Managing payroll is a complex business function that comes with minutia, and as businesses grow, payroll mistakes can get harder to handle. Many organizations are finding this out first-hand as their payroll function gets more and more complicated. In fact, up to 70 percent of current U.S. businesses are estimated to misclassify employees--a costly mistake.
This is precisely why, in this week’s episode of CFO Weekly, we sat down with Charles Read, Certified Public Accountant, U.S. Tax Court Practitioner, Member of the Internal Revenue Service Advisory Council and Founder and CEO at GetPayroll.
Charles helped us get to the bottom of what managing payroll is all about, and how it should be managed, including whether the function should be in-house or out.
“Anybody who does their own payroll and is not an expert, like we are, really needs to think twice about it," Read said.
What Scale of Company Needs Payroll-Related Services?
Whether it’s in or outsourced, every company needs to have a system for running payroll. Some are still working manually, others use SaaS, others completely hand it over to consultants, but there’s effectively some process that pulls together employee inputs and outputs, and calculates remuneration before that gets paid out. Charles’ team currently serves companies with up to 500 employees (although they can handle larger staff complements) -- at this scale, the cost and complexity of managing this in-house grows quite quickly.
This is partly due to what Charles calls exceptions, which increase proportionately to the growth of your business. As you grow your company and your staff complement, you have to consider each staff member as a person, with a unique story and set of legal and financial parameters that have to fit somewhere into your organization like a jigsaw puzzle. That person needs to be paid and compensated for their contributions and your organization needs to remain compliant.
A Decade of History & the Current State of Managing Payroll Mistakes
Charles takes us back 12 years, to when Former President, Barack Obama, entered office. We walk through updates that came in because of the recession, the FICA holiday and some of the confusion around forms and form changes. What’s interesting is that Charles picks up on how although the laws changed, the courts were continuing along the same path, really.
The ‘gig economy’ exploding like it did, caused massive disruptions across the United States, especially in California where there was quite a bit of back and forth over worker classification as employees versus independent contractors. More recently, in the past year or so, the federal government stepped into the debate to introduce new labor laws, some of which have already been rescinded. Handling such a dynamic state of flux makes it more challenging for companies managing payroll in-house to really stay on top of compliance requirements, which is why GetPayroll is there.
Let’s not forget about the impact of the COVID-19 pandemic. Apart from the growth rate of technology, and how it’s becoming more widely adopted by businesses, the pandemic exponentially accelerated the phase-out of physical checks. Where, a decade ago, GetPayroll was doing about 80% of their clients’ payments in checks, it’s barely even at 5% now - everything’s done through direct deposits or debit cards. The technology used to execute the payroll function is advancing alongside the rest of business technology.
Another thing we’ve almost entirely done away with, these days, is fax machines. Everything is now online or scanned and emailed for company payroll. The only reason to keep a fax machine now is on the (very) rare occasion that something needs to be faxed in to the IRS.
Computers have enabled us to scale up payroll without scaling up human resources. This is the most noticeable difference today, compared with a decade ago.
What Does the Future Hold for Payroll?
More tax changes, for one. The Department of Labor has already begun with this. The Biden administration is proposing several changes, and so is the progressive wing of the Democratic Party:
Increased child credit
Expansion of the second PPP
Expansion of tax credits
A lot of people don’t realize that as much as 70 percent of federal revenue is obtained through payroll execution. That withholding of taxes, employment taxes, FICA, Medicare -- it all goes through managing payroll. So when there are changes (from high-level tax rules to a single line on a form) managing payroll is inevitably affected through the process, and people get affected in different ways because of that. Examples include:
The new W4
1099-NEC being brought back in
New Hampshire’s unemployment tax rose 500 percent
Texas delaying the announcement of new tax rates until June, but still requesting for taxes to be paid now -- there’s confusion about which rate to use right now
Lay-offs triggering socialization where the fewer remaining employed people get taxed even more to cover social welfare costs of the growing number of unemployed people
Increased food rates
"The Labor Department estimates that 70 percent of U.S. businesses misclassify employees, either as independent contractors versus employees, or exempt or non-exempt,” Read said.
Advice for CFOs Managing Payroll Mistakes
CFOs undoubtedly have a lot on their plates right now:
Timekeeping (can cause wastage of up to 10% of total payroll)
On top of all of that, CFOs and financial leaders are dealing with compliance issues, internal controls and records retention. Not to mention the overlap with other business functions, like HR - what are the financial consequences of other functional processes not being adhered to and/or documented?
Charles covers all of the above, and so much more, in his latest book titled The Payroll Book. It’s a gold mine of knowledge and insight that a lot of CFOs can benefit from.
