8 steps to keep payroll compliant for small business owners

From the moment you hire your first employee, your business will enter a web of agencies with a say in how you run your payroll. The Internal Revenue Service (IRS) decides how often you need to deposit withheld taxes and which returns you’ll need to file. The Department of Labor (DOL) sets wage, overtime, and recordkeeping rules, and state agencies add requirements on top — and these can change from year to year. Keeping your business compliant requires knowing what each agency expects you to withhold, report, pay, and document.

Payroll software and outside providers can lighten the workload, but the IRS still holds you, the employer, responsible for filing your returns and depositing your taxes, even when someone else handles payroll.

This guide covers the basics of what payroll compliance is. Plus, you'll get an eight-step checklist and a calendar to help you meet your federal, state, and local obligations.

Payroll compliance means that your business is following all the government rules that affect your payroll processes, including:

• Classifying workers correctly
• Paying minimum wage or higher, plus any overtime
• Meeting your state's pay frequency and paystub rules
• Keeping records that each agency can inspect

A lot of these rules concern taxes. Payroll tax compliance involves everything from calculating taxable pay and withholding the right amount to depositing funds with each agency on schedule and filing tax returns.

Every paystub that your company issues will reflect money that you hold back for the government: federal income tax, plus the employee's share of Social Security and Medicare. You’ll hold that money on the government's behalf, which is why the IRS calls them “trust fund taxes.” (If you fail to hand it over, the trust fund recovery penalty can apply.)

Compliance in payroll requires regular attention. Add an incorrect tax setting or place a worker in the wrong category, and to fix it, you’ll have to revisit every pay period since the error began. Employees often notice these errors first. They plan their rent and bills around an accurate deposit, and receiving a lighter-than-expected paycheck will throw off all of that.

If your business isn’t payroll compliant, you could be on the hook for penalties and fines. Late or missing deposits can lead to IRS penalties, plus interest, and underpaying minimum wage or overtime can result in back wages and damages. The DOL can assess up to $2,515 per violation for repeated or willful violations.

Now that we’ve covered why payroll compliance matters, follow these eight steps to keep your company’s payroll systems on track and compliant.

Step 1: Register your business for the required payroll tax accounts

To register your business for the required payroll tax accounts, here’s what you’ll need to do:

• Register for an EIN.Start by registering for an employer identification number (EIN). It’s free, and you’ll need it for every return, deposit, and W-2 that you send.
• Register with your state. This usually means opening separate accounts for income tax withholding and unemployment insurance.
• Set up electronic payments. Every federal deposit moves by electronic funds transfer. The Treasury’s Electronic Federal Tax Payment System (EFTPS) does this at no cost.

Step 2: Classify employees and independent contractors correctly

You’ll need to follow different payroll rules depending on whether a worker is considered an employee or an independent contractor. For employees, withhold income tax, withhold and match Social Security and Medicare, and pay unemployment tax. For contractors, you generally don’t need to do any of that.

The IRS considers three kinds of evidence when determining whether a worker should be classified as an employee or an independent contractor:

• Who manages their work, and how
• Who sets pay terms and supplies the tools
• The contract, benefits, and expected work timeline

If you misclassify a worker, you could be held responsible for paying employment taxes for that worker. A worker’s status also has implications for minimum wage and overtime pay.

Step 3: Collect and maintain required employee documentation

Have each new hire complete two federal forms right away:

• Form I-9: This will verify that they can legally work in the US.
• Form W-4: This will tell you how much federal income tax to withhold.

Record each employee’s name and Social Security number exactly as they appear on their card, and collect any state withholding forms. Then, report the hire to your state’s new hire registry, which all 50 states run.

Step 4: Follow wage, hour, overtime, and pay frequency requirements

Here are the basics of what you need to know:

• Minimum wage: The Fair Labor Standards Act (FLSA) sets the federal minimum wage: $7.25 per hour for covered, nonexempt employees.
• Overtime pay: Overtime typically equals 1.5 times the regular rate for every hour over 40 in a workweek, but many states and cities require more — and your employee will get whichever rate is higher. You can only classify a worker as exempt from the FLSA’s overtime pay requirement if they meet both the salary and duties criteria that the DOL sets out.
• Minimum pay frequency: Some states set a minimum pay frequency, so check in with your local state office before committing to a weekly, biweekly, semimonthly, or monthly schedule. Many states also require that a paystub show the pay period, gross and net wages, and hours worked.

Step 5: Calculate wages, deductions, and payroll taxes correctly

Once a year, confirm the current rates and wage bases. Here’s what you need to know for 2026:

• Social Security and Medicare taxes: Social Security is 6.2% on wages up to $184,500 and Medicare is 1.45% with no cap, and you match both.
• Unemployment taxes: Federal unemployment tax is 6% on the first $7,000 per employee (or 0.6% once you claim the credit for paying state unemployment). Most states add their own employer unemployment tax.

