An Accountant’s Advice on How to Avoid Common Payroll Tax Mistakes

efore Sharrin Fuller became an accountant, she was a beauty salon owner in Las Vegas, Nevada. At the time, she didn't have the resources to outsource her bookkeeping and accounting, so she started doing it herself. 

“I loved doing the books for my salon so much, and it came easy to me. Then I had other business owners asking me to help them.” Sharrin admits, “Becoming an advisor to other businesses was never something I had envisioned for myself.”

Realizing how confusing it can be for small business owners to hire employees, onboard them, manage their payroll and comply with the law, Sharrin made the leap from owning a salon to opening up her own bookkeeping and accounting firm. 

“I have learned dozens of important lessons on what works and what doesn’t. I’ve figured out ways to make hiring and payroll for small businesses painless…okay, almost painless!” 

Today, Sharrin is not only an accountant and business coach, she’s also a member of ADP’s Accountant Advisory Board, where she helps ADP improve its payroll products for small business owners.

We asked Sharrin for a few pro tips on how to comply with payroll tax rules. In this article, we will give you Sharrin’s expert tips on how to avoid four of the biggest mistakes she sees businesses make when it comes to payroll tax: improperly classifying new hires, not gathering employee documents, not filing the correct payroll tax forms and not reporting withholdings.

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Mistake 1: Improperly classifying new hires

A critical error Sharrin has seen is small business owners not classifying employees correctly. Everyone you hire must be classified as either an employee or an independent contractor.

“While you’re not liable for any employment taxes on payments made to independent contractors, you need to make sure that their duties align with the IRS’ definition of an independent contractor.”

According to the IRS, “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. If you are an independent contractor, then you are self-employed.” Independent contractors pay self-employment tax on their net earnings from the profits of their business activities.

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If you are still unsure about your employees classification, Sharrin says, “There are several tests the IRS uses that you can use to self assess.”

Among the factors the IRS assesses:

• Continuity of relationship: Is there an ongoing employment relationship?
• Flexibility of schedule: Are the employees’ hours dictated by the company?
• Demands for full-time work: Is the employee full-time? 
• Need for on-site services: Is the job performed on company premises?

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If you determine that your workers are contractors and not employees, Sharrin points out that there are still filing obligations you must meet. 

“If your total payments to a self-employed individual are $600 or more, you are required to file an annual information return, or Form 1099-NEC, to report the payments to the worker and to the IRS.” 

Sharrin also has a reminder for small businesses whose contractors may not live in the same state. “Depending where a contractor is geographically based, they may owe taxes at the state and local levels as well, so it’s their obligation to know what taxes they owe.”

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Mistake 2: Not gathering employee documents 

There are two documents your new employees will need to fill out, the I-9 and W-4.

Form I-9 is used for employment eligibility verification. It’s used to confirm an employee's identity and eligibility to work in the United States. 

Form W-4 determines how much of the employee’s taxable wage should be withheld to pay federal taxes. If an employee does not provide a W-4, then you are obligated to withhold as if the employee were single with no other adjustments.

Sharrin also recommends asking eligible employees to complete Form 8850, which will help you determine if your new hire entitles you to a work opportunity tax credit. As she has taught many of her clients, the tax credits can be worth up to $9,600 per employee.

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Mistake 3: Not filing the correct payroll tax forms

As an employer, you must file the following payroll tax forms:

• Form 940: To report your annual FUTA or Federal Unemployment Tax 
• Form 941: To report tax withholding including the employer's share of FICA (Federal Insurance Contributions Act) tax
• Form 943: For employers with agricultural employees
• Form 944: For small employers eligible to pay employment taxes annually rather than quarterly
• Form 945: To report withheld tax from non-payroll payments, including pension distributions
  

As Sharrin points out, “The IRS is not a business owners’ friend. They are there to make sure businesses pay their fair share of taxes. As such, failure to file payroll taxes can result in fines and penalties. To top it all off, the IRS can also charge you interest on the penalties! The monetary obligations can really add up if you aren’t careful.” 

According to the IRS, “The Failure to File Penalty on your income taxes is 5% of the unpaid taxes for each month or part of a month that a tax return is late. The penalty won't exceed 25% of your unpaid taxes.”

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Penalties for Late Payroll Tax Deposits

The following table from the IRS shows the penalties for not depositing payroll tax payments by the correct due date. 

Mistake 4: Not reporting withholdings

From every paycheck, you will need to withhold the proper amount to cover employees’:

• income taxes, both federally and locally
• share of Social Security
• share of Medicare taxes (FICA) 
• state and federal unemployment texas 
• disability insurance (in some states)

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Form W-2 is used to report withholdings to employees, and Form W-3 is for the Social Security Administration. Employees need a copy of their W-2 by January 31 of each year. An additional copy, along with a W-3 summary, is due to the IRS by February 29. If you can e-file, the deadline is April 2.

“Employers must file returns by these specific deadlines. Most employers' returns are filed annually, however, the employer's federal return is filed quarterly. States also have their own filing schedules for their returns. I highly advise checking with your state tax department to make sure you stay in compliance,” says Sharrin. 

She also reminds business owners about penalties for late filings. In 2023, the IRS penalties are:

• $60 per Form W-2 if you correctly file within 30 days of the due date
• $120 per Form W-2 if you correctly file more than 30 days after the due date but by August 1
• $310 per Form W-2 if you file after August 1, don’t file corrections, or don’t file required Forms W-2
• $580 per Form W-2 if you intentionally neglect to file

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Takeaways 

“There are a lot of moving parts when it comes to setting up payroll,” says Sharrin. “Whatever you do, keep all of your records for at least three to seven years in case you are audited!”

Sharrin reminds small business owners that IRS rules in regards to payroll taxes are continually changing, so it can be beneficial to outsource your taxes to make sure you are staying compliant. “Failure to do so can create headaches and expenses in terms of late payment and payroll tax penalties, which no business owner wants to handle!”

It’s important to note that regulations and requirements can vary by jurisdiction, so we recommend consulting with a qualified tax professional or referencing the official IRS guidelines for the most accurate and current information.

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