returns are incorrect
Once the problem is understood, determine which correction procedure applies.
Depending on the nature of the mistake, you may need to adjust an employee’s pay, correct internal payroll records, make an additional tax deposit or amend a previously filed employment tax return.
Forms 941-X and W-2c May Be Required
Certain errors involving Form 941, Employer’s Quarterly Federal Tax Return, may need to be corrected by filing Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund.
If an employee’s Form W-2 contains incorrect information, you may need to issue Form W-2c, Corrected Wage and Tax Statement.
The appropriate correction depends on the type of error, when it was discovered and other circumstances. Because correction procedures can vary, it’s important not to delay once a payroll problem is identified.
Keep Documentation of Payroll Corrections
Maintain records showing what the payroll error was, which employees and periods were affected, and what steps were taken to correct it.
If the error affects an employee’s paycheck or tax information, communicate with the employee promptly. Explain what happened and let them know whether they need to take any action.
Clear documentation can also make it easier to respond to questions from tax authorities and to prevent the same mistake from happening again.
Keep Your Payroll on Track
Payroll tax mistakes can be expensive and time-consuming, but many errors can be prevented through consistent review procedures and careful recordkeeping.
Make sure payroll taxes are withheld correctly, deposits are made on time and all taxable compensation is properly reported. If an error does occur, addressing it quickly can help limit the potential consequences.
If you discover a payroll tax mistake or aren’t sure how a particular payment or employee benefit should be treated, consult a tax professional. Professional guidance can help you determine the appropriate correction and strengthen your payroll procedures to maintain compliance.
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