Can I Pay Employees Cash? What You Need to Know

Paying employees in cash might seem like a straightforward approach for some businesses, but it introduces complex legal and tax responsibilities that require careful attention. Employers must navigate a landscape of regulations to ensure compliance, regardless of the payment method. Understanding these obligations is important for any business owner considering cash payments, as adherence to federal, state, and local laws is mandatory. While cash transactions are permissible, they do not exempt employers from their duties concerning worker classification, tax withholdings, or meticulous record-keeping.

Worker Classification Fundamentals

Before any payment is made, correctly classifying workers as either employees or independent contractors is important. The Internal Revenue Service (IRS) provides guidelines to distinguish between these two classifications, as it directly impacts tax and legal obligations. Misclassifying a worker can lead to significant penalties, including back taxes and fines.

The IRS primarily considers three categories to determine worker status: behavioral control, financial control, and the type of relationship. Behavioral control examines whether the business has the right to direct or control what the worker does and how the work is performed. Factors include instructions given, training provided, and the extent to which the business controls the worker’s methods.

Financial control assesses whether the business dictates the financial and business aspects of the worker’s job. This involves how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, and whether the worker can incur a profit or loss. Independent contractors manage their own business expenses and have greater control over their financial arrangements.

The type of relationship evaluates how the worker and business perceive their association. This includes written contracts, employee benefits such as insurance or vacation pay, and whether the relationship is intended to be ongoing. If a business misclassifies an employee as an independent contractor, it can be held liable for employment taxes that should have been withheld and paid.

Federal Payroll Tax Compliance for Cash Payments

Employers retain specific federal tax obligations for their employees. These responsibilities include withholding federal income tax, Social Security and Medicare taxes (FICA), and paying Federal Unemployment Tax Act (FUTA) taxes. These taxes must be accurately calculated, withheld from employee wages where applicable, and remitted to the appropriate federal agencies.

Federal income tax withholding is based on the information provided by the employee on their Form W-4. Employers are required to withhold a portion of each employee’s wages and remit these amounts to the U.S. Treasury.

FICA taxes fund Social Security and Medicare programs. For 2025, the Social Security tax rate is 6.2% for both the employer and employee, applied to wages up to a certain annual limit, which is $176,100. The Medicare tax rate is 1.45% for both employer and employee, with no wage limit. Employers must withhold the employee’s share from wages and contribute their matching share, totaling 15.3% of wages for Social Security and Medicare combined.

Employers are also responsible for FUTA taxes, which contribute to state unemployment compensation funds. The FUTA tax is solely an employer-paid tax, meaning no portion is withheld from employee wages. The federal unemployment tax rate is 6.0% on the first $7,000 of each employee’s annual wages. Employers receive a credit of up to 5.4% for timely paid state unemployment taxes, reducing the effective FUTA rate to 0.6% in most cases.

Employers report federal income tax, Social Security, and Medicare taxes withheld from employee paychecks, along with their own share of FICA taxes, on Form 941, Employer’s Quarterly Federal Tax Return, which is filed quarterly. Annually, employers use Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, to report their FUTA tax liability. Employers must also provide each employee with Form W-2, Wage and Tax Statement, by January 31 of the following year, reporting annual wages and taxes withheld.

State and Local Payroll Tax Compliance for Cash Payments

Beyond federal requirements, employers must also comply with state and, in some cases, local payroll tax laws. These obligations vary significantly by jurisdiction, requiring businesses to research applicable rules for their location and employees. Many states require employers to contribute to State Unemployment Tax Act (SUTA) funds, also known as State Unemployment Insurance (SUI).

SUTA tax rates and the taxable wage base (the maximum amount of an employee’s earnings subject to the tax) are set by each state. These rates often depend on an employer’s experience rating, which reflects their history of unemployment claims. While most states require only employers to pay SUTA, a few states may require employees to contribute to SUI as well.

Many states also impose a state income tax, requiring employers to withhold a portion of employee wages for this purpose. State income tax withholding rules, forms, and filing procedures differ by state. Some states do not have a personal income tax, and others have reciprocal agreements with neighboring states that can affect withholding requirements for employees who live in one state but work in another.

Local payroll taxes, though less common than federal or state taxes, may also apply in certain cities or counties. These can include local income taxes or other specific payroll-related levies. Employers must identify any such local ordinances and ensure compliance with withholding, reporting, and remittance requirements. Compliance with state and local tax authorities involves specific forms for reporting wages and taxes, similar to federal forms like the W-2, but tailored to state and local regulations.

Record-Keeping and Documentation

Maintaining accurate and thorough records is important for compliance with tax and labor laws. These records provide an audit trail for federal, state, and local agencies. Without proper documentation, a business may face significant penalties for non-compliance.

Specific documentation is necessary. Employers should obtain signed wage receipts from employees for each cash payment, detailing gross wages, deductions, and net amount received. Detailed payroll ledgers showing compensation, withholdings, and net pay for each employee are also important. Time sheets or other records of hours worked must be maintained, especially for non-exempt employees, to demonstrate compliance with wage and hour laws.

Records of tax deposits made to federal, state, and local authorities, including confirmation numbers or other proofs of payment, are also important. The IRS requires employers to keep employment tax records for at least four years after the tax return’s due date or the date taxes were paid, whichever is later. Other federal agencies and state laws may have different or longer retention periods for certain records.

Employers must also retain copies of all federal and state tax forms filed, such as Forms W-2, 940, and 941, along with supporting documentation like Forms W-4. Proper record-keeping helps avoid penalties during audits and provides information for preparing annual and quarterly tax reports. Organizing these documents in an accessible manner is important, as agencies may request them.