How to Pay Employees in Cash Legally & Avoid Penalties

Cody Cromwell
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Calculate & Withhold Payroll Taxes & Deductions Correctly

Pay Your Payroll Taxes

Since payroll taxes are the most common federal employment taxes, they make up the majority of the tax that employers must pay. However, some payroll taxes are not due until the end of the year, like the FUTA tax, meaning that you will owe one set of payroll taxes but be able to take a deduction for another set.

There are two federal employment taxes that apply to every business that employs one or more workers. They are the FICA tax (contribution to Medicare and Social Security) and the FUTA tax (contribution to unemployment insurance). FICA taxes and FUTA taxes are the only employment taxes that must be paid in cash; employers must pay payroll taxes using cash or a cash equivalent method like a check or money order from an IRS-authorized tax payer.

One of the few exceptions to this rule is if your business is an S-corporation or an LLC. S-corporations and LLCs are taxed not as personal service corporations but as pass-through entities for income tax purposes. They do not pay FICA taxes because the contributions to Medicare and Social Security are collected from employees as a part of their paychecks and paid to the government on their behalf.

However, when they are self-employed, employees are responsible for the payment of their own Social Security and Medicare taxes. Employers are responsible for FICA taxes and, in accordance with 26 U.S.

Be Diligent About Tracking Work Hours

Pay Employees on a Regular Schedule

In the United States, employees – whether full- or part-time – receive their pay on a regular pay period or schedule. Every employer should know the respective state’s requirements and pay period laws governing when they must pay their employees. If an employer fails to pay employees on a regular pay period, penalties should be avoided by ensuring all payroll administration is conducted in accordance with state laws, and the worst-case scenario is avoided.

A common question I’m asked at this time of year is, –How much do employers have to pay per hour?” The answer depends on whether the employee is paid on an hourly, an 8-hour day, a 40-hour week, a non-shift list (holidays and vacation) pay cycle, or a flexible pay cycle. Based on the situations, I use three basic terms to describe the amount of wages employees receive: hourly wage, shift pay, and salary.

Hourly Wage is the amount a worker receives when they are paid on an hourly basis (salaried, salary-only or commission-only). The hourly wage will normally vary, based on the industry and job title involved. The state minimum wage will also be applied and will be used to calculate the overtime pay for a worker who works more than 40 hours in a week.

Open a Bank Account Specifically for Payroll

Payroll is easy to do in cash, but how will you know how much to pay yourself and pay your employees?

The most common method is to use an accounting system that has a segregated bank account specifically for payroll. Your bank account containing your company’s wages will need to be separate from your checking account since your withholding taxes and employee wages can’t be mixed. You can invest in a payroll system or your accountant can do payroll for you.

Banks will hold payroll checks for a fee and some will be able to deposit the checks into your account while others will hold that until you have paid them for that month or percentage of the year plus a monthly fee.

If you have separate accounts, you can set up automatic deductions from your company’s account that will transfer money directly to pay your employees and withhold taxes. This will help you avoid having too much or too little wages paid during the year.

Another option is to have your employer match and deduct those funds you include in your payroll checks. This will help you avoid having to pay taxes twice and will facilitate the process of recognizing a company match.

Have Employees Sign That They Received Their Paychecks

The Federal Fair Labor Standards Act (FLSA) makes it illegal for employer to not pay employees the full wages they’ve earned. The FLSA also makes it unlawful for your employer to take back any wages you’ve already been paid. So what’s an employer to do? One popular solution is having employees sign a statement that they’ve been paid. This practice is known as –wage gouging,” and is prohibited by law.

Furthermore, under federal law, employers are required to reimburse employees for any penalties that are imposed because of an employer’s violation of the FLSA. If an employee has not been paid, you’re required to reimburse that employee for the penalties that were imposed on the employee.

Make it a practice to have your employees sign a statement that they agree to the terms of your paychecks. This helps you stay in compliance with the FLSA, and prevents your employees from being unjustly penalized by the employer.

Create an Arsenal of Payroll Records & Store Them

Many employers have a paper trail of payroll records, but you should organize and store this information in more than one place. Make sure that this collection includes tax forms, time- and attendance data, statements, and paystubs that your employees will need to file with their tax returns. You should keep these on hand for at least five years.

If you run multiple business locations, coordinate with your payroll office to have records stored centrally. You may even pick up the tab! Make sure to back all of this information up … preferably in a secured location.

Let your staff use the most up to date technology at your disposal. This can make it easier for your employees to scan and submit paperwork, ensure they’re all on the same page with regards to policies and documentation, and realize that the system works and is easy to use.

