Startups are natural rule breakers. You’ve got to ruffle a few feathers and disrupt the status quo if you want to build the next Google. But there are two areas where startups definitely don’t want to break the rules: payroll and HR.
Startups that don’t comply with payroll and HR laws can face serious legal and financial consequences. Some penalties are even severe enough to (almost) drive them out of business. With that in mind, we've put together this list of the five biggest startup payroll and HR mistakes to avoid.
Related Article: How to Successfully Scale Your Startup
1. Paying Employees with Personal Finances
When your startup is fresh out of the gate, you often need to make unorthodox or challenging financial decisions to keep operations running smoothly. But mixing personal and business finances is among the most common of financial mistakes small businesses can make.
We get it — in the early days of a startup, having a business bank account can seem like a bit of a pointless activity. Brand new companies are rarely making any money and it might seem to the founder that there's no point in pretending like they’re paying their employees with company money, and not from their own wallet.
This is short-term thinking than can have dire consequences down the road. Eventually, that startup will have to disentangle all its expenses and pay back taxes. Furthermore, if the startup is ever sued or audited, that blurry distinction of personal and business expenses can render a founder’s personal assets vulnerable to court seizure. A startup could even be stripped of its corporate status. Most founders think, “That will never happen to me.” But it’s not worth tempting fate.
2. Misclassifying Employees
Related Article: Payroll & Payments: Independent Contractor vs. Employee
Treating an employee as an independent contractor, when they should in fact be legally considered an employee, is a costly mistaken for a startup to make. Startups do it to avoid tax and insurance obligations and other employment law requirements (e.g., overtime pay). Also, independent contractors typically are not entitled to receive retirement, health insurance, and other similar benefits an employer provides to its employees.
Misclassification is especially common in startups, where many practice “try before you buy” hiring. Yet if the responsibilities of the job don’t materially change when a contractor “converts” into an employee, the IRS considers that worker as having been an employee all along and can fine you for misclassifying them originally.
There are the state penalties, too. In California, the penalty for deliberate misclassification ranges from $5,000 to $25,000 for each violation.
What makes someone who works for you an employee?
Depending on the employment law at issue, different tests may apply to evaluate a worker's independent contractor status and it may be possible to be an independent contractor under one test and an employee under another. Under most laws, one key difference between employees and independent contractors is the degree of control you have over the worker, but the tests may differ in the number and type of factors considered and the weight assigned to each factor.
An employee under the Fair Labor Standards Act, as distinguished from a person who is engaged in their own business, is one who, as a matter of economic reality, follows the usual path of an employee and is dependent on the business which he or she serves.
Some states (such as California, Connecticut, Massachusetts, and New Jersey) have "ABC tests" that focus on issues beyond degree of control. For example, for a worker to be properly classified as an independent contractor under California's "ABC test," a company must demonstrate that the worker: * 1. is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact; and * 2. performs work that is outside the usual course of the hiring entity’s business; and * 3. is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. How to Correctly Classify Your Workers The guide for classifying different types of workers.
How to Correctly Classify Your Workers
The guide for classifying different types of workers.
3. Managing Compliance With Payroll Services
Payroll is hard to do, and the complexity of managing payroll tax obligations at the local, state and federal level easily adds up to a full-time job, even for a business with just a couple of employees. That’s why most businesses use a payroll service.
The issue is that payroll services only get you so far. Startups still need to worry about other employment-related requirements, like worker’s comp, unemployment insurance, new hire reporting, and Form I-9. HR compliance overhead in even the smallest of startups quickly escalates. That’s why many savvy startups use a Professional Employer Organization (PEO) to manage payroll and help startups comply with employment regulations.
A PEO enables customers to cost-effectively outsource the management of payroll, human resources support, employee benefits, and workers’ compensation through a PEO “co-employment” relationship with customers.
4. Overpaying for Healthcare and Benefits
Startup competition is fierce these days. If you want to attract top tier talent, especially developers, you’ve got to offer access to excellent benefits, especially health insurance. But even “good enough for now” health insurance plans are expensive, particularly for smaller companies, who pay more for less coverage.
It’s the law of leverage at work: the larger the company’s employee base, the sweeter the deal. What’s a startup to do?
A PEO can again be helpful here. By working with a PEO, employees are grouped together with the rest of the PEO’s co-employees to form one large group. This means that the PEO can offer the employees access to health coverage and rates on par with that of a large corporation, even though they work for a much smaller operation.
5. Complicating HR Services
Nobody likes paperwork, especially not fast-moving startups. Yet many businesses continue to use outmoded HR processes and legacy software. Stop the madness! We're in the 21st century and there's no need to ask your employees to fill out forms and fax them to the government/benefits provider/other forces that be.
There are several companies out there that are making software to help automate this and which help guide your employees step-by-step. When picking your HR system, prioritize something that works like your employees: online. If you're a Justworks customer, you already know all of this.
Justworks is a software-based PEO that makes document management easy, even as you grow. Get peace of mind knowing all the important documents related to your team, including employee handbooks and W-2s, are in one place, ready to access at any time.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.