When you’re doing payroll for your small business, every pay run will follow the same routine: Start the process by determining gross pay, then work out any applicable pre-tax deductions to determine the amount of wages subject to each tax. Then, use the appropriate taxable wage amounts to calculate withholding and payroll taxes.

Step 6: Deposit payroll taxes and file required forms on time

Depositing and filing are two separate jobs:

• Depositing: This means sending the tax money to the IRS throughout the quarter.
• Filing: This involves submitting a return after the quarter closes that reports wages paid and taxes withheld. You could still owe penalties if you skip deposits, even if you file on time.

Depositing

The IRS will assign your deposit schedule (monthly or semi-weekly) based on your tax history, not your payroll schedule. They’ll look at the employment taxes you reported over a 12-month lookback period which, for most businesses, runs from July 1 two years earlier through to June 30 of the previous year. If you report $50,000 or less in that period, you’ll generally get assigned to be a monthly depositor. If you report more than that, then you must deposit semi-weekly. If your tax liability reaches $100,000 or more on any day during a deposit period, you generally must deposit those taxes by the next business day, regardless of your usual deposit schedule.

Filing

Filing follows a fixed quarterly calendar, with due dates on April 30, July 31, October 31, and January 31. Use Form 941 to report income tax withholding, plus Social Security and Medicare.

Form 940 is an annual report covering federal unemployment taxes. Before January 31, send W-2s to employees and the Social Security Administration, plus Form 1099-NEC to any contractor who you paid $2,000 or more in 2026.

Step 7: Reconcile your payroll and maintain accurate payroll records

Before you approve a payroll run, compare the total against recent periods. If payroll usually lands at $45,000, but has suddenly jumped to $60,000, for example, find out why.

At year-end, conduct a payroll audit. Check that your Forms W-2 and W-3 (for transmitting wage and tax statements) tie back to the four Forms 941 you filed.

Hold onto key payroll records. The IRS and DOL run on different time horizons for recordkeeping:

• IRS: The IRS wants employment tax records for at least four years, including wage amounts and dates, W-4s, deposit confirmations, and the returns you filed.
• DOL: The DOL wants payroll records for three years, plus timecards and wage rate tables for two.

In short: Keep all of these records for four years and you’ll satisfy both agency’s requirements.

Step 8: Review state and local requirements, and monitor regulatory changes

Federal rules form the foundation of your payroll obligations. State and local requirements matter too, so follow all applicable rules. When they differ, you apply whichever one treats your employee better.

States differ on income tax, unemployment rates and wage bases, minimum wage, disability insurance, and paid leave. Some cities add payroll taxes of their own.

Multi-state payroll tax compliance gets more complicated every time you add a new location. If you hire a remote employee in another state, you’ll still need to register for that state’s withholding and unemployment accounts before the first paycheck, and then follow that state’s wage and pay rules.

Global payroll compliance follows the same logic: An employee working in another country will fall under that country’s payroll and labor laws. If you’re hiring abroad, read our guide to the best global payroll software to compare the options.

Rules change at every level, so assign one person on your team to track them in each state or country where you have employees.

Use this payroll compliance checklist to evaluate your payroll process cycle by cycle. The deadlines listed here are federal, so also add your state’s deadlines to your to-do list, too.

Most payroll and compliance challenges trace back to these common missteps.

Budgeting only for salary

Employer payroll taxes, benefits, and payroll software all stack on top of the salary in the offer letter, so every hire costs more than their salary alone.

Losing track of a pay change

If a raise, bonus, or new deduction never reaches the pay run, you’ll end up producing an inaccurate paycheck, and that could also lead to an inaccurate tax return.

Ignoring a lock-in letter

If the IRS determines that an employee’s withholding is insufficient, it may issue a lock-in letter specifying the withholding rate. Ignoring that letter can leave your business liable for the back taxes.

Using payroll software can help you stay on top of payroll and related taxes. It can help you calculate wages and withholding, update tables and wage bases as they change, and run direct deposit. Plus, these tools are often able to deposit your taxes and file your returns for you.

But the IRS makes it clear that you’re still responsible for compliance issues, even if you outsource payroll duties. Any errors related to worker classifications, pay rates, hours, and benefit elections will ultimately fall on you. So, even if you automate your payroll process, be sure someone from your team regularly monitors and reviews the tools’ output, as well as any information (like salaries and withholdings, for example) that feed into the system.

To build a smooth-running payroll process, it’s helpful to streamline your financial tools in one central place. Mercury connects to payroll and HR platforms, like Workday and QuickBooks Online Payroll, and you can fund your payroll provider directly from a Mercury checking account. When you have a connected software stack and a payroll routine that you can repeat each month, payroll will feel more manageable and easier to keep up with.

Want to take the hassle out of managing payroll compliance? Explore Mercury Payroll — a native payroll built into Mercury that lets you pay your employees, manage benefits and stay compliant — all from the same account you already bank with.

^{This article is for informational purposes only and does not constitute legal, tax, investment, or financial advice. Founders should consult their own legal and financial advisors before making important financial decisions.}