The 5 Most Expensive Payroll Errors—and How to Avoid Them

According to the IRS, 40% of small to mid-sized businesses face IRS penalties related to incorrect payroll filing. Here are the top five payroll mistakes leading to penalties and how to avoid them.

This post was authored by Deanna deBara for our friends at Gusto, a full-service online payroll platform that seamlessly integrates with Shopify.

According to the IRS, 40% of small to mid-sized businesses face IRS penalties related to incorrect payroll filing. And those penalties translate to huge numbers; according to the American Payroll Association, over 5 million employers paid a whopping $7 billion in civil penalties to the IRS in 2017 alone.

And retail businesses certainly aren’t immune to the consequences of payroll errors. As a retailer, chances are, you employ both part-time and full-time employees—and, if you’re a larger business, you may employ workers in a variety of locations. That’s a lot of opportunities for common payroll errors to happen—and a lot of opportunities for you to find yourself facing penalties for those payroll errors.

But what, exactly, are the most common mistakes that happen during the payroll process? What are the consequences? And, most importantly, how can you avoid those payroll mistakes (and the pricey penalties that go along with them)?

The 5 most expensive retail payroll mistakes (and how to avoid them)

Payroll mistake #1: Depositing employment taxes late

Penalty: Up to15% of taxes due for deposits still unpaid more than 10 days after the date of the first notice

When you’re managing a retail business—on or offline—chances are, you’re paying employees different amounts at different times. For example, if you run a brick and mortar business, you might have a part-time cashier who works a few shifts a week and a manager who works full time with benefits.

Or, if you manage a Shopify store, you might have a team of support staff who work a few shifts a week managing support tickets, an inbound marketing manager who works 20 hours a week generating new leads, and an e-commerce manager who works full time in your corporate office running your shop’s operations. With so many different pay structures, it can be hard to keep up with what taxes need to be paid, for who, and when.

But unless you want to find yourself dealing with some pretty intense payroll tax penalties, you’re definitely going to want to stay on top of when your payments are due.

As an employer, you’re required to deposit employment taxes, including federal income tax withheld and FICA tax, both on the employer and employee side, on a regular schedule (either monthly or semi-weekly)—and if you fail to make those deposits on time, you could find yourself facing hefty payroll tax penalties that increase based on how late you file.

How to avoid it:

If you want to avoid paying penalties for late filing, it’s important to be crystal clear on employment tax due dates (and put those due dates on your calendar!).

If you make deposits on a monthly schedule, you would deposit employment taxes by the 15th of the following month. If you make deposits on a semi-weekly schedule, you would deposit employment taxes for payments made Wednesday through Friday by the following Wednesday, and taxes for payments made Saturday through Tuesday by the following Friday.

If you do end up filing late, there are two exceptions that could help you avoid a penalty. According to the IRS, “the law allows the IRS to remove the deposit penalty if: (1) the penalty applies to the first required deposit after a required change to your frequency of deposits, and (2) you file your employment tax returns by the due date.” 

Payroll mistake #2: Mis-classifying employees and contractors

Penalty for classifying a non-exempt employee as exempt: 100% of unpaid overtime owed to the employee dating back three years from the employee claim

Penalty for classifying an employee as an independent contractor: 1.5% of all wages paid to the employee, $50 fine for failure to file Form W-2, 40% of employee FICA taxes, and 100% of employer FICA taxes

Penalty if the misclassification is determined to be intentional: Up to 20% of all wages paid to the employee, 100% of employee and employer FICA taxes, and criminal penalties of up to $1,000 and/or one year in prison

When you’re hiring your team, the way each team member is classified will depend, in large part, on their job duties and structure. For example, if you hire a freelance graphic designer for a short-term project, like helping you redesign your logo for your store, they’d be considered an independent contractor.

If you hire an hourly employee to work the sales floor a few shifts a week, they’d be considered non-exempt. And if you hire a VP of Marketing to work in your corporate office on a salary basis, they’d be considered exempt.

Those classifications play a huge role in how both you, the employer, and they, the employee, are taxed—and if you misclassify an employee as a contractor or a non-exempt employee as exempt, it could lead to HUGE (and expensive) issues down the road.

