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Using Cash to Pay Employees and Independent Contractors

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Using cash in payments to employees, independent contractors, summer workers, child employees, and others
While it is not illegal to pay employees and independent contractors in cash, it's not a good business practice, for many reasons. Some businesses use cash to pay employees in an attempt to avoid paying payroll taxes. This article discusses legal and tax issues and federal laws relating to income taxes, payroll taxes, and other tax matters. The information in this article is NOT intended to assist employers in evading taxes.

Paying employees with cash. Payroll and payroll tax issues:

  • Employers must withhold payroll taxes (federal and state income tax and FICA (Social Security/Medicare) tax) from employee pay;
  • Employers must also report and pay those payroll taxes, including both the employee and the employer portion of FICA taxes, to the IRS
  • Other employment taxes must be paid on employee earnings, including unemployment taxes, and state workers compensation fund payments
  • Employers must report employee income on Form W-2 each year. This includes cash income.
  • Employers must verify the work eligibility of newly hired employees, using Form I-9 or the E-Verify system. This verification put the employee in the federal system, and if these employees are paid in cash, agency cross-checks can uncover attempts to avoid payroll taxes by paying in cash.

Effect of cash payments on employees

  • Employees paid in cash who have no FICA taxes withheld are denied Social Security earnings that could have been used in calculating their potential Social Security benefits.
  • Likewise, employees who are not "on the payroll" are not eligible for workers compensation or unemployment benefits.

CPA Gail Rosen says this about paying employees with cash:

Being paid in cash can sometimes lead employers to pay their workers in cash. Paying workers illegally in cash can lead to serious problems in addition to tax problems. When a worker is "not on the books" you can suddenly have contingent liabilities that can truly be disastrous.
If a worker gets injured on the job and lands up in the hospital, they will be asked if they got hurt on the job. If the injured worker answers yes, then they will be covered under workers compensation. You are in serious trouble, if you did not pay in workers compensation because you paid them in cash.
Same thing is true for not paying into the state disability and unemployment fund. If for example, you fire the worker and they apply for unemployment, then you will have auditors knocking at your door.

Paying children, spouses, or family members in cash
The wages of children under age 18 who work in your business are subject to the same withholding, payroll tax, and employment tax requirements as other employees. If you hire your own children, they may not be subject to FICA taxes, but their wages must be reported to the IRS. Read more about hiring your children as employees.

Hiring your spouse or other family member to work in your business and paying in cash can also deprive this person of Social Security benefits, and all the other issues mentioned above, including your legal responsibility to report and pay payroll taxes, apply.

Paying independent contractors with cash
Many businesses pay contract workers (casual labor, summer workers, While payments to independent contractors have fewer issues than those to employees, two issues are worth noting:

  • Payments to contract workers must be reported annually on form 1099-MISC, and
  • You must verify taxpayer ID for independent contractors; if the taxpayer ID cannot be verified, you must take backup withholding from the contractor's pay.

Cash payments made to vendors and others with whom you do business must still be substantiated if you want these cash payments to be deducted as expenses on your business tax return. Even small payments in cash should be paid through a petty cash fund , with appropriate documentation.

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