How to set up payroll systems and ensure compliance?

The penalties for late payment of payroll taxes can be as high as 15%. For early-stage startups, where payroll often takes up a significant part of your budget, this can hit hard and makes up for over 40% of the funding. If payroll laws are intentionally broken, criminal charges are possible, not just fines. This risks damaging trust with your team and making it harder to hire since people are wary of employers with a poor track record on pay.

Overtime Violations Penality: Back Pay +Penalties	High
Late Payroll Taxes Penalty :15%	High
Recordkeeping violations Penality :Variable	Medium
Wage Discrimination Penality: Legal Action	High

Key steps in setting up a tax-compliant payroll system

The process of setting up your payroll systems begins at inception when you apply for an employer identification number (EIN) with the Internal Revenue Service (IRS). This is a federal tax ID required by all entities that have employees and must pay employment tax. This ID is also needed when your organization must pay excise, alcohol, tobacco, or firearm taxes. Even if your company only employs non-resident aliens, you might still require an EIN.

Assuming that your organization has fulfilled this basic requirement, establishing a robust system would involve the following steps:

• Classify your workforce – When you correctly classify your workforce into employees and independent contractors, it will be easier for you to calculate overall tax withholding and filing relevant forms such as Form W-2, Form W-4, and Form 1099-NEC.
• Assist your employees in completing their Form W-4 – While it is not mandatory to file Form W-4 (Employee’s Withholding Certificate), it does help you calculate the amount of federal tax to be withheld from your employees’ income.
• Build a database of benefits availed by each employee – Your company can unlock certain tax benefits based on the health and retirement benefits provided to its employees. So, a database of employee benefits will help you make accurate deductions and claim the right amount as tax credit.
• Choose a payroll schedule as per state laws – In most US states, a monthly pay frequency is permitted. However, certain states prescribe certain pay frequencies. For example, in Arkansas, employees must be paid at least twice a month. So, you must refer to state laws before choosing a payroll schedule.
• Maintain accurate records – Under the Fair Labor Standards Act (FLSA), employers must record details such as their employees’ personal information, hours worked, hourly pay rate, overtime earnings, deductions from wages, additions to wages, total wages paid in each pay period, and date of payment. In some states, you might need to comply with stricter recordkeeping requirements than those prescribed in FLSA.

Key aspects of payroll regulation compliance

To ensure payroll tax compliance, you must be mindful of the following seven key laws and regulations.

Withholding federal income tax

Employers are required to withhold a portion of their employees’ income and transfer the same as federal income tax to the Internal Revenue Service (IRS). You could withhold the federal income tax manually or through automated processes. The IRS recommends percentage and wage bracket methods for calculating federal income tax withholding amounts. You can also use alternative methods such as annualized wages, average estimated wages, cumulative wages, past-year employment, and term of continuous employment.

In case of employees who are non-resident aliens, you are required to follow a modified procedure for calculating federal income tax withholding.

Two key resources in these calculations are your employees’ Form W-4 and the IRS’s tax withholding estimator.

Fair Labor Standards Act (FLSA)

Earlier in this article, we discussed the recordkeeping requirements of the Fair Labor Standards Act (FLSA). This act also establishes standards for minimum wages and child labor for all full-time and part-time workers in the private as well as public sectors. The scope of this act also extends to the prohibition of retaliation against employees who filed complaints and safety standards.

For instance, manufacturing certain items that involve potentially hazardous processes cannot be conducted at an employee’s home.

The act also has important provisions for making workplaces safer and more accessible for mothers who are still nursing their children.
This act also establishes the minimum age for various types of farm and non-farm jobs.

Equal Pay Act (EPA)

Under the Equal Pay Act of 1963, any form of sex-based wage discrimination is prohibited. In addition to wages and salaries, the act also covers life insurance, bonuses, vacation and holiday pay, hotel accommodations, travel expense reimbursements, and retirement benefits. If people performing substantially the same duties are earning different wages, employers must increase wages to equalize pay. However, employers are not allowed to reduce wages to equalize pay.

