Certain types of businesses do most of their selling with cash. Many of these "cash businesses" also pay their workers and others in cash. 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, and some employees ask for cash payments to evade paying income taxes.
Payroll and Tax Issues When Paying Employees In Cash
Employers must withhold employment (federal and state income tax and FICA (Social Security/Medicare) tax) from employee pay. The employers must also report the amount of withholding for each employee to the Internal Revenue Service (IRS). Employers submit the total of both the employee—withheld from the paycheck—FICA tax and the employer portion of the taxes to the IRS on a scheduled basis. Employers must report employee income on Form W-2 each year. It includes cash income.
Employers must verify the work eligibility of newly hired employees, using Form I-9 or the E-Verify system. This verification puts 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.
Failing to Pay Employment Taxes
The IRS deals severely with employers who fail to report and pay employment taxes. Failing to file employment taxes is a common way businesses evade tax (illegal). The IRS can audit your business and will review all available incorporation, even if there are no payroll records or checks. If the IRS can file tax liens against property, and willful attempts to avoid filing and paying employment taxes can lead to criminal convictions.
When You Pay Cash to Employees
- Employees paid in cash and who have no FICA taxes withheld are denied Social Security earnings that could have been used in calculating potential Social Security benefits.
- Likewise, employees who are not "on the payroll" are not eligible for workers' compensation or unemployment benefits.
Certified public accountant (CPA) Gail Rosen says this about paying employees with 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. The 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
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 for Social Security/Medicare, but their wages must be reported to the IRS.
Hiring your spouse or other family members to work for your business and paying in cash can also deprive this person of Social Security benefits. And all the other issues mentioned above apply, including your legal responsibility to report and pay payroll taxes.
Paying Others in Cash
Many businesses pay contract workers (casual labor, summer workers, While payments to independent contractors have fewer issues than those of employees, two issues are worth noting:
- Payments to contract workers must be reported annually on Form 1099-NEC (formerly 1099-MISC before 2020), and
- You must verify taxpayer ID for independent contractors by having the person complete Form W-9; 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.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.