Protect Your Business From Common Payroll Tax Compliance Errors

Federal employment laws and payroll tax requirements are complicated and easily misunderstood. Mistakes can lead to penalties, interest, and even unexpected tax assessments. To minimize the risk for your business, it's important to understand the rules, but it's even more important to know how to avoid common errors.

Here are the top payroll tax compliance errors, with tips on how to avoid mistakes and stay on the right side of the law.

Table of contents – biggest payroll compliance mistakes

1. Misclassifying employees

The US Department of Labor has strict rules on which workers qualify as employees and which are independent contractors. When you hire an employee, you must withhold taxes from their pay and remit the taxes to the state. In contrast, with an independent contractor, you just give them a payment, and you don't have to withhold any tax (unless they're subject to back-up withholding on a 1099, which is rare).

Some employers mistakenly classify employees as contractors so they can avoid paying taxes and dealing with returns. But this compliance error can be extremely risky as it may expose you to back taxes, misclassification penalties, and interest.

If a worker complains that they've been misclassified, the IRS may review the situation, and if the agency agrees with the worker, you'll face a tax bill. You'll be responsible for the matching portion of any FICA taxes that you should have withheld from the worker's pay, and the IRS will also add penalties and interest to those amounts.

Misclassification doesn't always start with worker complaints – the IRS may also start an investigation. For instance, if you're in an industry that generally hires employees but you claim a large deduction for contract labor and don't report any payroll wages, the IRS may decide to audit your returns and look more closely at the relationship you have with your employees.

2. Not following FSLA overtime rules.

Another common payroll compliance mistake is not following the FLSA overtime rules. The Fair Labor Standards Act requires you to pay minimum wage to employees and to pay time-and-a-half when employees work more than 40 hours per week. There are special rules for qualifying healthcare workers and fire protection/law enforcement who work for very small organizations.

Failing to pay the right rate can subject you to civil penalties and even criminal exposure in some cases. Additionally, several states have overtime laws that supersede the federal law. For example, in California, you must pay employees time and a half if they work more than eight hours in a day.

3. Miscalculating payroll taxes

When you pay employees, it's up to you to calculate FICA and income taxes. You must calculate the correct amounts, or you may face personal liability for employee taxes that weren't withheld properly.

FICA tax calculations are based on federal law – as of 2025, you withhold 6.2% of employee wages up to $176,100 for Social Security, and you make a matching payment. For Medicare, you withhold 1.45% of all wages, and you make a matching payment. You should also withhold an additional 0.9% of wages that exceed $200,000 for a single filer or $250,000 for a married filing jointly filer, but you don't have to make a matching payment for that.

To calculate income tax, you use the information provided by your employee on their W-4 form. You are legally required to provide this form to all employees. They note their filing status, number of dependents, and information about other jobs or incomes. Those details help you determine how much income tax to withhold from their paychecks.

Employees can also claim an exemption on their W-4, and that can also lead to payroll tax issues.

4. Mistakes with exemptions

If your employee notes that they're exempt from taxes on their W-4, you don't have to follow up on that. If they mislead you, they'll simply face a tax bill and penalties at the end of the year.

However, if the IRS catches the error, they may send you a lock-in letter. That tells you how much you should withhold in tax, and if you don't comply with the letter, you will face penalties and potentially even be held responsible for the unpaid income tax.

5. Making late payroll tax deposits

Late payroll deposits lead to Failure-to-Deposit (FTD) penalties, but even worse, the FTD alert system may assign a revenue officer to your account to take a closer look into the matter. They may show up at your business unannounced or send a letter asking for a meeting.

Once they connect with you, they'll review the situation to see why you're not in compliance. At that point, you may catch up on your returns and payments (either by paying in full or by setting up a monthly payment plan), but if you don't comply, the agent may take matters into their own hands and start the Trust Fund Recovery Penalty assessment process.

The TFRP is worth 100% of the trust fund portion of unpaid payroll taxes – for example, if you owe $50,000 in FICA and income tax withheld from employee paychecks and $30,000 in matching FICA payments, the TFRP will be $50,000. The IRS may assess this penalty against any responsible individual in your company – that includes owners, shareholders, or even employees who handle finances or make decisions about paying payroll taxes.

