Don't let small business clients keep kicking the payroll can down the road

If you're working with a fast-growing small business or serving as the CFO, it's exhilarating to see the founder's vision becoming reality. 

The business has reached the point of needing full-time employees to handle all the new business coming through the door. But when the highest priorities are sales, business development and customer/client support, it's easy to put payroll and human resources on the back burner. Those functions aren't directly tied to revenue, so I understand it's hard to invest time and money there. But if your client doesn't, it can have an adverse effect on their bottom line and put them (and possibly you) at risk of legal and compliance issues.

Most small businesses we've worked with start with a manual payroll process. It's usually handled by the founder/owner or by an office manager or part-time bookkeeper who's wearing multiple hats. 

Small businesses often ask me how big they must be before they start outsourcing payroll. My answer: The moment you bring in your first contractor or plan to hire your first employee.

Payroll is too complicated to manage without the right expertise. Your client may think they're too small to need outside payroll assistance, but even at their size, tax withholding, state registrations, classification rules and filing deadlines can easily be missed. And the penalties for getting those things wrong add up fast. We've seen many early-stage businesses try to handle payroll themselves and they end up spending far more time and money cleaning up mistakes than they would have spent doing it right from the start. Payroll missteps are especially common in small businesses that are scaling fast or that rely on distributed or non-traditional workforces. If you are working with clients in the following industries, you'll want to pay special attention to the following:

• Technology/Software as a Service: Remote-first culture means employees are scattered across states (or countries). A single remote hire in a new state can trigger tax withholding, unemployment insurance, workers' comp, and paid leave obligations.
• Professional services and consulting: Heavy reliance on 1099 contractors creates misclassification risk. The IRS and the Department of Labor have both intensified scrutiny in this area.
• E-commerce and direct-to-consumer brands: Fast hiring of warehouse, logistics and customer service workers is occurring across multiple states, often with variable pay structures and overtime complications.
• Health care and home services: It's common to see a mix of W-2 and 1099 workers, varying licensure requirements by state, and complex scheduling and overtime calculations.
• Construction and skilled trades: For workers crossing state lines on projects, watch for the prevailing wage requirements and certified payroll reporting.

The common thread: Any business hiring across state lines, relying on contractors or scaling headcount quickly is at an elevated risk of making mistakes. Multistate payroll complexity alone now affects even very small businesses thanks to the remote work era.

7 common payroll mistakes

1. Misclassifying workers: Treating employees as 1099 contractors (or vice versa) is one of the most expensive mistakes a business can make. Studies show that 10% to 30% of employers misclassify workers. The IRS uses a multifactor test, and getting it wrong can trigger back taxes, penalties, interest, and retroactive liability for benefits.
2. Missing state registrations: Hiring a remote employee in a new state without registering for that state's payroll tax, unemployment insurance and workers' comp is incredibly common post-2020.
3. S-corp reasonable salary failures: S-corp owners either are not paying themselves a salary at all or setting it too low. The IRS flags this regularly.
4. Late payroll tax deposits: Penalties start at 2% for deposits one to five days late and escalate to 15% for unpaid amounts after an IRS notice. These stack up fast.
5. Incorrect W-2 and 1099 filings: With typos, wrong SSNs and mismatched wage amounts, the penalties can run $60 to $680 per form depending on how late the correction is.
6. Not structuring fringe benefits correctly: Home office reimbursements, vehicle allowances and health insurance for S-corp shareholders all have specific payroll treatment. Getting it wrong creates tax exposure.
7. Payroll not integrated with bookkeeping: Manual data entry between payroll and accounting creates reconciliation errors that compound over time.

Real-world example

A fast-growing SaaS client classified full-time engineers as contractors when those workers should have been classified as employees since those workers were full-time, used company equipment and were integrated into product teams. A state review found the misclassification and forced corrective work: converting 1099s to W-2s, filing amended quarterly returns (941-X) and state amendments, remitting retroactive payroll taxes, paying state unemployment insurance back-payments, and covering failure-to-deposit and failure-to-file penalties plus interest.

We registered the client in the required states, filed the corrected returns, implemented a single HR information system and payroll system that posts to the books and establishes monthly reconciliations. We also negotiated penalty/interest resolutions where possible. The result: no more surprise bills and the founder could refocus on growth.

When expanding across state lines

Every state sets its own rules for income tax withholding, unemployment insurance and filing schedules, and those rules don't always match the employer's home state. For example:

• Remote employee nexus: A single remote hire living in State B can trigger the need for a business to register as an employer in State B. They may also need to start withholding State B income tax and paying State B unemployment — all of which creates new deposit and filing obligations. (Some states even tax remote employees differently from where the company is located.)

• Different filing cadence and taxable wages: States vary on which wages are subject to state unemployment or how taxable fringe benefits are treated. A payroll setup that's fine in one state can be wrong in another, leading to back taxes and notices. The best practice is having a simple "nexus checklist" for every state where a worker lives/works so they register before payroll hits that state.
• Back taxes and amended filings: These may be needed if returns (941, state returns, W-2 and 1099 filings) don't match deposits.
• State notices and audits: These can occur because of missed registrations or incorrect withholding.

That's why your clients need to bring in an external bookkeeper, CPA or outsourced payroll vendor. Payroll is simply too complicated and too risky to be a do-it-yourselfer. For instance, we partner with Gusto to provide payroll services that integrate directly with our clients' bookkeeping.

6 things to look for in a payroll vendor

1. Integration with your accounting software: If payroll data doesn't flow automatically into your client's books, you're creating manual work and reconciliation risk. This is nonnegotiable.
2. Multistate compliance support: Even if your client is in one state now, you want a vendor that can scale with you as you grow.
3. U.S.-based support from real humans: When your client has a payroll emergency, they want someone who picks up the phone and understands their situation.
4. Combined payroll + HR/HRIS capabilities: Onboarding, employee self-service, PTO tracking and benefits administration should ideally live in the same system as payroll.
5. Tax filing and compliance built in: The vendor should handle tax deposits, quarterly filings, year-end W-2 and 1099 preparation, and new-state registrations.
6. Flexible pricing without long-term contracts: Avoid vendors that lock you into annual commitments. Your needs change as you grow.

Don't wait until your clients have outgrown their in-house capabilities. The best payroll solution isn't just software; it's a partner who understands the full picture of your business finances and can set things up correctly from day one.