3 Best Practices for Saving Money on Payroll
The fringe-credit, annualization & compliance mistakes that are costing you

If you work on taxpayer-funded jobs or you provide services to a government agency, you’re probably subject to the Davis-Bacon Act, McNamara-O’Hara Service Contract Act, state prevailing-wage laws or local living-wage laws. And small compliance mistakes quickly add up to big costs. 

On average, a 12-man company that works on public jobs 25% of the time will spend 15 hours a week on compliance issues/paperwork and waste $67,184 annually on overpaid wages and taxes. Three main reasons contractors overpay on government projects are the misapplication of fringe credits, miscalculation of annualization and misunderstanding of compliance. 

1. Fringe Credits

Most prevailing-wage jobs require that you pay a specific amount of fringe benefits to employees. For example, in San Diego, California, you pay $19.60 per hour in benefits on all prevailing-wage hours worked by carpenters. After deducting the credit for existing benefits ($4.53 per hour), you pay the difference ($15.07) in “cash” by adding it as taxable income. This leads to four common mistakes that can cost tens or even hundreds of thousands of dollars:  

  • Not using all available credits, thus, overpaying your employees
  • Calculating time-and-a-half (too much) on overtime fringe 
  • Paying the difference in “cash,” costing an average of 20% in payroll taxes, workers’ compensation (WC), and general liability (GL) insurance, as well as 30% in taxes for your employees
  • Assigning prevailing-wage work to employees with low benefits while you could pay higher wages (or offer greater benefits) and spend less to satisfy the prevailing-wage requirements

You may deduct a credit for offering these benefits:

  • Employer cost of health insurance (medical, dental, life, etc.)
  • Employer contributions to 401(k) plans
  • Vacation, holiday and nonmandated sick accruals
  • Union benefits and employer dues
  • Third-party training fees

You cannot take credit for these:

  • Employee deductions (employee paid health/401(k))
  • Use of company vehicles, phones and tools
  • Statutory benefits (WC and employer taxes)
  • Mandated sick, maternity and medical leave 
  • Mileage or expense reimbursements 
  • Holiday bonuses

To calculate each credit, divide your annual cost (e.g., employer health equal to $400 a month or $4,800 a year) by annual hours worked (e.g., 2,080 hours = $2.31 per hour). Any amount you pay in “cash” will cost you and your employees a lot in taxes and insurance. If you pay $15.07 per hour in cash, you pay another $3 per hour in employer costs, and employees pay an average of $4.50 per hour in taxes. That adds up to $3,750 for an employee working just 500 prevailing-wage hours a year.

As such, you’re better off depositing the $15.07 per hour into a third-party fringe trust. A properly structured fringe-cost trust fund can save these costs and still give employees access to cash and desired benefits. On the other hand, a poorly designed trust fund can block employees from their money and expose you to thousands in taxes or compliance penalties.

2. Annualization

You may try to satisfy the fringe by offering more generous benefits, but that will cost more than you expect. Most benefits are subject to annualization, which means that the credit is reduced based on a percentage of prevailing-wage hours each employee works (e.g., if you pay $5,000 a year in medical benefits for an employee that works on prevailing-wage jobs 25% of the time, you can only take $1,250 of credit. If you increased the contribution to $10,000 a year, you would just increase the disallowed credit from $3,750 to $7,500. 

Alternatively, you can provide certain benefits that are exempt from annualization and take 100% credit on your costs. While annualization-exempt benefits vary by state, they typically include:

  • “Cash” payments (requires you to pay taxes, WC and GL)
  • “Cash” payments with a Section 125 cafeteria plan (exempt from taxes and sometimes WC)
  • Hourly fringe health-savings accounts (contributions limited to $7,000 a year for employees with a high-deductible family plan) 
  • Hourly fringe 401(k) contributions

There are myriad fringe trusts on the market, so it’s important to be careful when reviewing the options. For example, the Department of Labor (DOL) determined in 2015 that supplemental unemployment plans were no longer exempt from annualization. Health trusts are also subject to annualization, and some even keep leftover funds when an employee’s hours are more than needed to cover insurance costs.

Depending on a client’s needs, we typically set them up with a multipurpose trust with Section 125, cash-fund and 401(k) components. This provides the largest company tax savings while giving each employee a configurable mix of retirement, tax-reduced spending and available cash as they need it. 

If you do set up a trust, you may consider reducing some general benefits that would be subject to annualization. For instance, an employer contributing 100% to employees’ insurance may want to reduce to the state’s minimum requirement (usually 50%).

3. Compliance

Penalties for lack of compliance can be significant and may come in the form of fines, debarment from government contracts and even criminal prosecution. State and local enforcement can be more aggressive, and private lawyers and unions are constantly trying to generate class-action lawsuits. Here are some easy steps to help you stay out of trouble:

  • File all certified, nonperformance and equal employment opportunity (EEO) reports accurately and on time.
  • Make sure employees are classified correctly.
  • Calculate the fringe credits for each employee—not averages. 
  • Keep all reports and make sure they match (e.g., timecards, daily reports, 5500 forms, fringe statements, etc.).
  • Know your unique state laws. A few examples include:
               o    Forty-five states and cities require sick pay.
               o    Some cities require minority, disadvantaged worker ratios.
               o    Some states calculate overtime using averages, while others rate in-effect.
               o    Many states require predetermined rate increases, travel and subsistence.
  • Pay weekly on federal (and some state) jobs.
  • Have employees sign off on all deductions, and do not use any disallowed deductions on certified payrolls (e.g., uniform, damage or unreturned items). 
  • Manage your subcontractors’ certified work. You are responsible for their compliance issues and employee payments. California and Massachusetts extend this to private jobs, too.


On the other hand, if you understand the laws, you can make them work for you. For instance:

  • Track nonproductive hours—Drive time, shop time and off-site hours are generally exempt from prevailing wage and fringe. 
  • Go negative on fringes—On federal and many state jobs, you can take credit for benefits in excess of the required hourly fringe rate to reduce the base prevailing wage.
  • Understand your state’s wage determinations—California allows employers to take credit against the fringe requirement without capping against individual sub-benefit amounts. 

Government contracts can be profitable but risky. As such, review your requirements with your awarding agency, general contractor and attorneys. Automate where possible and look into a fringe trust to increase profitability and outbid your competitors.