To narrow in on a responsible person, the IRS schedules interviews with your team. Then, they may assess the penalty against one or more people. If you're facing a potential TFRP assessment, make sure you appeal by the date on the notice of deficiency, or you may lose your chance.

If the penalty is assessed against multiple people, they are jointly and severally liable. That means if one person pays the full penalty, the others are off the hook with the IRS; however, that individual may file suit in civil court to recoup the funds from the other parties. It also means that the IRS can go after one or more people for the full penalty – for instance, if the IRS assesses this penalty against five shareholders but only two have assets, the IRS may just pursue those two to get the funds.

Additionally, if the IRS agrees to accept a settlement on a TFRP from one taxpayer, they can still try to collect the remaining amount from any other responsible people.

6. Not filing payroll returns correctly

Most businesses make payroll deposits on a monthly or semi-weekly schedule, and then, they file Form 941 payroll returns quarterly – there are other returns for annual filers or farmers/fishers.

Even if you've made timely deposits, you still need to ensure that you file your payroll returns correctly. Mistakes can lead to incorrect tax liabilities and increase the chance of an audit.

7. Misunderstanding tax on tips

The tax code requires you to report all tips -- many restaurateurs may believe that you only need to report credit card tips, but to be compliant with payroll requirements, you should report all tips. The tips are part of your employees' wages and are subject to FICA taxes and income taxes (based on their filing status and total income).

Business owners can claim a credit for their portion of FICA payments related to tips, but keep in mind that you cannot claim a credit on any tips used to get your employees' hourly wage up to the federal minimum wage of $7.25. For instance, say your employee earns $5 per hour and gets $10 in tips, and you pay them $15. You can claim the FICA credit only for the portion of the tip that exceeded the minimum wage ($7.75 in this case). In contrast, say they earn $10 per hour and receive a $10 tip. Then, you can claim the credit for the FICA taxes paid on the full $10 tip, as they already earn over the federal minimum wage.

To claim the credit, attach Form 8846 to your return. Then, note the numbers from that form on the K-1 form if you're a partnership or an S-corp, or Form 3800 for all other businesses. The credit does not directly reduce your tax due – rather, it reduces your taxable business income. If you can't use it this year, you can roll it back one year or forward up to 20 years.

As of 2025 and until 2028 (unless extended), some tips are not subject to income tax. However, this does not really affect business owners. Employers must still report and pay FICA taxes on tips. When tipped workers file their tax returns, they can claim a deduction worth up to $25,000, and that prevents them from paying income tax on their tips. The deduction starts to phase out if you have more than $150,000 in income for a single filer or more than $300,000 in income for a married filer.

8. Not looking into state payroll requirements

If your state has income tax, you must withhold state income tax from your employees' paychecks and remit it to the state. Most states also require you to file unemployment returns. And you may also have to meet other state requirements for withholding and paying certain taxes – for example, taxes related to state family leave requirements.

Most employers have to deal with at least two or three different types of state returns related to employees. But on top of that, you also have to understand the labor laws in your state. Your state may have minimum wage, sick pay, or other requirements that supersede federal law – you need to be aware of the rules in your state if you want to be compliant and avoid penalties or possible criminal exposure.

Also, most states' tax codes allow their revenue departments to hold business owners or other responsible parties personally liable for unpaid state business taxes.

9. Not responding to IRS requests for more info

The IRS or the state may contact you about unpaid payroll taxes or late deposits. Make sure you respond to them promptly – all tax agencies use strict deadlines that, if not followed, can lead to penalties, unwanted tax assessments, or collection actions like liens or asset seizure.

10. Working with generalists when they need help.

If you're dealing with a payroll compliance issue for your business, you don't need a generalist. You need a tax pro who has dedicated experience dealing with business tax problems, unpaid payroll taxes, late deposits, unfiled payroll returns, and trust fund recovery issues. In some cases, you may need someone who has experience with the tax code in your state.

The big tax relief companies do not have the experience you need – most of these firms are staffed primarily by salespeople and a few overworked, underexperienced tax pros. Instead, you need a small firm with dedicated experience that gives you a direct connection to the tax pro working your case.

But how do you find the right firm? That's where TaxCure comes into play. Using our proprietary software, you can easily search for tax pros based on their experience and location. Then, you can read reviews until you find the best fit for your needs. Don't wait – start your search below now.