Mastering Payroll Compliance: A Guide for Businesses

What Is Payroll Compliance?

Payroll compliance refers to the legal and regulatory requirements all businesses must follow when processing payroll, withholding taxes, classifying employees, and more. Failing to comply with federal, state, or local laws all ends with the same outcome: penalties, audits, and legal risk. This makes compliance a critical aspect of running a successful business in the United States.

Key Payroll Compliance Laws & Regulations

Many different regulations and laws impact payroll compliance. These come from the federal, state, and local levels, so it’s critical to stay informed about all of these for your business to remain compliant. Here are a few of the most significant laws and regulations pertaining to payroll compliance.

Fair Labor Standards Act (FLSA)

FLSA is primarily concerned with protecting workers from unfair labor practices. The main takeaways for employers are the establishment of a federal minimum wage and a 40 hour work week. For any hours worked over the standard 40, non-exempt employees must be paid 1.5x their hourly rate. (See more in our article about exempt vs. non-exempt employee status.)

Federal Income Tax Withholding (FICA/FUTA)

FICA is the Federal Insurance Contributions Act. This act mandates tax withholdings to fund Medicare and Social Security. FICA contributions are split between the employer and employee.

FUTA is the Federal Unemployment Tax Act, funding unemployment benefits. Unlike a FICA contribution, FUTA is paid solely by employers.

State-Specific Payroll Tax Requirements

In addition to the federal regulations listed above, state-specific versions of many laws and regulations also exist. FUTA, for example, also has a state-specific counterpart (SUTA). Each state sets its own deadlines, rates, and reporting rules, so it’s crucial for employers to stay updated and aware of regulations at the state level as well to avoid penalties.

Overtime and Wage Regulations

The FLSA mentioned above is one of the most prominent regulations for overtime and minimum wage. It is also important to be aware that states and even some localities set their own minimum wage—which would be higher than the federal minimum.

Employee Classification – 1099 vs. W2

In addition to exempt vs. non-exempt status, one of the most critical employee status distinctions is 1099 vs. W2. The key differences are centered around taxes, employment benefits, and the nature of the relationship between the employer and the worker. 1099’s are considered independent contractors and responsible for their own taxes and benefits, while W2 workers are considered employees, with those elements being handled by the employer. (See more about this distinction in our article comparing 1099 and W2 classifications.)

Benefits and Deductions Compliance

Tax-advantaged benefits are an area commonly overlooked by employers but are a critical part of payroll compliance. All employee benefits and payroll deductions must comply with both state and federal law to ensure correct withholdings and deductions.

Key regulations and laws pertaining to benefits and deductions include:

• ACA (Affordable Care Act) — requiring that employers with 50+ full-time employees offer health insurance to employees
• FMLA (Family and Medical Leave Act) — requiring employers to continue certain benefits for eligible employees on protected leave
• ERISA (Employee Retirement Income Security Act) — ensuring employees receive retirement benefits they’re entitled to
• IRS (Internal Revenue Service) — regulating what deductions must be handled as pre-tax vs. post-tax

Common Payroll Compliance Mistakes (and How to Avoid Them)

Poor Payroll Recordkeeping & Documentation

Accurate payroll recordkeeping is not just best practice—it’s a legal requirement. Businesses must maintain payroll records to comply with local, state, and federal labor law. Well-organized records also protect businesses in case of a dispute, audit, or compliance check. Avoid the potential penalties that come with poor documentation by:

• Staying current on and understanding legal requirements for how long documents must be kept in case of audit (both at the federal and state level)
• Keep both physical and electronic records in a secure location
• Use a clear, systematic filing system to both help you locate files when needed and to help identify missing items or discrepancies
• Regularly audit your payroll and HR information internally, making updates and filling gaps as needed
• Automate the process as much as possible to minimize the risk of errors and missing documentation

Inaccurate Payroll Calculations

Errors in payroll calculations can be caused by manual error, outdated tax rate info, or incorrect employee classifications. To avoid these mistakes:

• Use automated payroll software that updates rates and automatically calculates
• Stay current on tax rates (and any changes)

(Pro Tip: Always double check payroll reports before finalizing and processing any payments.)

Not Tracking Overtime Properly

Improperly tracking and compensating overtime is a major FLSA violation. Miscalculations occur when businesses do not factor in all qualified time. Time-tracking software that accurately logs employee hours can help with record accuracy.

While much rarer, improper overtime compensation can happen if a business misclassifies employees as exempt when they should be eligible for overtime pay. Regular review of employee status can help ensure compliance with overtime laws.

