Payroll compliance is the process of aligning a business’s payroll tasks with federal, state, and local regulations.
Federal, state, and local governments enact laws to ensure that employees get paid properly. Payroll laws also ensure that businesses withhold and pay payroll taxes correctly.
When a business isn’t compliant with payroll laws, several things can happen:
- Employees may not get paid correctly or fairly
- Employees may become dissatisfied with the company
- Businesses can run into legal troubles with employees or federal, state, or local governments
Payroll compliance can get tricky because there are several laws to consider to comply with federal, state, and local regulations. In this guide, I’ll break down the laws that govern payroll in the United States and common compliance issues businesses should proactively avoid.
Federal Payroll Compliance
The majority of payroll laws are made at the federal level, and even if you’ve been in business for a short time, you’ve likely heard of many of them.
The Fair Labor Standards Act (FLSA) oversees regulations regarding multiple aspects of paying employees, including the number of hours an employee can work, how to handle overtime pay, and child labor laws. Businesses look to the FLSA frequently for guidance on overtime pay, especially.
The FLSA also sets the minimum wage for the country—although states can set their own minimum wage as long as it is higher than the federal minimum wage—and recordkeeping laws for payroll.
Federal income tax is a percentage of an employee’s paycheck that goes toward their federal tax responsibility. Every employee required to pay federal income tax fits into a tax bracket that determines how much they pay from each check. For example, in 2024, the lowest earners are taxed at 10%, while the highest earning $609,350 or more get taxed at 37%.
Employers must also withhold Federal Insurance Contributions Act (FICA) tax from employee paychecks. This tax goes toward Social Security and Medicare funding. FICA equals 15.3% of an employee’s earnings, but the employee and employer each pay half. An employer’s responsibility is 1.45% for Medicare and 6.2% for Social Security.
The Federal Unemployment Tax Act (FUTA) is another payroll tax that only employers are responsible for. It goes toward the federal unemployment fund that eventually gets paid to states for their unemployment programs. Generally, employers pay 6% for FUTA tax, but only on the first $7,000 an employee earns.
Other federal payroll laws don’t directly influence pay as much as FLSA, income tax, FICA, and FUTA, but they are necessary for businesses to understand to ensure compliance.
The Equal Pay Act of 1963 was put into place to ensure that employees are paid fairly for their work regardless of their sex. To comply with this law, employers cannot discriminate against employees for their sex in terms of pay, employment, working conditions, opportunities for raises or advancement, etc.
Lilly Ledbetter Fair Pay Act of 2009 also assists employees in preventing pay discrimination from employers. This law broadens the amount of time an employee has to file a discrimination complaint, essentially allowing them to file a complaint even if they weren’t aware of the discrimination until much later after it initially began.
State Payroll Compliance
Employers must understand the laws in their operating state thoroughly, as new hire reporting is different in each state.
However, payroll laws also vary by state, so employers must follow the laws in the states in which their employees live, too. For example, a business operating in Alabama with employees in Florida needs to ensure that it complies with payroll laws in both states.
Paid time off (PTO) varies quite a bit from state to state. For example, Georgia doesn’t require employers to provide PTO. However, California gives employees the right to 24 hours or three days of paid sick time each year. Other states also require PTO in some form, like Connecticut, Maine, and Maryland.
PTO payouts also differ between states. For instance, Colorado bans employers from having a use-it-or-lose-it policy for PTO and requires PTO payouts upon an employee’s separation from the company. Meanwhile, several states, including Connecticut, Hawaii, and Kentucky, only require PTO payouts if the employer’s PTO policy requires it.
Minimum wage is another state-governed payroll law for businesses to comply with. This is the absolute minimum most employees have to make per hour. Each state can set its own minimum wage, like Montana’s $4.00/hour for companies not subject to FLSA or the District of Columbia’s $17.00/hour, the highest in the country.
Some states increase their minimum wage regularly, making it necessary for employers to monitor their state’s laws. Florida, for example, is increasing its minimum wage by $1 annually until reaching $15 in 2026.
Workers’ compensation is money paid to an employee who gets injured on the job.
Employers must also consider how workers’ compensation varies between states, typically among the types of employers required to provide workers’ comp insurance and how many employees a company needs to have before being required to provide it.
