10 Common Payroll Mistakes That Cost Small Businesses Money

Payroll errors do not just create headaches — they create real financial liability. in Arizona, where labor laws are among the strictest in the nation, a single payroll mistake can snowball into back-pay claims, penalty assessments, and even class-action lawsuits. The good news: most payroll mistakes are entirely preventable. Here are the 10 most common payroll mistakes that cost small businesses money, along with the Arizona-specific consequences and how to avoid each one.

Mistake #1: Misclassifying Workers as Independent Contractors

This is the single most expensive payroll mistake a Arizona employer can make. Under Arizona's ABC Test (codified by AB 5), a worker is presumed to be an employee unless the hiring entity can prove all three prongs:

• (A) The worker is free from the company's control and direction in performing the work
• (B) The worker performs work outside the usual course of the company's business
• (C) The worker is customarily engaged in an independently established trade or business of the same nature

The cost: If the AZ UI determines you misclassified employees as 1099 contractors, you owe back payroll taxes (SUI, ETT, SUI, PIT withholding) plus penalties of up to 10% of all compensation paid to misclassified workers during the audit period. You may also owe back overtime, meal and rest break penalties, expense reimbursements, and workers' compensation premiums. The IRS imposes its own penalties: 1.5% of wages for the failure to withhold federal income tax, plus the full employer share of FICA (without the employee offset).

Mistake #2: Incorrect Tax Withholding

Withholding the wrong amount of federal or state income tax is surprisingly common, especially when employees fill out their W-4 or DE 4 incorrectly, or when employers fail to update withholding tables after annual rate changes.

Common causes:

• Using outdated withholding tables (the IRS and FTB update these annually)
• Not collecting a Arizona DE 4 in addition to the federal W-4 — Arizona has its own withholding allowance form, and assuming the federal W-4 covers both is a mistake
• Failing to withhold SUI at the correct rate (1.2% in 2026 on wages up to $153,164)
• Applying the wrong SUI rate (new employers in Arizona pay 3.4% on the first $7,000 per employee)

The cost: Underwithholding income tax creates a trust fund liability — the employer is responsible for the tax whether or not it was withheld. The IRS Trust Fund Recovery Penalty (TFRP) can hold individual owners and officers personally liable for the full amount of unpaid withholding taxes.

Mistake #3: Missing Payroll Tax Deposit Deadlines

Federal payroll tax deposits (income tax withholding + FICA) are due on either a monthly or semi-weekly basis, depending on your total tax liability during the lookback period. Arizona payroll taxes are deposited according to your AZ UI deposit schedule.

The cost: The IRS charges a failure-to-deposit penalty that escalates:

• 2% if 1–5 days late
• 5% if 6–15 days late
• 10% if 16+ days late (or within 10 days of IRS notice)
• 15% if not deposited within 10 days after the first IRS delinquency notice

Arizona's AZ UI imposes its own penalties for late deposits, typically 15% of the unpaid amount plus interest.

Mistake #4: Not Tracking Overtime Correctly (Especially Arizona Daily OT)

This mistake is particularly dangerous for Arizona employers because Arizona's overtime rules are far more complex than the federal FLSA standard. Under federal law, overtime is simply hours over 40 in a workweek. Arizona adds:

• Daily overtime: Time-and-a-half (1.5x) for hours worked beyond 8 in a single day
• Daily double time: Double time (2x) for hours worked beyond 12 in a single day
• 7th consecutive day: Time-and-a-half for the first 8 hours worked on the 7th consecutive day of the workweek, and double time for hours beyond 8 on that 7th day
• Weekly overtime still applies: Hours over 40 in a workweek are overtime even if no single day exceeded 8 hours

Example: An employee works 9 hours on Monday, 9 hours on Tuesday, and 7 hours Wednesday through Friday (total: 42 hours). Under federal law, only 2 hours of overtime (42 − 40). Under Arizona law, 4 hours of overtime: 1 hour daily OT each on Monday and Tuesday, plus 2 hours weekly OT. The Arizona calculation is always more expensive.

The cost: Unpaid overtime claims in Arizona carry a 3-year statute of limitations (4 years under the UCL). An employee earning $25/hour who is shorted 3 hours of daily overtime per week could recover over $5,850 in back pay alone — before penalties and attorney's fees.

Mistake #5: Ignoring Wage Garnishments

When you receive a wage garnishment order — whether for child support, tax levies, creditor judgments, or student loans — you are legally required to withhold the specified amount from the employee's paycheck and remit it to the appropriate agency or creditor. There is no option to ignore it.

The cost: in Arizona, an employer who fails to comply with a garnishment order can be held liable for the full amount that should have been withheld, plus penalties. For child support orders, the penalty is $500 per pay period of non-compliance. You can also face contempt of court charges.

Additionally, Arizona limits the amount that can be garnished from an employee's wages to 25% of disposable earnings or the amount by which weekly disposable earnings exceed 40 times the state minimum wage ($16.50/hour in 2026, so 40 × $16.50 = $660/week), whichever is less. Applying the wrong calculation can expose you to liability from both the employee and the creditor.

