Overview

Payroll compliance issues can lead to fines, back taxes, employee claims, and reputational harm. In my practice helping small and mid-size employers, the same problems recur: misclassification, missed deposits, state withholding errors, and weak internal controls. Addressing these quickly, with documented corrections and the right tools, usually prevents escalation. (See DOL on employee classification: https://www.dol.gov/agencies/whd and IRS payroll resources: https://www.irs.gov/businesses/small-businesses-self-employed/payroll.)

Top payroll compliance issues — and how to fix each

1) Misclassification of workers (employee vs. contractor)

  • Why it matters: Misclassification can trigger unpaid payroll taxes, overtime claims, and penalties under the Fair Labor Standards Act (FLSA) and IRS rules.
  • Fix: Re-evaluate roles against DOL/IRS criteria, reclassify where appropriate, issue corrected W-2s or 1099s, and file amended payroll returns (Form 941-X) for periods with payroll tax errors. For detailed guidance on classification, consult the DOL and IRS guidance and document the analysis. (DOL: https://www.dol.gov/agencies/whd)

2) Incorrect overtime and wage calculations

  • Why it matters: Under the FLSA, non‑exempt employees are owed correct overtime; errors cause back pay and penalties.
  • Fix: Audit timekeeping and pay calculations, convert flat-piece or commission pay into an hourly equivalent where required, correct prior pay with payroll adjustments, and update job descriptions and pay policies. Train payroll and HR staff on exemption tests.

3) Failure to withhold or deposit employment taxes on time

  • Why it matters: Late or missing deposits generate penalties (including trust fund penalties for withheld taxes).
  • Fix: Reconcile payroll tax liabilities each pay period, use automated payroll deposits or ACH, set calendar reminders for deposit schedules, and, if you miss a deposit, calculate and remit the amount quickly and prepare to file Form 941-X for corrections. If you’re facing difficulty, contact the IRS’s Employment Tax Services early to discuss options.

4) Multistate and remote-employee withholding errors

  • Why it matters: Employees working in multiple states or remotely can create complex withholding and unemployment insurance obligations.
  • Fix: Review nexus and withholding rules for each state where employees work. Consider centralized payroll software configured for multistate rules or rely on a payroll provider. See our guide on state withholding for remote employees for common scenarios and remedies: Payroll Withholding for Remote Employees: State Rules Simplified.

5) Inadequate recordkeeping and missing documentation

  • Why it matters: Poor records make it hard to defend pay practices in audits and to correct errors accurately.
  • Fix: Keep payroll records for at least the minimum state and federal periods (DOL and IRS guidance), store job descriptions, timecards, benefit elections, and payroll registers, and run periodic retention reviews. See our checklist for audit preparedness: Small Business Audit Preparedness: Employee and Payroll Records to Keep.

6) Weak internal controls and fraud exposure

  • Why it matters: Single-person payroll processing increases the risk of errors and misuse of funds.
  • Fix: Separate duties (time approval, payroll processing, bank reconciliations), require multi-person approvals for uploads and ACH payments, reconcile payroll bank accounts monthly, and implement internal audit steps described in our controls guide: How to Implement Internal Controls to Prevent Payroll Errors.

7) Benefits, ACA and retirement reporting errors

  • Why it matters: Misreporting employer-provided health coverage or retirement contributions can drive penalties and incorrect withholding.
  • Fix: Reconcile benefits records quarterly, confirm plan reporting (Forms 1095-B/C, 5500 series when applicable), and correct errors promptly with amended filings.

8) Late or incorrect year-end and information returns

  • Why it matters: Wrong W-2s, 1099s or late filings affect employees and contractors and may trigger penalties.
  • Fix: Reconcile annual totals before issuing forms, correct with W-2c/1099-corrections, and file amended returns promptly.

How to run a quick payroll compliance audit (quarterly checklist)

  • Verify worker classifications and job descriptions.
  • Reconcile payroll registers to general ledger and bank statements.
  • Confirm federal and state tax deposits were timely and match payroll liabilities.
  • Spot-check overtime calculations and timecard approvals.
  • Review employee benefits, garnishments, and year-to-date withholdings.
  • Document findings and corrective actions; track completion dates.

Correcting errors without making things worse

  • Be timely: The faster you identify and correct mistakes, the lower the chance of penalties growing.
  • Use the right forms: For federal employment tax corrections, Form 941-X corrects Form 941; other corrections may need state-level amended returns.
  • Keep proof: Save calculations, correspondence, and corrected pay stubs.
  • Consider voluntary disclosure: For large, systemic problems, voluntarily contacting the IRS or state agency and proposing a correction plan can reduce penalties.

Penalties to watch for

  • Trust Fund Recovery Penalty (TFRP) for unpaid withheld federal income and FICA taxes.
  • Failure-to-deposit and failure-to-file penalties.
  • State-level penalties for withholding or unemployment insurance missteps. (See IRS and DOL resources.)

When to use payroll software vs. a payroll service or CPA

  • Use software when you need automation: tax calculations, deposit reminders, and multistate support.
  • Use a payroll service or CPA when complexity (multistate, large headcount, union rules, or suspected misclassification) exceeds internal capacity. In my experience, outsourcing payroll controls for a few high-risk clients stopped recurring errors and reduced audit exposure.

Practical tips to prevent future issues

  • Automate deposits and tax calculations with reputable payroll software.
  • Perform quarterly payroll audits and document fixes.
  • Maintain written payroll policies and role-based access controls.
  • Train payroll and HR staff annually on FLSA, overtime, and state withholding changes.

When to get professional help

  • An audit or agency notice arrives.
  • Repeated misclassification or large unpaid tax liabilities exist.
  • You need assistance negotiating payment plans or penalty abatements.

Sources & further reading

Professional disclaimer
This article is for educational purposes and does not replace legal, tax, or accounting advice. For tailored guidance on payroll compliance issues specific to your business, consult a qualified CPA, payroll professional, or employment attorney.