Missing Deadlines for Tax Payments

IRS deadlines are strict. Late tax payments can result in penalty fees and interest charges—and raise a company’s profile for potential audit.

Recommendations for avoiding late payments include:

• Automatic payment through a payroll software
• Keeping a compliance calendar that notes key filing dates (federal, state, and local)
• Working with an accountant or payroll provider who will stay current on the business’s behalf

Misclassifying Employees

A common mistake in payroll compliance is misclassifying workers as independent contractors instead of employees. If the IRS later determines that a worker should have been classified as a W2 employee, the business can owe back taxes and be subject to fines and legal ramifications.

Business can stay compliant for employee classification by following IRS guidelines, clearly outlining worker status in employment contracts, and auditing workforce classification for all employees.

Best Practices for Staying Compliant

Automate Payroll Processes

Withholding taxes, calculating wages, and maintaining accurate records of earnings and deductions are all elements of payroll processing. While this can be time-consuming—and risky—when done manually, payroll automation can now save significant time and provide peace of mind for business owners.

While most business owners are aware of federal requirements, state and local level compliance usually falls outside of an owner’s wheelhouse.

By limiting the opportunity for error in these factors, owners can focus on other, more revenues generating outcomes of their business.

(Pro Tip: While automation helps significantly with compliance, set-up and monitoring is best handled by a professional.)

Automate HR Processes

HR and payroll significantly overlap when it comes to compliance. Like with tax automation and payroll automation, business owners can save time and eliminate headaches through automated HR processes.

For example, consider the employee lifecycle. Electronic onboarding helps with the administrative side of searching for good-fit prospects and then ensuring they have the correct documentation completed once hired. Systems can flag administrative personnel when a new hire qualifies for 401(k) or health insurance so they can apply the benefit. Automating this process ensures timeliness compliance—and helps the business avoid the implications of violation.

Use Reliable, Regularly Updated Payroll Software

A comprehensive Human Resources Information System (HRIS) is the backbone of human resources and payroll management. An HRIS platform helps to keep track of items like hiring, firing, state regulations, federal laws, etc.

Building out the infrastructure within the HRIS will proactively update the team on any changes in procedures or laws, bringing additional peace of mind. Additionally, simple items like minimum wage updates and timely tax payments through the automated system help to take the burden off of remembering tasks—and reduce the likelihood of error.

(Pro Tip: Using an automated system to centrally house employee information can also enhance data security!)

Conduct Regular Payroll Audits

A good practice is to annually review I9 classification for all employees. In addition to their classifications, be sure to also ensure employee records are accurate. This includes personal information (like name, address, and social security number) and any banking information is also current.

(Pro Tip: Check out our Year-End Checklist article for more helpful reminders!)

Stay Current on All Regulatory Changes

One of the most common payroll compliance errors is simple ignorance. Changes to laws and regulations around payroll occur regularly, and being aware of those changes is critical. To stay current, businesses can:

• Monitor legislation for any news about changing regulations
• Consult with legal advisors, HR professionals, and accountants
• Use payroll software to automatically update for new regulations

The easiest and most accurate option is to outsource payroll to a trusted payroll service provider who can monitor these changes and proactively help with any adjustments.

Outsource Your Payroll Processing and HR Documentation

Most penalties and late fees the IRS issues are due to lack of knowledge or just not completing tasks on time. While there is a cost to having an automated compliance system/payroll and HRIS, the benefits outweigh the costs many times over.

Take for example the business owner who processes payroll either on their own, or through software set up in-house without expert oversight. This can save on some cash in the short term, but time is money. And it is even more money when the owner makes a mistake that causes delays in payments or inaccuracies with records.

By using an outsourced provider for both software and services, owners effectively leave the liability for these potential errors to their chosen provider.

Conclusion

HR and payroll compliance is critical for a business to be successful. With potentially crippling fines and government sanctions with a violation, compliance is vital.

Common pitfalls include misclassification of employees as exempt vs. non-exempt or as a 1099 contractor vs. a W2 employee, inaccurate payroll calculation, and missed payment deadlines. But with the right processes in place, businesses can reduce risk and maintain employee trust.

While compliance is complex, there are many solid solutions available to help ensure a business remains violation-free. HRIS systems can help with automation, saving time and ensuring timeliness. And working with a software and service provider that offers a comprehensive payroll/HRIS system in a single platform can provide even more peace of mind.

With the right systems and service personnel in place, companies can effectively create attractive working environments—all while keeping the IRS and state agencies at bay!

To see how Green Payroll can help you with your payroll and HR compliance, contact us today!