Giving your workers a payroll advance simply means offering them early access to their paychecks (generally due to an unforeseen event) with agreed-upon conditions. It basically functions as a short-term loan that employees repay with future paycheck deductions. Before offering staff this option, you should carefully consider legal regulations, taxes, and alternatives.
Several laws affect payroll advances, but they are subject to change, so it’s essential to check them at least a couple of times a year if you issue advances.
What to Consider Before Issuing Payroll Advances
Payroll advances can help employees and garner goodwill for your company. Before you act, however, it’s important to consider the implications.
The first item to consider is the stress that a payroll advance may place on your payroll team. If you have a small payroll team, payroll advances may become overwhelming. This is why many companies simply don’t offer them.
Each advance made to an employee requires time-consuming and complex tracking. You’ll need to ensure all state and federal taxes are accounted for and ensure proper recordkeeping. If not managed correctly, your company risks noncompliance violations.
Should you withhold payroll taxes from a payroll advance? Since a payroll advance is essentially a short-term loan, you won’t need to withhold payroll taxes from it, and your employee should pay you back in full. You’ll continue to process payroll as usual, withholding taxes and the agreed-upon amount from each paycheck until the debt is fully paid.
Federal law prohibits paycheck deductions that would reduce an employee’s pay below the minimum wage—but payroll advances are an exception. If an employee owes your company money because of a payroll advance, then your company can withhold money to pay back the advance at rates that may reduce the employee’s pay below the minimum wage. Note that this is a federal exception, and some states do not allow this practice, so check your state and local laws.
Compliance tip: Companies cannot profit from payroll advances to employees. You can add administrative fees to cover any paperwork, recordkeeping practices, or bank charges, but you cannot profit from the advance, so keep any charges low.
Under federal law, there are only certain reasons you can deduct pay from an employee, like taxes and benefits. For any reason not provided for under federal or state law, you must get the employee’s consent, in writing, before initiating any deduction.
For more specific information about the regulations for payroll advances in your state, check out our state payroll guides. They cover everything from minimum wage to labor laws and even provide in-state resources for any additional guidance you need:
State Payroll Directory
If you’re advancing more than $10,000, you’ll need to check the federal prevailing rate on personal loans and consider charging the same rate. The IRS updates applicable federal rates monthly.
Charging 3% when the federal rate is 6% will require you to recognize the difference as taxable income to the employee (more calculations, more paperwork). The IRS will consider any fees you charge as interest, even administrative fees, so be sure to include that in your calculation.
How to Manage Payroll Advances
Since implementing a payroll advance is your responsibility, you’ll need to create and manage the process. If you’re using a payroll provider, you should loop a representative in to ensure all transactions are captured accordingly. Some providers even have tools to help you manage this more efficiently—you can label an off-cycle payment as an advance and set the amount to be deducted as a repayment from the employee’s next paycheck (or next several paychecks, depending on how much you pay out).
Note that you will have to fund all payroll advances, so you will essentially absorb all the risk. If the employee’s performance starts to slip or they do a no-call, no-show one day, you’ll need to weigh the costs of terminating them (the chance of you receiving repayment decreases) or giving them a chance to improve—at least until you recoup the funds.
Here are some items to consider when developing your payroll advance policy:
- How often will employees be able to take advances? We recommend putting strict limits on this of no more than once per year.
- Which employees will be eligible? You may have part-time employees that should not be eligible because of their reduced income and the extended time it would take for them to repay the advance.
- How much can an employee receive as an advance? Technically, a payroll advance should be no more than the employee’s paycheck.
- Are you going to charge fees or interest? You can, but be careful about how much, as you’re not allowed to make money off the transaction.
Above all, a payroll advance should be accompanied by a written agreement between you and the employee. This document sets the advance payment terms and how you’ll recoup the advance through payroll deductions.
When creating the payroll advance repayment agreement, make sure it includes the following information:
- The employee’s name
- The date of the payroll advance and amount
- The date of the first deduction, if more than one, and the frequency of deductions
- The amount of the deduction
- The company’s right to collect any remaining balance if the employee is no longer employed
When to Offer a Payroll Advance
Usually, the first time a company considers offering a payroll advance is when an employee requests one. Being proactive, however, you can develop your policy and be ready when an employee makes a request.
Here are some common reasons employees may request a payroll advance:
- A sudden medical bill
- Car repairs
- Emergency financial situation
- Poor credit reducing their ability to get a traditional loan
You can and should ask the employee for a reason. Your company can determine what’s legitimate and what’s not. After all, a request for a payroll advance to buy a new TV differs greatly from a request because of an unexpected medical bill.
Compliance Note: Do not pry. An employee may provide you with a reason when they make the request—but don’t ask follow-up questions. It may seem insincere, but because a payroll advance is often the result of a personal situation, asking more questions may put your company at risk of a discrimination claim.
Pros & Cons of Payroll Advances
| PROS | CONS |
|---|---|
| Relief for employees suffering financial hardship | Added administrative costs |
| Increased employee loyalty | Employees may need additional funds |
| Additional benefit for employees | Potential for abuse if not properly monitored |
It’s important to note that you may have trouble recovering the payroll advance if an employee quits or is terminated. This is why it’s vital to have a written agreement in place. Even if an employee quits, you have a legally binding contract, allowing you to pursue legal action. Be careful trying to recoup the entire remaining balance from an employee’s final paycheck, as this might violate state law.
Payroll Advance vs Employee Loan
A payroll advance is technically a loan to an employee. So what’s the difference?
The main distinction between a payroll advance and an employee loan is that a payroll advance provides the employee with their wages before payday. The employee must repay the advance through paycheck deductions. Meanwhile, an employee loan may involve larger sums of money that get repaid over a longer period.
A payroll advance is often best for those employees who need quick access to funds. An employee loan may be more suitable for those who don’t need immediate cash but may need larger sums of money that they’ll repay through paycheck deductions over a longer period.
Payroll Advance Alternatives
Before issuing a payroll advance to any of your employees, you may want to consider alternative ways to pay employees. Below, we’ll talk briefly about two other options that provide employees with funds between paychecks: traditional payday loans and on-demand pay.
Bottom Line
Payroll advances are best for serious emergencies that can’t be fixed with a single paycheck. We’re not saying to issue a $10,000 advance to an employee who earns $10 an hour, but $1,000 could be reasonable. Advances help your workers deal with financial shortages but are better reserved for one-off events. And since they’re short-term loans, they’re issued solely to help employees.
