This article is part of a larger series on How to Do Payroll.
A payroll advance is a short-term loan that employees repay with future wages earned. 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’s important you consider legal regulations, taxes, and alternatives before offering staff this option.
What to Consider When Issuing Payroll Advances
Several laws affect payroll advances, and they are subject to change. So, it’s important to check them at least a couple of times a year if you’re issuing advances. Additionally, you should note that you aren’t allowed to profit from payroll advances. This means you don’t need to apply outrageous interest rates (20% would be excessive). Here, we will take a look at laws and interest rates around advances.
Laws Impacting Payroll Advances
- Payroll advances can’t reduce employee paychecks below minimum wage (federal is currently $7.25 per hour).
- You aren’t allowed to charge outrageous interest rates. In fact, many states have their own limits.
- If you issue an advance that exceeds $10,000 and apply an interest rate below the federal rate, you will have to recognize the difference as the employee’s income.
Regardless of the advance amount you approve, you’ll need to set guidelines on how it will be repaid. Large amounts that would eliminate an employee’s paycheck or bring it below minimum wage (calculated based on the number of hours they work) will need to be collected over multiple paychecks, or you will violate federal labor laws.
In addition, be sure to check your state’s employment laws. California, for example, won’t allow you to deduct money from an employee’s paycheck to repay a payroll advance unless the employee agrees to it—and we encourage you to get that agreement in writing.
Interest Rates for Payroll Advances
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.
For more specific information about what regulations are in place for payroll advances in your state, check out our state payroll directory. These detailed guides cover everything from minimum wage to labor laws and even provide in-state resources for any additional guidance you need.
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 make sure all transactions are captured accordingly. Some providers even have tools that can 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 of 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.
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.
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 a little bit about two other options that provide employees with funds between paychecks: traditional payday loans and on-demand pay.
Payroll advances are best for serious emergency situations 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.