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Common Payroll Mistakes to Avoid as a Small Business Owner in the USA (2025-2026)

Running a small business is a marathon, and payroll is often the most complex leg of the race. According to the IRS, nearly 33% of employers make payroll errors every year, leading to billions of dollars in collective penalties.

For a small business, a single mistake—like a late tax deposit or misclassifying a worker—can lead to fines ranging from 2% to 15% of the total tax bill. As we move into 2026, new tax laws have adjusted thresholds and reporting requirements that every owner must know.

Here are the most common payroll mistakes to avoid to keep your business compliant and your employees happy.

1. Misclassifying Employees as Independent Contractors

This is the “King of Mistakes.” Business owners often hire “1099 contractors” to avoid paying for benefits, Social Security, and Medicare.

  • The Risk: If the IRS determines your contractor is actually an employee (because you control when, where, and how they work), you could be liable for 100% of the unpaid FICA taxes, back wages, and overtime.
  • Pro Tip: Use the IRS “Three-Category Test” (Behavioral, Financial, and Relationship) to determine status. When in doubt, it’s safer to classify them as an employee.

2. Missing Tax Deposit Deadlines

The IRS does not play around with deadlines. Payroll taxes (Federal Income Tax, Social Security, and Medicare) are considered “trust fund” taxes because you are holding them on behalf of the government.

  • The Penalty: A deposit just 1 to 5 days late can trigger a 2% penalty. If it’s more than 15 days late, that jumps to 10%. If you receive a notice and still don’t pay, the fine hits 15%.
  • 2026 Strategy: Mark your calendar for the 15th of every month (or your specific semi-weekly schedule) and never “borrow” from the tax fund to cover other business expenses.

3. New 2026 Threshold: Forgetting Form 1099-NEC

For years, the rule was simple: if you paid a contractor $600 or more, you issued a 1099.

  • The Change: Starting in 2026, the reporting threshold for Form 1099-NEC and 1099-MISC has increased from $600 to **$2,000**.
  • The Mistake: Don’t Stop Tracking Your Smaller Payments! You still need to report these as business expenses, even if a 1099 isn’t legally required for the IRS.

4. Miscalculating Overtime for Non-Exempt Staff

As discussed in our Overtime Guide, the federal salary threshold for overtime exemption increased to $1,128 per week ($58,656/year) in 2025.

  • The Mistake: Many owners think “Salary = No Overtime.” This is wrong. If your salaried employee earns less than the threshold, you must pay them one and a half times their regular rate for any work exceeding 40 hours. Failure to do so can lead to expensive Department of Labor (DOL) lawsuits.

5. Poor Record-Keeping

The IRS requires you to keep payroll records (including W-4s, I-9s, and time sheets) for at least 4 years.

  • The Mistake: Many small businesses lose paper records or fail to track “off-the-clock” work. If you are audited and cannot prove how many hours an employee worked, the IRS usually sides with the employee’s estimate.

6. Not Factoring in State-Specific Taxes (e.g., California SDI)

If your business operates in multiple states or has remote workers, you cannot use a “one-size-fits-all” tax approach.

  • The Example: In California, you must withhold State Disability Insurance (SDI), which no longer has a wage cap as of 2024.
  • The Mistake: Forgetting these state-level nuances can result in your business owing thousands in back taxes to state agencies like the EDD.

How to Protect Your Business

  1. Automate: Use reliable payroll software that calculates taxes and files forms automatically.
  2. Audit Quarterly: Every three months, double-check that your W-2 data matches your quarterly Form 941 filings.
  3. Use a Calculator: Before hiring a new person, use our U.S. States Salary Calculator to see the Total Employer Cost (including your half of FICA and SUTA), so you aren’t surprised by the expense.

Conclusion

Payroll mistakes are expensive, but they are 100% preventable. By staying updated on the 2026 threshold changes and maintaining strict deposit schedules, you can focus on growing your business instead of fighting the IRS.