How to avoid it:

Misclassifying employees can end up being one of the most costly payroll mistakes a retail business can make—so it’s important to make sure you understand each classification and classify every person you hire correctly straight out of the gate.

As the name suggests, independent contractors have more independence than employees. According to the IRS definition, “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.”

Classifying an employee as exempt or non-exempt will depend on their role, job duties, and responsibilities. Generally (but not always), salaried employees are considered exempt—while hourly workers are non-exempt. Non-exempt employees are protected under the Fair Labor Standards Act (FLSA) and entitled to overtime pay, while exempt employees are not.

Payroll mistake #3: Processing payroll using the wrong state

Penalty: Varies

If you run a larger retail business, you might have a corporate office or flagship store that’s based in one state—but also have retail operations (and employees) in other states. If you run an e-commerce operation, you might have employers and contractors scattered across the country—but all putting in work on your Shopify store.

Every state has different wage laws and rules—and, as an employer, you’re required to abide by the laws and rules for the state where your employee works, not the state where your company is based.

So, for example, let’s say your e-commerce operation is based in Detroit—but you just hired a few full-time customer service representatives in Seattle. Michigan and Washington have different minimum wage laws—and while you might pay your Detroit-based CSRs $10 per hour (which is fine, since minimum wage in Michigan is $9.65 per hour), in order to comply with the state of Washington’s minimum wage laws, you’d have to pay your Seattle team at least $13.50 per hour.

How to avoid it: 

If you have employees that work in different states, keep accurate payroll records and organize your files based on state. Because bottom line? If you’re calculating your employee’s wages and withholdings based on the state where your business is based (and not the state where the worker is actively employed), it could lead to wage inaccuracies—which, in turn, could lead to serious penalties.

For example, if you underpay an employee based on their state’s minimum wage laws, you would be on the hook for any and all back pay owed to that employee. And if your withholdings were incorrect and you didn’t pay accurate taxes, you could also be on the hook to the IRS for penalties and interest.

Payroll mistake #4: Miscalculating or failing to pay overtime

Penalty: 100% of overtime pay owed, civil penalties of up to $1,000 per violation, and any additional state penalties

In retail, shifts typically last between four and eight hours—and chances are, you’re being careful to keep your overtime costs down by scheduling your non-exempt employees for 40 hours per week or less. 

But if there is a situation where a non-exempt employee works more than 40 hours per week (for example, an employee stuck around for a few hours after their shift to help the manager stock new merchandise), it’s important to make sure those hours are properly documented—and the employee is being compensated accordingly.

As mentioned earlier, non-exempt employees are protected under the FLSA and entitled to overtime pay. According to the Department of Labor, “unless exempt, employees covered by the Act must receive overtime pay for hours worked over 40 in a workweek at a rate not less than time and one-half their regular rates of pay.”

There’s also no cap on overtime hours for non-exempt employees; if they work over 40 hours, you’re legally required to provide overtime pay for every one of those hours. In addition, many states have their own overtime rules—and if your state falls under that category, you’ll need to provide overtime compensation that aligns with any applicable state laws.

If you don’t pay overtime wages to your employee for the pay period those overtime hours were worked, they can file a complaint with the Department of Labor—and not only will you have to pay those overtime wages, but you could also face a $1,000 civil penalty (plus any additional penalties brought by the state).

How to avoid it:

If you don’t want to pay for overtime, it’s important to schedule accordingly and make sure that no employees work past their scheduled shift times. It’s also important to keep meticulous time records so you know exactly when your employees clocked in and out, how many hours they worked in a given week, and whether you’ll need to process overtime pay each pay period.

Payroll mistake #5: Keeping inaccurate, incomplete, or disorganized records

Penalty: Varies

In an ideal world, your retail business will never have to deal with the dreaded “A” word—audit. But if you do find yourself facing an audit from the IRS, it’s imperative that you have accurate, complete, and organized payroll records. Otherwise, you could find yourself facing a variety of fines, penalties, and other tax or payroll-related issues.

