How to Pay Employees Cash Legally: A Step-by-Step Process

Paying employees in cash involves more than simply handing over money. It means ensuring every aspect of the payment process fully complies with all applicable employment laws and tax regulations. This approach requires employers to adhere to the same stringent payroll, tax, and reporting requirements as any other payment method. Legal compliance protects both the employer from penalties and the employee by ensuring proper tax contributions and benefit eligibility.

Determining Employee Status

Correctly classifying individuals who perform services for a business is a foundational step, directly influencing all subsequent compliance obligations. The Internal Revenue Service (IRS) provides common law rules to distinguish between an employee and an independent contractor. These rules examine the relationship based on three main categories: behavioral control, financial control, and the type of relationship.

Behavioral control assesses whether the business has the right to direct or control how the worker does their job. This includes evaluating instructions provided, the degree of training given, and the methods used to perform the work. For instance, if a business dictates work hours, provides specific tools, or requires attendance at training sessions, it suggests an employer-employee relationship.

Financial control looks at whether the business controls the financial and business aspects of the worker’s job. This involves considering factors like the worker’s investment in equipment, whether the worker can realize a profit or loss, and the extent to which the worker’s services are available to the general public. If the business covers all expenses, pays a regular wage, and prevents the worker from seeking other clients, it leans towards employee status.

The type of relationship considers how the worker and business perceive their relationship. This includes evaluating written contracts, whether employee benefits are provided, and how long the relationship is expected to last. A written contract stating an independent contractor relationship, without benefits, and for a specific project, supports contractor status.

Misclassifying an employee as an independent contractor can lead to substantial financial and legal repercussions for the employer. The business could be held responsible for federal and state income tax withholding, Social Security and Medicare taxes, and Federal Unemployment Tax Act (FUTA) taxes that were not withheld or paid. Penalties for misclassification can include back taxes, interest, and significant fines, potentially escalating to criminal charges in severe cases.

Understanding Payroll Taxes and Withholdings

Once a worker is correctly identified as an employee, the employer becomes responsible for specific payroll taxes and withholdings, regardless of whether wages are paid in cash or by other means. Federal Income Tax (FIT) withholding is a portion of an employee’s gross wages that the employer is required to deduct and remit to the U.S. Treasury. The amount withheld is based on the employee’s Form W-4, which provides information about their filing status and dependents.

Federal Insurance Contributions Act (FICA) taxes fund Social Security and Medicare programs. For Social Security, both the employee and employer each pay 6.2% of wages up to an annual wage base limit, which is $168,600 for 2024. For Medicare, both the employee and employer each pay 1.45% of all wages, with no wage base limit. An additional Medicare tax of 0.9% applies to individual wages exceeding $200,000, which only the employee pays.

The Federal Unemployment Tax Act (FUTA) imposes a tax on employers to fund unemployment compensation programs. The FUTA tax rate is 6.0% on the first $7,000 of each employee’s wages annually. Employers can generally receive a credit of up to 5.4% against the FUTA tax for timely payments to a certified state unemployment tax system, effectively reducing the federal rate to 0.6%.

Beyond federal taxes, employers must also account for state-level payroll taxes. Many states require withholding for state income tax, similar to the federal system, with rates and rules varying by state. Employers also typically pay State Unemployment Insurance (SUI) taxes, which contribute to the state’s unemployment fund. SUI rates vary by state and are often experience-rated, meaning businesses with more former employees claiming unemployment benefits may pay higher rates.

The employer’s responsibility extends to accurately calculating these amounts, deducting them from the employee’s gross pay, and remitting both the withheld employee portions and the employer’s share to the appropriate government agencies. This process ensures that all tax obligations are met for each cash payment.

Reporting Wages to Government Agencies

After calculating and withholding the necessary payroll taxes, employers must formally report these wages and taxes to federal and state government agencies. For employees, the primary federal reporting document is Form W-2, Wage and Tax Statement. This form reports an employee’s annual wages and the amount of taxes withheld, and employers must furnish it to employees by January 31 of the following calendar year.

Form W-3, Transmittal of Wage and Tax Statements, accompanies the paper filing of all W-2 forms to the Social Security Administration (SSA). This form summarizes the total earnings, Social Security wages, Medicare wages, and withheld taxes for all employees reported on W-2s. The deadline for submitting Form W-3, along with copies of all W-2s, is also January 31.

Employers generally use Form 941, Employer’s Quarterly Federal Tax Return, to report income, Social Security, and Medicare taxes withheld from employee wages, as well as the employer’s share of Social Security and Medicare taxes. This form is filed quarterly, with due dates typically on April 30, July 31, October 31, and January 31. This ensures regular reporting of payroll tax liabilities.

Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, is used to report the annual FUTA tax liability. This form is due by January 31 of the year following the calendar year in which the wages were paid. Most employers are required to deposit FUTA taxes quarterly if their liability exceeds a certain threshold.

For making federal tax payments, employers typically use the Electronic Federal Tax Payment System (EFTPS). This system allows for secure and timely electronic payments of federal taxes, including income, Social Security, Medicare, and FUTA taxes. Many states also provide their own online portals or electronic payment systems for submitting state income tax withholdings and State Unemployment Insurance contributions.

Essential Record Keeping

Maintaining thorough and accurate records is an important aspect of legally paying employees cash. Employers must keep detailed payroll records for each employee, documenting gross wages, all deductions (such as federal and state income tax, Social Security, and Medicare), and the final net pay. These records should also include the dates and amounts of each cash payment made.

Time and attendance records are also necessary, showing the hours worked each day and week for all employees. This documentation supports the calculation of regular and overtime pay, ensuring compliance with federal and state wage laws. Employee information, including their full name, address, Social Security number, and the completed Form W-4, should also be readily accessible.

Copies of all filed tax forms, such as Forms W-2, W-3, 941, and 940, must be retained. These documents serve as proof of compliance with federal reporting requirements. Similarly, records of state-specific payroll tax filings and payments should be kept.

Crucially, when making cash payments, employers must obtain proof of receipt from the employee. This can be a signed wage receipt or a payroll ledger entry signed by the employee, acknowledging the exact cash amount received. This signed acknowledgment provides concrete evidence of payment, which is invaluable in case of an audit or dispute.

Federal law generally requires employers to keep all payroll records for at least four years from the date the tax becomes due or is paid, whichever is later. The Fair Labor Standards Act (FLSA) also mandates that employers keep certain records for three years, including payroll records, collective bargaining agreements, and sales and purchase records. These record-keeping practices are fundamental for demonstrating compliance, facilitating audits, and resolving any potential wage or tax disputes.