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Avoiding 5 common mistakes when setting up payroll for small businesses

Posted by Tasnim Ahmed

August 3, 2023

Payroll mistakes aren’t uncommon, they’re routine. And the consequences are costly!

According to a 2022 Ernst & Young survey, the average organization makes an average of 15 payroll mistakes per payroll period — resulting in an average of $291 each to employers. And that adds up to a staggering $4,365 every time you run payroll. 

Fortunately, you can steer clear of these blunders and their climbing costs if you know what to watch out for. Read through these five common payroll mistakes small businesses make.

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Payroll mistake #1: Employee misclassification

Many small businesses find it challenging to decide if a worker belongs in the employee or contractor category. In fact, the 2022 HR Processing Risk and Cost Survey by EY states, “12 percent were fined by a regulatory body (such as the IRS or a state authority) for a misclassification or error. These organizations were fined an average of 30 times, with a cost of $5,200 on average last year in total. The largest total of fines reported was $100,000”.

The two key classifications that should be taken into consideration under the Fair Labor Standards Act (FLSA) are –

  1. a) Independent contractors or employees
  2. b) Exempt or nonexempt

The Department of Labor (DOL) provides six-step guidance to assist you in choosing the appropriate classification, but among the determining variables are how long an individual has been employed by the organization; if they own equipment of their own; and who sets their schedule. As an alternative, you can submit Form SS-8 to request that the IRS calculate it for you.

A worker is usually regarded as an employee by the IRS if the employer has control over how they conduct their duties and is obligated to deduct income taxes, medicare taxes, unemployment taxes and social security taxes from their wages. However, the state, city, or country where your firm is located can have additional criteria or standards for defining “an employee”.

Whereas, independent contractors are defined as employees for whom the employer has the right to manage or guide the final outcome of the work, not the process of doing it.

Determining who is eligible for overtime pay is the primary distinction between exempt and non-exempt workers. Non-exempt workers are typically paid hourly and are entitled to overtime pay only if they work more than 40 work hours in a week.

The classification must be accurate because contractors are not eligible for minimum pay or overtime, but employees might be. For an employee, you are required to deduct income tax and contribute the employer’s portion of payroll taxes. Penalties for misclassification may be imposed in addition to the requirement to pay back any taxes owed together with interest.

Some of the protections provided by the Act are not applicable to employees who are FLSA exempt. For instance, they are not mandated by law to be paid for overtime.

Payroll mistake #2: Pay miscalculation

Payroll administrators need to keep a tab on many things including deductions, commissions, overtime, paid time off (PTO)and more. The standard norm for overtime pay is 1.5 times the wage of the employee if they work for more than 40 work hours in a week.

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A few states have additional regulations; for instance, in California, even if a worker doesn’t work over 40 hours in a week, they must be paid overtime if they work over eight hours in a day.

Pay calculations that are incorrect might also be due to poor time-tracking skills. The odds of making a pay error be it overpayment or underpayment increases if your firm lacks an effective system for tracking employee work hours or PTO.

Poor payroll management, such as failing to account for vacation days, may necessitate making adjustments to the original sum of money. For accuracy, you can either use a competitive payroll software or choose to outsource payroll services.

Payroll mistake #3: Late payroll

Employee payments may not be made on time if a payroll deadline is missed. Depending on the firm’s expenditure guidelines, this error can result in a total loss of wages. You must exercise extreme caution in order to meet the deadline.

Payroll mistake #4: Incorrect tax payment and missed deadlines

Tax miscalculation is due to the complexity and changing payroll taxes rules. You must monitor changes at every stage since your firm may be liable for federal, state and local taxes. Employees who reside in multiple jurisdictions may also have separate tax liabilities.

You can even prevent having to pay taxes or make payroll adjustments by ensuring that the tax rates are correct.

Besides, payroll taxes must be paid by a certain date, and failing to do so may incur late fees or penalties. It’s crucial to be mindful of deadlines and start making your tax payments before the due date.

Payroll mistake #5: Inaccurate records

Audits and hefty fines may result from failing to keep accurate payroll records. In FY 2022, the IRS assessed  “USD 23.8 billion in additional taxes for returns not filed timely and collected almost USD 2.3 billion with delinquent returns”.

The IRS mandates that you maintain records for every employee, including a copy of W-4 tax withholding forms and details of all wages paid. Additionally, the FLSA mandates that you keep even more specific records like total hours worked for nonexempt employees. You must maintain those documents for at least three years in order to be in compliance with the FLSA.

Outsourced payroll services can help

To simplify and streamline your payroll process and avoid all of the above-mentioned mistakes (and more), consider partnering with an outsourced payroll service provider. Besides, establishing a solid payroll process to ensure you can avoid as many mistakes as possible, these experts can help you with calculations and related taxes, and stay abreast with ever-changing payroll regulations and tax laws.

Want more? Escalon has helped over 5,000 small businesses across a range of industries to optimize routine business functions, like taxes, accounting, insurance payroll and HR. Talk to an expert today.

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This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.


Tasnim Ahmed
Tasnim Ahmed

Tasnim Ahmed is a content writer at Escalon Business Services who enjoys writing on a multitude of subjects that include finops, peopleops, risk management, entrepreneurship, VC and startup culture. Based in Delhi NCR, she previously contributed to ANI, Qatar Tribune, Marhaba, Havas Worldwide, and curated content for top-notch brands in the PR sphere. On weekends, she loves to explore the city on a motorcycle and binge watch new OTT releases with a plateful of piping hot dumplings!

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