Can I Legally Pay My Employees Cash?

Paying employees in cash involves a complex web of legal and tax obligations for employers. While this method might appeal for its perceived simplicity, it does not exempt an employer from federal, state, or local responsibilities related to payroll, taxes, and labor laws. It introduces additional considerations for accountability and record-keeping that must be managed to ensure compliance.

Legality of Cash Payments

Paying employees in cash is permissible under federal law, provided all employer obligations are met. The payment method, whether cash, check, or direct deposit, does not alter an employer’s legal responsibilities; businesses must adhere to all applicable tax withholding and labor regulations. Correctly classifying workers as employees or independent contractors is a fundamental aspect of legal compliance. Misclassifying an employee to avoid payroll taxes and labor law obligations can lead to severe penalties, including back taxes, fines, and interest. Proper classification dictates the employer’s legal and tax responsibilities.

Federal Tax Requirements

Employers paying cash wages must fulfill various federal tax obligations, including withholding specific taxes from employee wages, making employer contributions, and accurately reporting these amounts to the IRS. Businesses must first obtain an Employer Identification Number (EIN) from the IRS, which is a federal tax ID number required for most businesses, especially those with employees. Employers are required to withhold federal income tax from employee wages based on information provided on the employee’s Form W-4.

Additionally, employers must withhold and contribute to Social Security and Medicare taxes, collectively known as Federal Insurance Contributions Act (FICA) taxes. For 2025, the Social Security tax rate is 6.2% for both employee and employer, applied to wages up to an annual limit of $176,100. The Medicare tax rate is 1.45% for both, with no wage base limit.

Beyond FICA taxes, employers are also responsible for Federal Unemployment Tax Act (FUTA) taxes, which help fund unemployment compensation programs. The FUTA tax is paid solely by the employer, not deducted from employee wages. The standard FUTA tax rate is 6.0% on the first $7,000 of each employee’s annual wages, though employers often receive a credit reducing the effective rate to 0.6%. Reporting these federal taxes accurately is accomplished through specific forms. Employers must provide each employee with a Form W-2, Wage and Tax Statement, by January 31 of the following year, which details wages paid and taxes withheld. Quarterly, employers file Form 941, Employer’s Quarterly Federal Tax Return, to report federal income tax withheld, as well as Social Security and Medicare taxes (both employee and employer shares). Annually, Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, is filed to report FUTA tax liabilities.

State and Local Tax Requirements

State and local tax obligations for employers paying cash wages vary significantly across jurisdictions. These taxes are distinct from federal requirements. Many states require employers to withhold state income tax from employee wages, similar to federal income tax. Rates and rules for state income tax withholding differ widely, with some states having no state income tax.

Employers must also contribute to State Unemployment Insurance (SUI) taxes, which fund state-level unemployment benefits. This tax is typically paid by the employer, though some states may require employee contributions. Some localities may impose their own wage or other specific employer taxes. Certain states mandate employer contributions for programs such as disability insurance or paid family leave. Employers must consult state and local tax authorities to determine all applicable taxes and their reporting requirements.

Maintaining Accurate Records

Accurate record-keeping is essential for employers, especially when paying employees in cash, as it provides proof of compliance. Federal law, including the Fair Labor Standards Act (FLSA) and IRS regulations, dictates specific record retention periods. Payroll records, such as hours worked, gross wages, itemized deductions, and net pay, must be maintained for at least three years under FLSA. Records used to compute wages should be kept for two years.

Tax-related employment records, including Forms W-4, W-2, 941, and 940, must be retained for at least four years after the tax due date or payment date. Some records, like those for retirement benefits, may need to be kept for six years or more. Employers must maintain comprehensive employee information, including names, addresses, Social Security numbers, and W-4 forms. For cash payments, obtaining a signed receipt or acknowledgment from the employee for each payment demonstrates proof of payment during audits or disputes. These records are necessary for preparing tax forms, responding to audits, and proving adherence to wage and hour laws.

Compliance with Labor Laws

All employers, regardless of payment method, must adhere to labor laws designed to protect employees. The Fair Labor Standards Act (FLSA) establishes federal minimum wage standards, currently $7.25 per hour. If a state has a higher minimum wage, employers must pay the higher rate. The FLSA also mandates overtime pay for non-exempt employees who work more than 40 hours in a workweek. Overtime must be paid at a rate of at least one and one-half times an employee’s regular rate of pay.

Employers are required to provide employees with a detailed pay statement, or pay stub, at each pay period. This statement must clearly show gross wages, all deductions, and net pay, even when wages are paid in cash. Federal child labor laws, also part of the FLSA, impose restrictions on the employment of minors, including limitations on working hours and types of occupations. For instance, children under 14 may not be employed in most non-agricultural jobs, and specific hour restrictions apply to 14- and 15-year-olds. These labor standards ensure fair treatment and safe working conditions for all employees, and their applicability remains unchanged regardless of how wages are disbursed.