Sometimes, an employee might hit a financial rough patch. Something unexpected might happen, such as a medical emergency, that requires more money than the employee has saved up.
If this happens, the employee might ask you for a salary advance to help them make ends meet. Before you begin giving payroll advances, you need to know what you are required to do and make a payroll advance agreement.
What is a payroll advance?
A salary advance is essentially a loan you can give an employee. The advance comes from wages you will pay the employee in the future.
An employee payroll advance is not like loaning a few dollars to a friend. Your friend might pay you back sometime in the future when they have the funds, but there is no guaranteed time when you’ll get the loaned money back. A salary advance is a real loan with repayment terms.
To make repayments, you deduct wages from the employee’s future wages. You might deduct the full repayment from one paycheck, or you might deduct a smaller amount from several future paychecks.
Your business is not required to give payroll advances to employees. However, if you provide a salary advance to one employee, you should equitably provide advances to other employees as well. You cannot discriminate based on race, religion, disability, etc.
Creating a payroll advance policy
If you permit advances, it is advisable to have a payroll advance policy. Having an established policy helps you fairly decide when to give a payroll advance, how much to advance, and what the repayment terms are.
Your salary advance policy should define who is eligible for an advance. You can require employees to work for you for a specific amount of time, have no disciplinary actions against them, or meet other qualifications. You can choose who is eligible as long as you don’t discriminate.
Determine how much money employees can request. You might set the cap at a specific dollar amount or a percentage of an employee’s wages. You should also determine how often employees can ask for an advance, such as once per year.
In your pay advance policy, you can also note your preferred method of deducting wages for repayment. An employee’s specific repayment plan should be detailed in the payroll advance agreement.
Creating a repayment plan can be tricky. Repayment deductions cannot drop the employee’s wages below the prevailing minimum wage. This means you might need to spread out the payroll deductions over more paychecks, especially if the employee earns lower wages.
You might also want to create a policy in case an employee who has an outstanding advance is terminated. Explain how you expect to get the remaining money back, such as subtracting it from the final paycheck.
You can charge a fee or interest to cover your paperwork and recordkeeping responsibilities. Federal laws do not set a maximum fee or interest rate. However, you cannot profit off the advance, so keep the fee or interest rate low.
Make sure you check your state laws when creating your payroll advance policy. State laws might have stronger rules than federal law.
The salary advance agreement
Before you give an advance to an employee, you should both agree to and sign a pay advance agreement. The agreement lets you both know your obligations while helping protect you from possible legal issues in the future.
The employee payroll advance agreement should include the employee’s name, the total amount being advanced, and the date you will distribute the funds. It should explain the payback schedule and include an explicit agreement that lets you remove funds from future paychecks. You should also include a section on how you expect to receive the owed funds if the employee is terminated. When you and the employee fill out the agreement, add the date of the agreement and your signatures.
Keep a copy of the agreement in the employee’s payroll records.
What to do when an employee asks for an advance
When an employee asks you for an advance, do not pry into their situation. You probably want to be sure the money will be used for what you deem as a good reason, but resist.
Inform the employee of your salary advance policy. Make sure they understand the terms. If the employee is eligible for a payroll advance, notify them.
Create the employee advance agreement. You and the employee should both agree to and sign it. Once the agreement is signed, distribute the advance on the promised date.
Running a payroll advance in your payroll
When you pay an advance, you must first create a non-taxable money type to add to your payroll. You might call this money type “Advance” or something similar so you and the employee can easily identify it.
After you create the money type, use it to pay the advance when you run payroll. Simply add the money type to the employee’s pay and set the total amount of the advance. If you choose to pay the advance outside of a regular payroll run, be sure to skip any voluntary deductions on the advance payout.
After paying the advance, you need to create a deduction for future payroll runs. This deduction will allow you to recoup the advance payment. Name the deduction something like “Advance Repayment” so it can be easily identified. Set parameters for the deduction so it follows the repayment terms and withholding ends when the advance is recouped. Add the deduction to the employee’s payroll record so it will subtract wages from the following paychecks.
How to handle taxes for salary advances
Because a salary advance is money that would normally be part of an employee’s wages, you must withhold and pay payroll taxes on the amount.
Don’t withhold and pay taxes on the advance when you distribute it. Calculating taxes when you distribute the money could cause you to withhold the wrong amount. For example, if you pay the advance with the current paycheck, the additional money could move the employee into a higher tax bracket for federal income tax withholding.
Instead, calculate taxes when you deduct the repayment amounts from the employee’s wages. You should calculate taxes based on the gross payroll amount, then deduct the repayment amount. The advance repayment amount is essentially a post-tax deduction.
Let’s say you have an employee who earned $1,000 for their weekly paycheck. You need to deduct $100 for an advance repayment.
You first need to withhold taxes.
$1,000 X 7.65% (for FICA tax) = $76.50
Let’s pretend the employee is single and has one federal withholding allowance. That means you must withhold $139 for federal income tax.
$1,000 – $76.50 – $139 = $784.50
The employee would have $784.50 after you withhold taxes. For this example, we’re going to assume there aren’t any state or local taxes.
Now, you need to deduct the advance repayment.
$784.50 – $100 = $684.50
The employee has a net pay of $684.50. Because you deduct the repayment amount after taxes, you and the employee both still pay taxes on the advance.
You can run advances and repayments in Patriot’s small business payroll software. The easy-to-use software lets you quickly add and remove deductions. Get your free trial!
This article is updated from its original publication date of 5/30/2012.
This is not intended as legal advice; for more information, please click here.