How to Pay Employees in Cash Legally & Avoid Penalties

Paying employees in cash isn’t usually the most efficient way to give your workers their paychecks, but it’s not illegal. As long as you’re meticulous when doing payroll calculations and withhold, file, and pay your payroll taxes, the IRS will give you a pass.

There are certain steps every business should follow when processing payroll, but employers who pay cash need to focus on certain processes more closely or tweak them a bit to fit their payment practice, which we explain below. For more about how to do payroll download our free “How to Do Payroll” E-book below to learn the basics.

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1. Calculate & Withhold Payroll Taxes & Deductions Correctly

Paying your employees in cash isn’t a pass you can use to avoid learning how to do payroll. You need to perform the basic steps all employers are responsible for, like calculating Social Security, Medicare (6.2% and 1.45% of earnings, respectively), and income taxes due as well as withholding any deductions for health insurance, garnishment payoffs, and so forth.

Pay Your Payroll Taxes

Payroll taxes are usually the biggest issue employers deal with when trying to remit paychecks in cash. The IRS and some state and local governments require you to withhold taxes from your employees’ paychecks, meaning you’ll need to deduct the amounts due and send it to the proper agencies. They don’t usually accept cash, so you’ll need a way to access at least some of your money electronically.

You’re also responsible for paying some employer payroll taxes out of your own business funds. You’ll need to track your calculations from gross to net pay (and everything in between) to ensure you get it right. You will be charged penalties if you’re late sending payments or accidentally short pay the government.

2. Be Diligent About Tracking Work Hours

Assuming you have hourly workers (most jobs that lend themselves to cash payments are based on hourly work), you’ll need an effective way to track employee work hours. There are labor laws governing how long your employees can work before they cross into overtime; federal law requires you to pay any hours worked on over 40 in a workweek at the time and a half rate, or 1.5 times the employee’s regular hourly rate.

You’ll also need to check your state overtime laws; California requires overtime pay for any hours worked over eight in a day and double time for daily work hours exceeding 12.

3. Pay Employees on a Regular Schedule

Paying employees in cash can give you a false sense of freedom, but don’t give in. It’s best to establish a standard payroll process that includes which days or dates you will regularly pay your employees and follow it accordingly. Weekly, biweekly (every two weeks), and semimonthly (twice a month) are the most common pay periods.

Most states have minimum pay frequency requirements you have to follow to avoid being penalized. Monthly is the greatest time many states will allow you to have in between payroll payments, but for some states, like Virginia, Ohio, and California, semimonthly is the minimum requirement.

4. Open a Bank Account Specifically for Payroll

Earlier, we discussed the need to be able to electronically transfer your money to pay expenses like payroll taxes. To take this a bit further, we recommend opening a bank account that’s specifically reserved for payroll transactions. Do this even if you have a general business banking checking account; keeping payroll funds separate makes them easier to track and document for audit purposes (you need to maintain an excellent paper trail, because you’re more likely to be audited if you’re paying employees cash).

Here are a few rules to follow regarding your payroll bank account:

• Don’t convolute the transaction list with unnecessary deductions and withdrawals. If you’re paying employees every two weeks, commit to withdrawing all funds you need to distribute at one time per pay period. And pay taxes, deductions, and other payroll expenses on the same dates each month, when possible.
• Only run payroll transactions through the account—no exceptions.
• Have a regular deposit schedule. This will make reviewing transactions easier to sift through, and it’ll be easier to show auditors where your funds are coming from.

5. Have Employees Sign That They Received Their Paychecks

One control you should definitely implement is establishing an approval system you can use to document that employees received their pay. Cash won’t track itself, and some people aren’t honest—they may lie and claim they didn’t receive their paycheck.

We recommend creating a simple spreadsheet you can use for each pay period.

Include the following:

• Pay date
• Pay period for which employees are being paid
• Each employee’s name
• The amount they’re being paid
• Space for a signature

You should also insert your company logo, or at least the name, on it as well for even more transparency.

