Payroll Mistakes to Avoid the First Time You Run Payroll

Running payroll for the first time feels simple right up until the moment it isn’t. Misclassify one worker, miss one deposit deadline, or get the overtime rate wrong and you are looking at back pay, interest, and possible penalties from agencies that do not grade on a curve. Here are the payroll mistakes small businesses make most often on their first run, and what to do instead.

Mistake 1: misclassifying employees as independent contractors

This is the most scrutinized error in small-business payroll. Paying workers as 1099 contractors when they should legally be W-2 employees means you have been skipping withholding, employer FICA contributions, unemployment insurance, and potentially workers’ compensation. The IRS and the DOL both have multi-factor tests for classification, and neither test is a checklist you pass by issuing a 1099.

The question is not whether you want the worker to be a contractor or whether they prefer it. The question is whether the economic reality of the relationship makes them an employee. If they work set hours, use your tools, serve your clients exclusively, and cannot substitute another person to do the work, they are almost certainly an employee.

Mistake 2: calculating overtime incorrectly

Overtime under the FLSA is 1.5 times the employee’s “regular rate” for hours over 40 in a workweek. Most employers know this. What many do not know is what goes into the regular rate.

What is included in the regular rate

• Base hourly wages
• Shift differentials
• Non-discretionary bonuses (production bonuses, attendance bonuses)
• Commission payments for a workweek
• The value of meals or lodging provided as compensation

What is excluded from the regular rate

• Gifts and discretionary bonuses
• Vacation pay, holiday pay, sick pay
• Profit-sharing distributions
• Overtime premium itself

If you pay a $100 attendance bonus in a week where an employee works 48 hours, that bonus is included in the regular rate, which raises the overtime rate for that week. Many first-time payroll runs simply multiply base hourly wage by 1.5 and stop there. That underpays.

For tipped employees, the regular rate calculation is even more complex. See How to Handle Overtime for Tipped Employees for the detailed breakdown.

Mistake 3: using the wrong minimum wage

The federal minimum wage is $7.25 per hour, but it is the floor, not the ceiling. Many states and cities have significantly higher minimums. If your state minimum is $15/hour and you pay $7.25, you are violating state law every pay period, regardless of whether you’re meeting the federal floor.

Minimum wages also change on predictable schedules (often January 1). Set a reminder to check your state and city rates at the start of each year. The DOL publishes a current list of state minimum wages on its website.

Mistake 4: missing payroll tax deposit deadlines

Federal payroll taxes (income tax withholding, Social Security, Medicare) must be deposited with the IRS on a schedule based on your total tax liability. New employers generally deposit monthly or semi-weekly. The penalties for late deposits start immediately:

• 1-5 days late: 2% penalty
• 6-15 days late: 5% penalty
• More than 15 days late: 10% penalty
• 10+ days after IRS notice: 15% penalty

These are percentage-of-deposit penalties, not flat fees. On a $5,000 payroll tax deposit, a 10% penalty is $500. Most payroll software handles deposit scheduling, but if you are running payroll manually or with a generic spreadsheet, you need to track the deadlines yourself.

For a streamlined approach to the full payroll workflow, see How to Run Weekly Payroll in 30 Minutes or Less.

Mistake 5: forgetting state and local payroll requirements

Federal requirements are the floor. State requirements add to them, and city requirements can add more. First-time payroll runners commonly miss:

• State income tax withholding: most states with an income tax require you to register and withhold for employees who work in that state, even if the company is based elsewhere.
• State unemployment insurance (SUI): every state has its own SUI rate, wage base, and filing schedule. This is separate from the federal FUTA.
• State-specific pay requirements:California requires reporting time pay when an employee reports to work but is sent home early. New York has a “spread of hours” rule. Oregon and several other states have predictive scheduling laws.
• Final paycheck timing: most states require final wages to be paid within a specific number of days after termination. Some require immediate payment. Missing this deadline can trigger penalties equal to additional days of wages.

Mistake 6: not keeping records from day one

The FLSA requires employers to keep time records for non-exempt employees for at least 2 years and payroll records for at least 3 years. The IRS requires employment tax records for at least 4 years. If you run your first payroll without a system in place to archive those records, you are one audit away from having nothing to show.

A digital time clock handles this automatically. Every punch is timestamped and stored. Payroll exports create a record of wages paid. For the full recordkeeping breakdown, see Recordkeeping Requirements for Time and Pay Records.

First payroll setup checklist

1. 01

   Classify every worker correctly

   Confirm each worker is either a W-2 employee or a legitimate 1099 contractor using the IRS and DOL economic reality tests. Document your reasoning.
2. 02

   Register with your state tax agency

   You need a state employer identification number for income tax withholding and SUI before you can run payroll in most states.
3. 03

   Set up EFTPS for federal tax deposits

   Register at eftps.gov before your first payroll so you can make deposits on schedule. It takes about 5 business days to receive your PIN by mail.
4. 04

   Verify the correct minimum wage for every location

   Check federal, state, and city minimums for each work location. Apply the highest rate that applies.
5. 05

   Turn on time tracking before the first shift

   The FLSA requires records from day one of employment, not from when you decide to get organized. A GPS time clock creates that record automatically.
6. 06

   Calculate overtime using the full regular rate

   Include shift differentials and non-discretionary bonuses in the regular rate before computing the overtime premium.
7. 07

   Archive payroll records after every run

   Export a payroll register and pay stubs for each period. Store them where you can retrieve them in 4 years when an IRS letter arrives.

Frequently asked questions