There's nothing wrong with paying employees in cash. However, both the employer and the employee must report the cash wages and pay taxes on them. Failing to do so can result in huge penalties from the state and federal government.
Reporting Requirements for Cash Wages
Employers are responsible for paying the employer portion of Social Security and Medicare taxes, which currently amounts to 7.65 percent. They're also responsible for remitting tax payments to the state and federal government on a quarterly basis. The amount of wages and taxes paid are a tax deduction for the business. Employees also are responsible for paying 7.65 percent in payroll taxes and must also pay income tax on their gross earnings.
Consequences for Employers
Employers that want to avoid payroll tax expense and bookkeeping requirements may be tempted to pay employees in cash and not report it. This is referred to as paying an employee "under the table." This practice is illegal and they'll be subject to stiff fines and even criminal prosecution if caught. The state of California estimates that an employer who pays under the table and is caught will pay over 20 times more than if they reported the income and paid taxes correctly.
Consequences for Employees
Being paid under the table isn't ideal for employees either. Leaving income off of your tax return is considered tax evasion by the Internal Revenue Service and penalties will be especially high if the IRS believes you knowingly misrepresented your income. Not having a record of wages can also make it difficult or impossible to file a state unemployment claim or a worker's compensation claim.
Withholding payroll taxes, remitting payments to the state and keeping accurate records can be burdensome for a small business. Employers that are struggling with payroll procedures, or have no previous experience in it, may benefit from a third party payroll company. These companies will process employee payroll for a reasonable monthly fee. Although does affect your bottom line, the cost is much less than enduring a payroll audit or IRS investigation.