Getting everything right when you’re running a small business is, as any small business owner knows, an illusion. There will be mistakes and bumps along the way to success. Even processes as essential as payroll get goofed up or have to change from pay period to pay period for various reasons. The good thing is that there’s a corrective tool at your disposal for making modifications to manage payroll changes or fluctuations outside of annual raises.
This process is known as retroactive pay. Here’s everything you need to know about how it works and what it means in order to start putting it to work in your small business as soon as possible.
What is retroactive pay?
Retroactive pay is when a business owes an employee more than they were paid. The business can then correct the issue by providing retroactive pay. Whether it was an accounting or clerical error, or something like an ongoing contract negotiation, or a raise that takes place in the middle of a pay period — there are all kinds of reasons that retroactive pay might be necessary.
Retroactive pay is also different from back pay, even though some people might confuse the terms and use them interchangeably. Retroactive pay is only the difference between what an employer paid and what they actually owed. Back pay is a payment for work that an employee previously completed but never
received payment for at all. This can be common after disputes such as when an employer holds pay and a court then orders back pay.
Retroactive pay is only the difference between what an employer paid and what they actually owed. Back pay is a payment for work that an employee previously completed but never received payment for at all.
One more thing to note: Retroactive pay can be mandated. Courts can order a business to issue retroactive pay in the event of things like:
- Overtime violations
- Paying less than minimum wage
- Breaching a contract
However, if all of your business practices are on the up and up when it comes to the law and social decorum, then this is something you’ll probably never have to worry about.
How do I calculate retroactive pay ?
Luckily this isn’t too far off from calculating your regular pay period payments. You’ll need to know the basics like:
- The dates of the pay period in question
- How many hours the employee worked (if the person is an hourly employee)
- The amount of payment they received for the pay period
- The correct amount that they should have received
Just subtract the amount received from the amount owed and you’ll have the difference that you owe to your employee in retroactive pay.
How does retroactive pay work?
The most important thing to note is that different states have different laws when it comes to retroactive pay.
Whether it’s a clerical error that resulted in less pay, or a raise that was going to take effect mid-pay period, all you have to do (once you calculate the difference owed) is cut a check for that amount. You can issue a special, separate check or you can roll it into the employee’s next regularly scheduled payment — up to you!
The most important thing to note is that different states have different laws when it comes to retroactive pay. States like Texas and New Mexico don’t allow state employees (and employees of state institutes of higher education as well in Texas’ case) to receive retroactive pay no matter what, even if there was an error. California, on the other hand, allows employees to sue if their pay statements don’t include the exact dates for which they were paid. So when issuing a retroactive check in California, don’t forget dates.
Of course, you’ll want to make sure there aren’t any city or other local ordinances that impact how (and if) you’re able to go about issuing retroactive pay.
What do I need to know about retroactive pay and taxes?
Just like with any other forms of payment, you have to withhold relevant payroll taxes — everything from state mandated withholdings to the big ones like Social Security, Medicare, and the like. When it comes to income tax, though, retroactive pay takes a bit of a different route depending on the type of payment method you use (a separate check or lumping it into a future payment).
If you go the individual check route, the IRS is going to count this as supplemental wages, i.e. an additional payment for employees outside of their regular wages (even though it seems like retroactive pay is part of regular payments, the IRS won’t see it that way technically). When going down this route, consider withholding a flat amount from the sum of the pay.
If you roll retroactive pay into an upcoming paycheck and don’t
mark part of it as retroactive pay, then you’ll use the same tax withholding practices as you normally would for the full amount of the check. If you roll it into one payment but you do mark a portion of it as retroactive pay, then you’ll have to do a little math between what was already withheld and what needs to be additionally withheld from the retroactive portion of this check as well as the “normal” payment part of the check.