Under this act, wage disparity exists when people of different sexes are paid differently for performing work that requires equal skill, effort, and responsibility, under similar working conditions and within the same establishment.

Federal Unemployment Tax Act (FUTA)

Under the Federal Unemployment Tax Act (FUTA), an employer must pay an unemployment tax of 6% of the first $7,000 paid to each employee annually. Let us explore how you can comply with this act through an example.

Here, we will calculate the tax liability for a company that went through significant attrition in the last year. As a result, 20% of its workers received less than $7,000 in the last year.

Particulars	Amount
Number of employees	500
Employees with a minimum annual wage of $7,000	400
Taxable wages per applicable employee	$7,000
Total taxable wages	$2,800,000
Tax rate	6%
Total unemployment tax	$168,000

In some states, you might need to pay a State Unemployment Tax. In such cases, you can receive a tax credit on federal unemployment tax of up to 5.4%, effectively reducing the FUTA rate to 0.6%.

Federal Insurance Contributions Act (FICA)

Under the Federal Insurance Contributions Act (FICA), employers as well as employees are required to pay Social Security taxes and Medicare taxes. In 2024, these taxes will help fund the retirement, disability, and survivorship benefits of about 5.8 million people. Since these taxes are paid equally, the applicable tax rates are as follows:

• Social Security tax –  6.2% for employees as well as employers with an applicable wage base limit of $176,100 in 2025
• Medicare tax – 1.45% for employees as well as employers
• Additional Medicare tax – 0.9% to be withheld by the employer for employees who are paid more than $200,000 in a year and certain other employees

For an employee who earns more than $176,100, the Social Security tax will be calculated using the wage base limit of $176,100 and not their entire annual income.

Davis-Bacon Act

If your company undertakes public contracts, you must familiarize yourself with the minimum wage and overtime pay requirements of the Davis-Bacon Act.

This act secures a minimum wage rate for workers involved in federally funded or assisted construction, alteration, and repair of public buildings or public works. It applies to contracts in excess of $2,000. In any such contract, the contractors and subcontractors must pay their laborers and mechanics the locally prevailing wages and fringe benefits for similar projects in the same area.

Furthermore, in similar contracts exceeding $100,000, the contractors and subcontractors must pay their laborers, mechanics, guards, and watchmen 1.5 times their regular rate for each hour worked beyond 40 hours in a workweek.

State laws

In addition to the federal payroll-related laws, you must also comply with state laws. Earlier in the article, we discussed the state-specific requirements for pay frequency. These laws also govern payroll aspects such as minimum wage, prevailing wage, child labor, paid rest periods, and meal periods.

In states where there is no provision for minimum wage, the federal minimum wage of $7.25 per hour is applicable. However, in certain states, you must pay a higher minimum wage. For instance, in California and New York, a minimum hourly wage rate of $16.50 is applicable. Unless a state specifies overtime pay rates, the overtime wage rate must be 1.5 times the employee’s regular rate.

Once again, you must familiarize yourself with your state’s contract value thresholds beyond which prevailing wage is mandatory. Presently, 26 states have prevailing wage laws. For instance, in California and Rhode Island, the prevailing wage law applies to contracts exceeding $1,000.

Eqvista – Compliance through accuracy!

An often-underestimated aspect of income tax compliance is 409A valuations. Due to the complex nature of stock-based compensation and its history in America, employees must pay the tax underpayment penalties. However, the onus to perform a valuation that complies with Section 409A of the Internal Revenue Code (IRC) falls on the employer.

Due to this disconnect between responsibility and liability, employees are likely to sue their employer for negligence if they are penalized for non-compliance with Section 409A.

To avoid straining your relationship with employees and protect your reputation, you must hire a reliable 409A valuation provider, such as Eqvista. Our team has consistently delivered audit-ready 409A valuations to small and established companies for the last seven years.

Get unlimited 409A valuations starting at just $990 per year. Contact us to place an order now!