6. Create an Arsenal of Payroll Records & Store Them

Employers who pay their workers in cash do it for different reasons; if your reason is to avoid paperwork and bureaucracy, you should reconsider. You won’t have to write checks or deal with payroll software (which simplifies things, by the way), but you will need to maintain sufficient documentation that makes it clear how much money you’re paying out, who you’re paying, what work you’re paying for, and so forth.

Since you’re winging payroll on your own, you’ll be responsible for creating many of these documents yourself; to name a few:

• Pay stubs
• Bank records (statements, transaction reports)
• Accounting records
• Hiring documents (I-9, W-4 Forms, offer letters)
• Time cards

7. Monitor How Much Your Payroll Amounts To

Once you start paying out more than $5,000 weekly, you should consider other ways to pay your employees their paychecks. You’ll be placing yourself at risk carrying that amount of cash around and are likely to be stolen from or lose the money.

Also, avoid making repeated withdrawals of more than $10,000 in cash at one time. The bank is required by law to report cash withdrawals of those amounts to the IRS. This will raise red flags, and you’ll likely face an audit after a few reports, even if your payroll process is legit.

8. Observe Payroll Laws

We’ve mentioned a few laws in this article, minimum wage, overtime, etc., but we encourage you to familiarize yourself with other payroll laws as well to prevent any compliance issues.

For instance, determine whether you have to purchase workers’ comp for your employees (most likely, you do) and how you’ll pay it out (this will come out of your business funds, not employee paychecks). And if your employees receive tips, you’ll need to establish a system for allocating (if you go that route) and paying them out. You also need to be familiar with tip reports and tipped minimum wage (a lower minimum wage rate you’re allowed to pay if employees earn enough tips).

Paying Employees Under the Table

While paying your workers in cash is completely legal, paying them under the table is illegal and could land you in jail. Under the table pay is untaxed cash employers issue to workers to avoid having to withhold and pay taxes. Employers who engage in paying employees under the table do so to avoid creating any kind of paper trail that would set off red flags with the IRS.

Why Paying Under the Table Doesn’t Work Forever

If you (or someone you know, just in case you’re researching for a friend), need more convincing that paying under the table is a bad idea, ponder the following reasons why it won’t work forever, especially if you intend to have a successful business:

• Paying in cash leads to more scrutiny and a higher potential for audits. IRS audits are very thorough, and attempting to hide transactions from them can get you into deeper trouble
• It becomes harder to hide workers as your business and revenue grow. No business owner wants to continue barely breaking even or operating at a loss.
• Employees don’t receive future Social Security or Medicare benefits if their pay isn’t legit. Once they begin to feel cheated, you’re more likely to be outed.

Penalties for Paying Employees Cash Under the Table

If you’re thinking you can ride out the risk of paying employees under the table until you’re caught and just pay a little cash to get out of it, think again. The consequences can be steep.

• Of course, you’ll pay back taxes.
• You’ll also owe interest and penalties that grow exponentially the farther back the IRS manages to trace your under the table pay activity.
• Worse, you can lose your business. If the expenses are too great, you’ll go bankrupt.
• And even worse than losing your business, you can be prosecuted for tax evasion, which could land you in prison for a maximum of five years.

Talk about steep consequences, paying under the table is not a risk we recommend you take.

Bottom Line

Paying employees their paychecks in cash is 100% legal. However, it’s not the most efficient way to distribute payroll, and it won’t eliminate the need for establishing an organized payroll process, proper documentation, or a bank account. Spend time researching how to do payroll and the ins and outs of the laws that govern it before you begin. And ultimately, remember, learning how to pay employees in cash legally will not only save you time and money but will also prevent you from going to prison or losing your business.

If you want to save money but keep yourself organized, consider using payroll software. There’s free software, like Payroll4Free.com and also super affordable software that comes with free direct deposit, like Patriot Payroll.