Tip: Having an online access to your employees’ paystubs can help you keep track of their hours. Print their paystubs so that they have a hard copy to submit to their employer.

Monitor How Much Your Payroll Amounts To

You must have some knowledge of your financial budget to keep a monthly payroll, but when it comes to how much the payroll amount adds up to on a weekly or daily basis, you may not have a full grasp of the budget. Knowing the exact cash balances is crucial in making smart personnel decisions. So thorough preparation will go a long way in avoiding penalties and a better opportunity to successfully manage payroll.

Take the time to develop formal procedures to help deal with cash at your firm. This way, the firm and your worker can track an employee’s pay in the days after pay day, and you can avoid carrying any fudged figures. For example, you can develop a policy for freezing the pay level in the days following pay day, and monitor the history of your employee’s pay from the previous four pay cycles to prepare for the first pay day of the current pay cycle.

Rest assured that the additional procedures you put into place will avoid you from catching a lot of flack. The administration and wage taxes can be easy to avoid, even if your accounting department has failed you. And since you’re the one abiding by the rules of the Payroll Act of 1942, you’ll never be held liable for any mistakes made by your accounting personnel.

Observe Payroll Laws

Before you decide to eliminate your check with one of those nifty card swipe machines, you should be aware that some states and cities have laws against paying employees via check. These laws vary from state to state, so check with your local payroll office for up-to-date impelment rules whenever you make changes to your payroll procedures.

List of States with Payroll Laws:

  • Minnesota – Minnesota Payroll Laws
  • New Jersey – State of New Jersey‒s Payroll Compliance Division
  • New York – New York State Department of Labor
  • Electronic Check writing and Payroll Laws

Most states and cities have laws that make it a crime (and therefore, illegal) to pay employees electronically such as by check or by direct deposit. Depending on the type of job, it can be illegal without a proper tax receipt if the check or direct deposit is mailed and if you don’t include the employees’ address. So as a precaution before changing your payroll practices, check your payroll office for current regulations to ensure that there are no penalties.

Paying Employees Under the Table

Paying cash under the table is a best practice for any business that wants to retain the most amount of cash on hand at all times. The profit motives are clear…every dollar you retain is a dollar that can’t be stolen, and under-the-table payments help you process all transactions without ever having to report them to the government. You also know for certain that your employer isn’t reporting any of it to the government either, and that’s a comfort that’s hard to argue with.

When your business deals with employees on a cash basis, this becomes even more important. If your employees are paid by check, there is always the question of just how much they’re actually paid. Their paychecks aren’t completely transparent and you can’t really be sure that you’ve been getting a full accounting of what’s been going out the door in terms of wages.

Under-the-table cash payments offer the ultimate sense of security. No red tape and no bureaucracy. The employee is paid for his services as he represents the business.

Why Paying Under the Table Doesn’t Work Forever

It seems to be that paying employees in cash forever is not an effective or sustainable strategy. Doing so can cause other issues that you may not have even considered. In order to be able to avoid any penalties and decrease your risk of being audited for violating the tax laws, hiring a few employees that are paid in cash is definitely not the correct course of action.

The debate has always been … should you spend the money and buy gift cards for your employees or continue to pay them cash and risk penalties that may be assessed by your government at some point in the future?

Here’s the thing … in no place in their tax laws does it state that an employer must buy gift cards for their employees. Rather, the gift card laws in the tax laws state that you can’t have any type of compensation that is …

{1}. Cash (C- in your bank statement)
{2}. A coupon (T- in your bank statement)
{3}. A gift (G- in your bank statement)

So if gift cards aren’t in the tax laws, why is there this debate of whether or not you should buy them for your employees? There is a debate and it’s because gift cards are no longer considered cash.

Penalties for Paying Employees Cash Under the Table

Defense Tip- Employees who find out you are paying them in cash under the table may sue you for wage theft. The judge has the power to hold you in contempt and order you to pay all of your employees properly.

Since the IRS knows that paying employees in cash under the table is illegal on IRS Form W-2, your employees may report you to the IRS if they find out.

Wage theft is illegal, and if you or any of your employees are caught illegally paying employees in cash, you can be held in contempt of court and be sentenced to a fine.

Bottom Line

This guide covers the eligibility criteria to withhold federal income tax from an employee’s wages and the requirements relating to all of the different types of wages. It then provides a list of common wage types to help you identify which wages must be reported and which do not have to be reported. The guide concludes with a discussion of the W-4 Form (and its alternatives), how to report income to the IRS, and which records must be kept to ensure that any withholding established through the use of withholding forms is accurate and tax effective.