Updated: January 8, 2025

Understanding payroll tax penalties plus best practices to prevent them

Published By:

Jon Davis

More from our experts

Payroll tax penalties can include everything from unwanted attention from Uncle Sam in the form of steep tax obligations, costly fees, and, in some cases, even criminal charges. However, businesses can usually avoid these consequences of payroll errors by staying on top of the basics. While payroll tax penalties are serious business, they are also fairly easy to avoid.

 

In this employer’s guide, we’ll cover some of the most common penalties, reasons why they come up, and strategies you can use to avoid them altogether.

What are the typical payroll tax penalties?

The government may penalize businesses for a number of different payroll tax issues, including:

 

Late filing penalties

A late filing penalty is no laughing matter: The IRS failure-to-file penalty is typically 5% of taxes owed for every month (or part of a month) that the return is late, up to a maximum of 25%. Clearly, it pays for businesses of all sizes to ensure all tax payments are made on time.

 

Late payment penalties

The IRS late payment penalty varies based on the number of calendar days a deposit is late, starting from the due date of the deposit. The penalty rates are 2% for deposits that are 1 to 5 days late, 5% for those that are 6 to 15 days late, and 10% for deposits that are more than 15 days late. Furthermore, the IRS charges fees of 15% for amounts unpaid more than 10 days after the date of the first notice or the date on which you received the notice and demand for immediate payment.

 

Trust fund recovery penalties

According to the IRS, if you are responsible for “withholding, accounting for, or depositing or paying specified taxes including NRA withholding and employment taxes, and willfully fail to do so, you can be held personally liable for a penalty equal to the full amount of the unpaid trust fund tax, plus interest.” In other words, employers who deliberately keep employee taxes that are owed to the IRS can be charged a serious fine.

 

Negligence and fraud penalties

The IRS may charge a 20% penalty to businesses for underpayments, negligence, and outright fraud.

 

“It pays to do the right thing,” says David Kindness, one of OnPay’s subject matter experts and a certified public accountant with over ten years of experience helping small businesses.

 

Be proactive

“While businesses can sometimes appeal tax-related penalties and fines, payroll penalties can be a serious drag on an organization’s finances and time. To avoid them altogether, businesses should pay careful attention to payroll tax forms and deadlines or the safest bet is to work with a vendor who can organize and automate payments.”


— David Kindness, Certified Public Accountant (CPA)

Moving on, let’s find out more about what tends to be the root of these less-than-ideal scenarios.

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Common causes of payroll tax penalties

Believe it or not, payroll tax penalties are often the result of human error or overlooked payments. That’s why most businesses that take advantage of automation, delegation, and a review process tend to avoid them altogether. The most common causes of payroll tax penalties today are:

 

  • Failure to deposit taxes in a timely manner: Late deposits that incur steep penalties are often due to an inadvertent employee error. Automating your payroll tax preparation ensures on-time deposits, preventing these penalties and keeping your business running smoothly.
  • Incorrect calculations: It is critical to ensure that your organization is calculating payroll taxes correctly. While you can file amended returns to fix mistakes and errors, the IRS penalty for incorrect information is a hefty 20%, so it’s best to avoid the issue altogether. Errors in manual data entry can easily lead to incorrect calculations, and even a small miscalculation can be very costly to a business.
  • Inadequate record keeping: Some organizations fail to keep adequate and complete records, which often leads to errors, omissions, and the inability to produce supporting documents when they are needed. Make sure your payroll tax records are well-maintained and organized and that you review record-keeping processes on a regular basis.
  • Misclassification of employees: Organizations must properly classify regular employees versus independent contractors, consultants, and freelancers or they could face potential tax consequences. Common misclassification errors can lead to penalties. If you aren’t doing so already, it is wise to regularly review employee classifications to ensure everyone is classified properly, particularly following any changes in work responsibilities.

 

Once more, we caught up with David who points out that “Inadequate technology can also cause errors, leading to payroll tax penalties. In most cases, it’s worth investing in automated payroll software that can reliably manage payroll taxes and other tax-related obligations.”

 

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Consequences of ignoring payroll tax obligations

Ignoring payroll tax obligations comes with serious consequences for businesses across industries:

 

  • Financial impact: In addition to steep fees and fines, the IRS can also place a lien on your company’s assets, leading to significant negative financial and operational impacts.
  • Legal repercussions: Businesses that fail to pay payroll taxes can also face serious criminal charges. Intentionally misrepresenting your tax situation or committing tax fraud could result in a felony charge and up to a $10,000 fine and/or five years in prison.

 

In addition, businesses that ignore payroll tax obligations can face reputational damage, reduced employee morale, and ongoing financial issues. Authorities can also require time-consuming payroll and tax audits.

 

Typically, businesses are required to pay at least 90% of their taxes due during the previous year to avoid an underpayment penalty. Managing and paying payroll tax obligations on time prevents the possibility of serious consequences and also helps to maintain a business’ overall financial health.

Strategies for avoiding payroll tax penalties

Fortunately, there are several smart strategies and industry best practices for avoiding payroll tax penalties that are relatively easy for businesses of all sizes to implement. It is important to make sure your business engages the following strategies:

 

Keep accurate records

Accurate and complete payroll records are essential for businesses that want to avoid payroll tax penalties and other issues. These records can include employment forms, pay records, timesheets, current employee information, and other related payroll details. Likewise, businesses should conduct regular audits to ensure that their records and payroll are both in good working order.

 

Consider software tools

There are a number of tools with tax compliance features that can go a long way toward making sure that you never miss a deadline. Most tools can manage payroll and tax calculations, withholdings, and deductions while automating the filing and paying of business payroll taxes (federal, state, and local). Plus, it doesn’t have to break the bank.

 

Host regular training for staff

Why wait for an emergency to arise before you train your staff on proper payroll processes? Rather, businesses should schedule regular training for staff on payroll management, payroll tax obligations, and how to correct errors. All new employees should receive comprehensive training and education to prevent issues from happening in the first place. Education can go a long way toward preventing compliance problems.

 

Consult with tax professionals

When in doubt, consult with a tax professional such as a CPA or EA. With expert help, you can develop strategies for managing your tax obligations, making on-time payments, and bolstering your business with smart financial practices and procedures. By leveraging their knowledge of taxes, professionals can offer valuable advice to support your business’ finances.

 

It is also important to stay on top of any updates or announcements from the IRS and other tax authorities (like state or local governments) to make sure you are compliant with all new tax regulations that apply where you do business.

Avoid payroll tax penalties for peace of mind

Though penalties that come with payroll mishaps can be a lot to handle come tax time, many online payroll providers handle calculations and deductions so businesses can avoid tax deposit snafus in the first place. Some vendors can even help you stay current with federal regulations and local requirements, and handle mandatory state new-hire reporting as your team grows.

 

Ready to simplify your payroll? Our team is here to answer your questions and looking forward to supporting your business’ growth and success.

Take a tour to see how easy payroll can be.

Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.