So, for example, let’s say you find yourself audited by the IRS—and when they’re going through your records, they realize that you didn’t complete or file W-2’s for a batch of seasonal employees you hired for extra support in one of your stores. Depending on how late you are in filing those W-2’s, you’ll pay between $50 to $260 in fines for each W-2. Multiply that by 10 employees, and you’re looking at a tax penalty of between $500 and $2,600.

Or let’s say you failed to send 1099s to a group of freelance writers you hired to write product descriptions for your Shopify store. The minimum IRS penalty for failing to provide 1099s to contractors is $250—so if you failed to send 1099s to 10 contractors, you’re looking at a fine of $2,500.

How to avoid it:

It’s important that you keep accurate, complete, and up-to-date payroll records for all of your employees, including W-2s, time sheets, and pay records. And don’t think you can just toss your records in the trash once an employee leaves; the IRS requires you to keep most employee and payroll records for at least four years—and the Small Business Administration (SBA) recommends keeping all payroll records for six years (since some states have different requirements). 

Keeping meticulous employee and payroll records might feel like a pain in the moment—but if the IRS comes knocking for an audit, you (and your business bank account!) will be grateful you did.

Payroll best practices to prevent penalties

No business wants to spend their hard-earned revenue on payroll penalties. And luckily, there are a set of best practices to implement in your payroll process that can help you avoid payroll mistakes (and the penalties that go with them):

• Run reports in advance. The more time you give yourself to manage your payroll, the more time you have to identify and correct any errors. Running reports well in advance (and not the day before you run payroll) will give you the time you need to review for mistakes—and fix those mistakes if necessary.
• Budget for tax payments. Employment taxes are due on a regular schedule. You know you’re going to have to pay them—and budgeting for them will ensure that you have the funds available to make your deposits when they’re due (and avoid any late penalties in the process).
• Make a payroll checklist. There are a lot of to-do’s when it comes to running payroll. Creating a checklist that outlines all your payroll-related tasks and when they need to be completed can help you stay on track. To make sure you check each to-do off your list, you can add your payroll checklist items to your calendar and set an alarm to remind you to get things done.
• Automate your payroll system. When you process payroll manually, you’re leaving a lot of room for human error. By automating your payroll process—rather than trying to tackle things like withholdings, overtime, and PTO yourself—you take the human out of the equation and significantly lower your chances of making a costly payroll error.
• Deal with any payroll errors immediately. No matter how on top of your payroll game you are, mistakes can happen. But if you notice a payroll mistake, the key is to deal with it immediately. The sooner you recognize and correct any payroll errors, the less likely you are to pay increasing interest and fines. If you can prove it was an administrative oversight (and not an intentional act), you may even be able to get your penalty waived. So, when it comes to payroll errors, the sooner you face and deal with them, the better.

Payroll errors FAQ

What are common payroll errors?

• Incorrect pay rate calculations
• Failure to comply with wage and hour laws
• Late processing of payroll
• Inaccurate withholdings
• Inaccurate payroll deductions
• Incorrect time tracking
• Failing to pay overtime
• Misclassifying employees as independent contractors
• Failing to provide required benefits
• Misclassifying exempt and non-exempt employees

What happens if payroll is wrong?

If payroll is wrong, the employee should be notified immediately of the error and the employer should correct the error as soon as possible. Depending on the nature of the error, the employer may need to consult with an accountant or lawyer to ensure they are properly correcting the issue and meeting all legal requirements. In some cases, the employer may need to issue additional payments to the employee to make up for the error.

How do you fix payroll errors?

• Review all payroll records and documents: Review all payroll records and documents, such as time sheets, pay stubs, and wage statements, to determine the cause of the error.
• Correct the error: Depending on the type of error, it may be necessary to make corrections to an employee’s earnings, deductions, or taxes.
• Notify the employee: Once the error has been corrected, it is important to notify the affected employee right away.
• Document the error: Finally, be sure to document the error and the steps taken to fix it in the event of any future issues.

How long do you have to correct a payroll error?

This depends on the laws in the state where the payroll error occurred. However, generally, employers must correct the error as soon as possible and must report any corrections to employees within the same pay period.