Payroll mistakes are more than clerical slip-ups. They can trigger steep IRS penalties, interest, and audit scrutiny. The most common issues involve late tax deposits, worker misclassification, incorrect forms, and bad data. For example, failure to deposit penalties escalate from 2% – 15% of the unpaid amount, plus interest.
This article walks through seven high-risk errors, what they cost, and how to prevent them. If you want fewer surprises and notices, dial in your processes or leverage payroll services like Patriot Software that automates calculations, filings, and deposits to keep you compliant.
Payroll error #1: Missing payroll tax deadlines
Payroll tax deadlines are the due dates for depositing and reporting federal payroll taxes (federal income tax withheld, Social Security, and Medicare).
Late deposits are among the most expensive mistakes. The IRS applies escalating payroll tax penalties when deposits are late, plus interest until paid.
Typical federal deposit penalty rates:
| How Late? | Deposit Penalty |
|---|---|
| 1–5 Days Late | 2% |
| 6–15 Days Late | 5% |
| More Than 15 Days Late | 10% |
| After IRS Notice or Demand | Up to 15% |
How to avoid: Set a deposit schedule and monitor confirmations to avoid payroll tax penalties. Or, use a full-service payroll software.
Payroll error #2: Late or incorrect returns
Information returns are IRS-required forms (e.g., Forms W-2 for employees) that summarize income and tax data. Filing late, failing to file, or submitting incorrect forms can trigger per-form penalties.
A failure-to-file W-2 penalty, for example, can be severe. You may be looking at a maximum penalty of around $1 million dollars (small businesses) or a few million dollars (non-small businesses).
You can also incur penalties such as:
- Filing with incorrect information (e.g., incorrect taxpayer identification number)
- Filing by paper when you met the IRS electronic filing requirements
- Failing to give required information
How to avoid: Set a schedule (or use full-service payroll), use taxpayer identification number verification tools, reconcile totals to payroll registers, and build a pre-deadline review step to catch errors early.
Payroll error #3: Misclassifying workers
Misclassification means treating workers who should be employees as independent contractors, which bypasses payroll withholding and reporting. It’s a top payroll error that triggers penalties, back taxes, and audits.
Consequences can include:
- Employer liability for back withholding and FICA tax, with interest
- IRS penalties and potential state-level fines
- Increased audit scrutiny and legal exposure
Adam Garcia, Founder of The Stock Dork, stressed the importance of proper classification of employees, saying,
A big mistake many small business owners make is misidentifying what employees are. Many different obligations don’t actually apply to contractors. Payroll tax, for instance, is only obligated for actual employees. There are small nuances though, and it’s important to do your tax law research beforehand.”
How to avoid: Use the current DOL contractor rule (six-part Economic Reality Test) and IRS worker classification guide (behavioral, financial, and type of relationship). For gray areas, seek expert advice or request an IRS determination using Form SS-8.
Payroll error #4: Incorrect tax withholding
Tax withholding is the amount taken from employee wages for federal, state, and local taxes. Using outdated income tax withholding tables means incorrect calculations, which leads to IRS notices and penalties. Tax withholding is also incorrect if you use outdated W-4 forms.
How to avoid:
- Ask new hires to fill out federal and state W-4 forms
- Maintain current payroll tax tables and update manual payroll as needed (or use online payroll to automate it)
- Correct employment taxes immediately if you withhold the wrong amount
Payroll error #5: Calculation errors (wages and benefits)
Seemingly small math errors can cascade into wage disputes, corrections, and penalties. Frequent issues include:
- Miscalculating regular pay rates or shift differentials
- Incorrect overtime
- Missing or misclassifying taxable fringe benefits
- Not paying earned bonuses or commissions
Incorrect overtime calculations, in particular, can lead to wage disputes and even civil or criminal penalties.
According to John Li, Co-founder and CTO of Fig Loans, overtime calculations are crucial. He said:
If you fail to calculate your employee overtime correctly, you may be liable to pay back liquidated damages. That’s a load of cash for a small business owner to fork over, so calculate these hours properly and have employees sign off on their timesheets.”
How to avoid: Automate calculations with payroll software.
Payroll error #6: Poor recordkeeping
Recordkeeping means keeping organized payroll data (wages, hours, forms, tax filings, and employee demographics) so you can report accurately and defend audits.
Missing, inaccurate, or incomplete data (e.g., SSNs, addresses, dates) raises audit risk and can cause rejected filings.
The IRS directs employers to keep employment tax records for at least four years after the date the tax becomes due or is paid.
The Department of Labor requires keeping payroll records for at least three years and records used to compute wages (like time cards) for at least two years.
| Record | How Long to Keep | Agency |
|---|---|---|
| Records used to compute wages (e.g., time cards) | 2 years | Department of Labor |
| Payroll records | 3 years | Department of Labor |
| Employment tax records | 4 years | IRS |
How to avoid: Create a strong and organized recordkeeping system. Consider using payroll software to generate and maintain records automatically.
Payroll error #7: Failing to correct errors quickly
Delaying corrections increases penalties, interest, and the chance of an audit. When you find an error in a filed payroll return, the IRS requires you to file corrections.
Use Form 941-X to fix errors on a previously filed Form 941. You may also need Form W-2c to correct W-2s.
What to do if you find an error:
- Identify what went wrong, which employees and periods are affected, and the dollar impact
- Use the appropriate IRS correction form (e.g., 941-X, W-2c) and amend state returns if needed
- Document the fix and controls you’re adding to prevent recurrence
- Consult a payroll expert or accountant before filing to avoid compounding errors
How to avoid: Once found, fix errors fast!
FAQs
IRS penalties for late deposits typically range from 2% – 15% of the unpaid taxes, depending on how late you are, with interest accruing until the balance is fully paid.
Misclassification means you did not withhold and remit the proper payroll taxes, which can trigger back taxes, IRS fines, and heightened audit risk.
File correction forms promptly (e.g., Form 941-X).
Use automated payroll software like Patriot Payroll to calculate, file, and deposit payroll taxes, maintain accurate records, and verify worker status and withholding.
Patriot Software payroll
Patriot Software helps small businesses and accountants avoid costly payroll errors with calculations, up-to-date tax rules, and built-in filing with Full Service.
Our Full Service calculates and withholds taxes; files federal, state, and local forms; and deposits payroll taxes.
Real-time compliance updates keep rates and thresholds current, while robust recordkeeping centralizes payroll data, W-2/1099s, and payment histories for audit defense.
This article has been updated from its original publication date of December 27, 2017.
This is not intended as legal advice; for more information, please click here.