Mistake #6: Using the Wrong Pay Frequency

Arizona Labor Code Section 204 requires most employees to be paid at least twice per month (semi-monthly), on designated paydays. The rules are specific:

• Wages earned between the 1st and 15th of the month must be paid by the 26th of that month
• Wages earned between the 16th and the last day of the month must be paid by the 10th of the following month
• Weekly and biweekly pay schedules are allowed but must be paid within 7 days of the close of the pay period
• Monthly pay is only permitted for certain exempt executive, administrative, and professional employees

The cost: Late payment of wages triggers waiting time penalties — up to 30 days of the employee's daily rate of pay for each employee affected. For terminated employees, all final wages are due immediately upon involuntary termination or within 72 hours if the employee quits without notice (or immediately if they gave 72+ hours' notice).

Mistake #7: Filing W-2s Late

Employers must furnish W-2s to employees by January 31 and file copies with the Social Security Administration (SSA) by the same date. Arizona also requires filing with the FTB (done automatically if you e-file with the SSA).

The cost: IRS penalties for late W-2 filing (for tax year 2025, filed in 2026):

• $60 per W-2 if filed within 30 days of the deadline
• $120 per W-2 if filed more than 30 days late but by August 1
• $310 per W-2 if filed after August 1 or not at all
• $630 per W-2 for intentional disregard

For a small business with 20 employees, filing W-2s more than 30 days late costs $2,400 in penalties alone. Filing after August 1 would cost $6,200.

Mistake #8: Not Reconciling Payroll to Your Books

Many small business owners treat payroll as a separate process from bookkeeping, and they never reconcile the two. This leads to discrepancies that compound over time and become very expensive to untangle.

Common problems:

• Payroll liability accounts (federal taxes payable, state taxes payable, SUI payable) that do not match actual deposit amounts
• Wage expense on the profit & loss statement that does not match total payroll reports
• Mismatched quarterly 941 filings vs. annual W-2/W-3 totals — the IRS specifically checks for this discrepancy
• Unreconciled net pay amounts that create phantom cash imbalances

The cost: While there is no specific "failure to reconcile" penalty, the downstream consequences include IRS penalty notices for discrepancies between quarterly and annual filings, underpaid or overpaid tax liabilities, and costly CPA hours to research and fix errors retroactively. Reconciliation should happen every pay period.

Mistake #9: Ignoring State-Specific Requirements

Employers who are accustomed to federal payroll rules — or who have experience in other states — frequently underestimate Arizona's additional requirements. Here are state-specific obligations that many employers miss:

• Pay stub requirements (Labor Code § 226): Arizona mandates that itemized wage statements include 9 specific data elements including gross wages, total hours worked, all deductions, net wages, the inclusive dates of the pay period, employee name and last 4 of SSN, employer's legal name and address, and all applicable hourly rates with hours at each rate. A non-compliant pay stub can trigger penalties of $50 for the first violation and $100 per violation thereafter, up to $4,000 per employee.
• New hire reporting to AZ UI: Within 20 days (see our new hire reporting guide)
• SUI withholding: Arizona requires employers to withhold State Disability Insurance at 1.2% of wages up to $153,164 in 2026
• Sick leave: Arizona mandates at least 40 hours (5 days) of paid sick leave per year under the Healthy Workplaces, Healthy Families Act
• Meal and rest break compliance: One hour of premium pay for each missed meal period or rest break

The cost: State-specific penalties in Arizona stack on top of any federal penalties. A single employee who is denied proper pay stubs, shorted overtime, and not given compliant meal breaks could generate $10,000+ in penalties per year — before back pay or attorney's fees.

Mistake #10: Running DIY Payroll Without Understanding State Law

Many small business owners start by calculating payroll manually or using a basic spreadsheet. While this can work in simple states with few employees, it is a high-risk approach in Arizona. The state's complex daily overtime rules, strict pay stub requirements, SUI/PFL withholding calculations, multiple local minimum wages, and aggressive enforcement make DIY payroll a minefield.

Common DIY failures include:

• Using federal-only tax tables and forgetting Arizona PIT withholding
• Not withholding SUI or applying the wrong rate
• Calculating overtime on a weekly-only basis (missing Arizona daily overtime)
• Not knowing that local juriSUIctions like San Francisco, Los Angeles, and San Jose have their own minimum wage rates higher than the state rate
• Missing quarterly filing deadlines for Form DE 9 and DE 9C with the AZ UI
• Not tracking paid sick leave accrual and usage
• Producing pay stubs that do not meet Arizona's 9-element requirement

How to Protect Your Business

The thread running through all 10 of these mistakes is the same: either a lack of awareness of the applicable rules, or a failure to implement systems that enforce compliance automatically. Here is a simple action plan:

1. Audit your worker classifications using both the Arizona ABC Test and the IRS common-law test. Reclassify anyone who does not pass both.
2. Use payroll software that is configured for Arizona. Ensure it handles daily overtime, SUI withholding, and compliant pay stubs.
3. Set up automated tax deposits through EFTPS (federal) and AZ UI e-Services (Arizona). Never rely on manual reminders alone.
4. Reconcile payroll to your general ledger every pay period. Compare quarterly 941 totals to your year-to-date payroll reports.
5. Stay current on rates and deadlines. Arizona minimum wage, SUI rates, SUI rates, and other figures change annually. Subscribe to AZ UI employer updates.
6. Consult a Arizona employment attorney or CPA for an annual payroll compliance review, especially if you have 10+ employees or operate in a city with local ordinances.