5 Small Business Payroll Challenges: Penalties & Solutions

You’re growing your business and expanding your team. Hiring employees will help you offload minor tasks so you can focus on big-picture business growth. Finding high-quality candidates and hiring the right team is only the start of an employer’s responsibilities. Small business payroll processing presents unique and complex challenges. 

As a new employer, you want to maintain compliance and pay your workers fairly. You might feel overwhelmed with employment tax rules, but you don’t have to navigate the requirements alone.

This article will cover the top small business payroll challenges for new employers. We’ll also help you avoid common payroll mistakes that could lead to fines or penalties. 

Top 5 Small Business Payroll Challenges

1. Manual Payroll Processing: Time and Resource Constraints

Small business owners may initially prefer to keep their payroll processing in-house. Rather than hiring a payroll service provider, some entrepreneurs manually track employee hours and calculate paycheck figures.

However, the greater your number of employees, the more time-consuming your small business payroll becomes. Employment laws require complex calculations and detailed time tracking. Manual data entry increases the risk of human error.

You can avoid costly mistakes by outsourcing your payroll solution. You’ll also free up time and resources for business tasks. 

Payroll service providers offer streamlined automation, accurate record-keeping, and direct deposit. 1-800Accountant’s outsourced payroll services represent a cost-effective alternative to manual payroll processing. You can free up your time to grow your business and increase your confidence in your employment tax reporting.

2. Payroll Accuracy

Accurate payroll tax reporting requires detailed time tracking. Small business owners must consider several inputs to determine employment tax calculations, including the following:

• Hours worked

• Pay rates

• Employee vs. contractor classification 

• Benefits and deductions

• Federal and state withholding

Additional considerations vary by industry. Outsourced payroll tax professionals can help you track industry-specific employee data.

Correct Classification of Employees and Contractors

Independent contractors are typically part-time or temporary workers who establish their own work location and schedule. Contractors and freelancers generally maintain independence from the business. In contrast, employees must follow company policies and schedules.

Generally, hiring an independent contractor has fewer payroll tax implications than hiring an employee.

However, employment laws and tax rules can be complex and nuanced. The employee vs. independent contractor distinction considers numerous factors. Small business owners risk facing fines and penalties for misclassification of employees. 

Avoid misclassification errors by reviewing the IRS employee vs. independent contractor classification guide. We recommend consulting payroll tax professionals for personalized guidance.

Accurate Deductions and Withholdings

Employment Benefit Deductions

Employment benefits help companies attract high-quality candidates and improve team morale. Many employers offer health insurance, retirement plan contributions, and paid time off.

Employee benefits can impact pre-tax and after-tax wages. Small business owners must track the benefits offered to each employee and determine the pre- or post-tax deductions. For example, health insurance benefits represent pre-tax payroll deductions. Certain retirement plan contributions reduce employees’ after-tax pay.

Your outsourced payroll tax solution can help your business correctly calculate deductions and withholdings on your employee paychecks.

Federal and State Withholding

Businesses withhold employment taxes from workers’ wages. Employment taxes generally consist of the following elements: 

• Federal income tax

• State income tax (if applicable)

• Social Security and Medicare taxes

• Federal and state unemployment taxes

Federal and state tax rates vary by location and income bracket. Small business owners must accurately calculate and withhold each component. Businesses then submit tax withholding to the IRS or state taxing authorities. 

Payroll tax reporting can be complex and dynamic, and reporting errors can generate fines. 

Fortunately, payroll service providers offer automated withholding calculations to support your small business. Outsourcing allows you to streamline payroll processing and avoid errors. 

Keeping up with Regulatory Changes: State and Federal

Employment laws and tax regulations change frequently. Federal, state, and local taxing authorities adjust tax rates annually. Consider the following examples of regulatory changes your business must track and follow. 

• Federal, state, and local tax rates

• Minimum wage requirements

• Withholding thresholds

• Benefit eligibility

• Retirement plan contribution limits

• Remote work rules 

• Freelance contractor restrictions

Additional rules may apply, depending on your industry or location. 

Dynamic employment tax laws add complexity to your small business payroll management. Your company should monitor the relevant employment laws and keep your payroll system current.  1-800Accountant’s team of payroll tax professionals can support your small business by tracking employment laws and updating your payroll software.

3. Compliance with Wage and Labor Laws

The Fair Labor Standards Act (FLSA) imposes fair wage requirements for overtime and hourly workers. The law requires businesses to pay appropriate rates and maintain accurate records. For example, employers must pay overtime wages (at least 1.5 times the worker’s wage) to hourly employees who work more than 40 hours a week. 

The FLSA fact sheets provide detailed guidance for each industry.

Non-compliance with FLSA requirements could result in penalties. Fines for violations include up to $10,000 and back pay to employees who weren’t fairly paid.

4. Avoiding Payroll Fraud

Payroll fraud is the malicious manipulation of a company’s payroll system. The following examples represent payroll fraud:

• Adding fake employees into the payroll system

• Reporting hours not worked

• Manipulating timesheets

• Adjusting payroll system pay rates

Any company could suffer from payroll fraud, regardless of size and sophistication. These activities can cost employers thousands of dollars in unearned wages.

Business owners can implement internal controls and automated systems to discourage dishonest employee behavior. Outsourcing your payroll solution to professionals can help your business avoid payroll fraud.

5. Maintaining Payroll Records and Tax Compliance

Employers must comply with various record-keeping rules and tax filings. 

The IRS generally requires businesses to maintain employment tax records and payroll data for at least four years. Employers should retain the following: 

• Company and employee information

• Tip and wage records

• Income tax withholding forms

• Tax returns

Small business owners can refer to IRS guidance for additional record-keeping rules. 

Employers file payroll tax returns to report employee wages and withholding amounts. The IRS requires annual reports (as well as quarterly, depending on the number of employees). Additionally, state withholding returns have varying due dates. 

Penalties for failure to submit withholding taxes could be up to 15% of the liability. The IRS also imposes interest and penalties for failure to file returns timely.

Your business can develop human resources policies to comply with tax reporting rules and prepare for audits. Avoid costly penalties by consulting tax professionals for help with tax preparation and filing. 

Get Expert Help to Avoid Payroll Penalties

Small business payroll challenges present the following potential pitfalls for new employers:

• Errors and oversights waste valuable time and risk penalties for incorrect tax filings.

• Failing to follow FLSA rules could require back pay of employee wages.

• Lenient internal controls encourage payroll fraud and dishonest employee behavior.

• Employers can face fines and penalties for failing to follow record-keeping and tax compliance rules.

You can avoid mistakes and navigate payroll challenges confidently with outsourced payroll services. The experts at 1-800Accountant can help your small business monitor tax regulations and meet filing deadlines. Professional tax preparation and filing services support your tax compliance year-round. 
Schedule a free consultation with 1-800Accountant for specialized help with payroll, business taxes, and bookkeeping.