Outsourcing Payroll - to Prevent Future Mistakes
With all the elements that CFOs have to oversee, it’s easy to assume that challenges magically disappear through outsourcing payroll. It’s not that simple. Charles mentions that even though his team may produce the payroll for clients, some checks don’t get cashed, which leads to reconciliation glitches.
Charles’ team also creates handbooks for clients and offer timekeeping management. Tax mistakes are the greatest portion of what melts away when outsourcing payroll, in addition to deduction calculations, deposits, reports, IRS errors and filing. To hire an in-house payroll expert raises direct costs by well into six figures, whereas outsourcing reduces that cost and shares the responsibility to find answers to questions along the way.
Outsourcing payroll comes with other perks, like the accessibility of experts (no delays due to sick or annual leave), updated hardware and software that doesn’t cost you directly, experts who can keep up with legal, financial and tax-related changes. You don’t lose hours sitting on calls with the IRS because your outsourced team would take care of it (if you chose GetPayroll, of course).
Are Clocks the Best Way to Track Time Worked?
Charles recounts his own experience of the old manual time clock with employee cards that needed to be punched in and out. The clerical team would have issues adding and subtracting all the hours accurately, leading to mistakes that translated into payroll issues. Today, time is automatically calculated thanks to electronics.
It doesn’t mean that this process needs zero supervision, though. There has to be some degree of control and protection for both the employees and the business, like a biometric clock or geofencing for teams with members spending a lot of time on the road. Geofencing works in a way that tracks your employees as they move within a set distance of the geofence parameters you set, like a depot or a client’s office; your employees’ phones register and get tracked as logged in, when within that set distance of the geofence beacon, which communicates with the payroll system.
People will always try to find loopholes or game the system, so removing dependency on manual systems is highly recommended.
Pros and Cons of On-Demand Pay
On-demand pay is used for companies like rideshare businesses. An Uber driver can get paid multiple times in one day. It creates unique challenges for financial administration:
What happens at financial year-end?
What’s taxable and what’s not?
Risk of overpayment
Hourly rates and trust risk - your word against theirs
Docking of pay after overpayment
Managing former workers who were overpaid - does that money become gifts to them? Is it theft? How should this be managed, both legally and financially?
Even so, there are companies moving more and more toward this scenario because it’s a revenue share model. The flip side of this is that it increases costs too. Managing payouts to gig employees still comes with a cap and tax limit, so it requires much more effort to monitor and find that limit, then adjust the process, and to do that daily, weekly, monthly and annually and fluctuate processes - it’s a highly volatile context.
To date, there’s no in-depth guidance on this from the IRS even though Charles’ team has submitted a list of important questions on the issue. It’s a work in progress, and until it’s available, nobody really knows what the correct way is of managing this way of working. Furthermore, the COVID-19 pandemic created a backlog for the IRS, to a scale of 20 million unopened emails - it’s safe to say that this could take a while, even though they’ve brought this number down significantly.
The Gig Economy and Managing Payroll Mistakes & Independent Contractors
Since we’ve just mentioned that the law around this is in a state of flux, Charles encourages consideration of common law rules. He adds that this is still the basis for many courts across the country, and a good place to start. Bear in mind that even new rules can be rescinded so you need to have some degree of flexibility here.
The best way forward is to stay on top of all the changes and keep unpacking what each one means for your own business. There are always going to be cases for both employees and independent contractors. As employees, taxes are withheld and submitted by organizations, which makes the government happy and tax compliance is relatively simple and probably quite successful.
But if taxes aren’t withheld or reported, as in many gig economy situations, compliance falls from roughly 99% all the way down to 27%. Even though gig workers with 1099-NEC have a higher compliance rating in general, it’s still nowhere close to W2 employees, for example. In the gig economy, taxes get paid later on when tax returns are submitted, whereas the government prefers the employee structure because they get what they’re due long before that point in time.
"The only thing I can advise CFOs on is to stay on top of it. If you have a choice, make people employees then you don’t have to worry too much," Read said.
If you go the route of independent contractors, and the IRS then releases guidelines that determine that you should have gone with employee classification, then you’re going to have tax problems. The IRS will make sure that you then pay the back taxes, and trying to collect those back from an employee is not a smooth process. Remember that there’s also interest and penalties that may apply.
In reality, for a CFO, there shouldn’t be a huge difference between paying an employee and paying an independent contractor. You may not be withholding or paying the contractor’s tax, but you should still be compensating that person in time for their contributions to the business. The difference is who pays the tax, and when does it get paid to the IRS, and this is really the issue.