To illustrate, Florida requires construction companies with just one employee to carry workers’ comp, while non-construction companies with four or more employees need to carry it. Most companies in Illinois have to carry workers’ comp insurance with just one employee except for sole proprietors and agriculture businesses.
Workers’ comp usually applies to employers with remote employees as well. Employers providing workers’ comp for remote employees should align their policies with each state in which their employees live.
Local Payroll Compliance
Cities and municipalities can implement their own payroll taxes. Local payroll taxes are usually either charged to employees as an income tax or charged to employers.
These laws look much different across municipalities, which can make things complicated for companies with remote employees in several states and cities.
Let’s look at a few local payroll taxes to illustrate:
- The city of Seattle, Washington, charges a payroll tax to employers with payroll expenses of at least $8,511,281 or with at least one employee earning a minimum $182,385. The tax rate ranges from 0.7% to 2.4% of the company’s total payroll expenses, depending on the amount of its payroll expenses.
- Cleveland Heights, Ohio, charges a 2.25% income tax to employees rather than employers. The tax is imposed on most workers within Cleveland Heights.
- Denver, Colorado, imposes a payroll tax known as the Occupational Privilege Tax (OPT) on employers and employees working in city limits. Employees earning at least $500 per month pay $5.75 per month for OPT, while most employers are subject to an OPT charge of $4 per month.
Common Payroll Compliance Issues
Not Adhering to the Equal Pay Act
Although the Equal Pay Act has now been around for decades, companies still face compliance issues surrounding equal pay for all.
Employers should base pay on a person’s credentials rather than whether they’re a man or a woman, as described by the Equal Pay Act. However, according to the Pew Research Center, the average American woman earns 82 cents per dollar the average American man makes.
To ensure that pay issues negating the Equal Pay Act don’t arise, companies should conduct regular pay audits. Run an annual pay audit to catch salary disparities among employees and update salary bands to match or exceed market midpoints.
Misclassifying Independent Contractors
The FLSA lays ground rules for who can and can’t be considered an employee. This is to prevent companies from classifying employees as independent contractors paid with a 1099 rather than a W-2 to avoid paying taxes or benefits.
For example, say a company wants to hire a tech support specialist for a set schedule, 40 hours a week. However, the company pays this employee with a 1099 as a contractor, so the employee is responsible for paying their own taxes, and the company skirts the responsibility of paying the sick leave and health insurance benefits its W-2 employees get.
Misclassifying employees as independent contractors violates FLSA and could lead to penalty-inducing wage claims. Companies can also be subject to numerous state and federal penalties regarding the unpaid taxes and benefits they’re responsible for.
Businesses should become familiar with the definition of an independent contractor by referring to IRS common law rules and the FLSA’s explanation of independent contractor status.
Also, businesses must have a clear process for determining classification written into their policies and, if possible, use a third-party workforce management service to classify employees during onboarding.
Miscalculating Pay, Overtime, or Taxes
Mistakes happen, but when they occur in pay, overtime, or tax calculations, businesses may end up in a costly compliance battle. It’s more common for smaller companies not using payroll services to make these mistakes, as a simple error in miscalculating pay for one employee can lead to other miscalculations in their overtime, benefits, and taxes.
Therefore, a payroll service is the best line of defense against small mistakes in pay calculations that can snowball into major compliance issues. Also, an accounting professional or team should review all tax forms before submitting them.
Not Keeping Accurate Records
The FLSA requires employers covered by the law to maintain updated payroll records of all non-exempt workers for at least three years, either stored at the business or a records office. Also, employers are required to keep other records, like wage rate sheets and time cards, for at least two years.
States and other jurisdictions can also set their own requirements for maintaining records, with laws potentially varying by agency. For example, Ohio requires employers to hold employee records for three years but also to maintain specific records of payroll expenditures for at least five years for the state’s workers’ comp agency to review.
Because these laws vary by jurisdiction, holding records for at least seven years is a good rule of thumb for most companies.
Key Takeaways
Payroll compliance takes work. Staying current with the many federal, state, and local compliance laws is challenging. But it’s necessary to keep your business running smoothly, maintain employee satisfaction, and prevent costly mistakes.
Look for a high-quality, reliable payroll service to get your payroll in order and help your business comply with everything from employee working hours to employee classification.
