Recently we’ve seen the following scenario happen in two nonprofit organizations:

First, the organization accidentally overpays an employee. In one organization, it was confusion over how to use the payroll software which caused a paycheck to be submitted twice for processing. In another organization, a bonus paycheck was direct deposited to the wrong employee. Both were innocent errors.

In both organizations, the “solution” to the overpayment to an employee was to deduct money from future paychecks to pay back the excess wages.

The only problem with this approach is that it does not fix the problem. In fact, it causes more problems. The affected employee at one organization lamented, “I knew something was wrong, but I couldn’t explain it and I didn’t want to rock the boat!”

A Typical Payroll Overpayment Scenario

Jan Arden, an employee of XYZ Organization, is accidentally paid a $500 bonus twice. The additional wages to Jan cause the following payroll taxes to be calculated:

In addition, XYZ Organization, pays $38.25 in matching employer Social Security and Medicare taxes, bringing the total payroll cost to $538.25.

XYZ Organization tries to fix the problem by making deductions from Jan Arden’s future paychecks, similar to repaying an employee loan. The organization also withholds a travel reimbursement owed to the employee. (This really happened.) The goal is to make the employee repay the $500 erroneous gross pay amount.

Multiple Problems Created

This approach causes multiple problems, the biggest one being the employee is forced to repay $500 when she only received $411.75. You could argue that the employee received a $411.75 net paycheck plus credit for Federal income tax withheld plus credit for Social Security and Medicare taxes which total $500. While the Federal income tax withheld will be applied toward the employee’s personal tax return, the employee will have $500 in taxable “phantom” wages on her W-2 which will make her Federal income tax bill higher. And the $38.75 matching Social Security and Medicare tax she paid is, well, can we all agree it’s money gone for the foreseeable future? Bottom line, the employee is not receiving a fair deal here.

The employer is also not made whole. The employer is out-of-pocket the wages of $500 plus another $38.75 in matching Social Security and Medicare tax for a total of $538.75. On top of that, the employer may owe state unemployment taxes. (Note that 501(c)(3) organizations are not subject to Federal unemployment tax.)

Besides being an unfair solution for the employee, this arrangement also causes problems for accounting. The bookkeeper cannot post the amounts deducted from future paychecks against wages because wages are not impacted by this repayment. The only place the deduction amounts could reasonably be posted is to miscellaneous income.

You can see how a domino effect of the problems begin to pile up:

• The employer pays too much in wages
• The employer pays extra payroll taxes on the overpaid wages.
• The employee is forced to repay more money than the error generated.
• The employee may have a confusing mix of remedies applied, including payroll deductions and withholding reimbursements.
• The books of the organization are muddied by overpaid wages and taxes and other entries to record the payroll deductions and unpaid reimbursements.

Simple Solutions

Fortunately the solution is simple, especially if you catch it quickly. Here are two options:

1. Ask the employee to return the net amount paid and have the payroll service reverse the erroneous paycheck. This approach may work if payroll tax returns have not been filed for the quarter affected. This approach is more complicated if the excess payment was tacked on to other wages the employee was entitled to receive.
2. Reduce the employee’s future wages for the amount of the overpayment. You may need to spread out the reduction in gross wages over several pay periods so as not to create a cash flow hardship for the employee. (What do many people do when they get extra money? They spend it!)

Of course the best solution is to avoid such problems in the first place. Training for staff on how to double check for accuracy and requiring approval by a manager before payroll is submitted can cut down on errors. But if you do run into a payroll overpayment, avoid a domino effect of additional errors trying to fix it with payroll deductions! You now know about good options for making it right — for both the employer and the employee.