Those who have followed the series Mad Men probably remember a number of scenes when Roger Sterling gave someone a wad of cash to do a job for him. It's probably safe to assume that money wasn't reported to the IRS. Although it is not illegal to pay employees and contractors in cash, there are a variety of downfalls associated with this business practice. Most importantly, it complicates the process of paying an accurate amount of payroll taxes.
You are required to report all wages to the IRS, including those that are paid in cash. If you pay a worker in cash, you are still required to pay payroll taxes. Not doing so means you are paying the person "under the table," which is illegal. If you neglect to do so and your business is audited, you could find yourself facing a large penalty.
Accurate records are a must. If you decide to pay an employee in cash, keep accurate records of how much you paid them as well as the date on which the money was surrendered. Again, this can help protect against future issues, such as in the case of an audit.
Impact on workers' compensation and unemployment. What happens if you pay in cash and a worker files a workers' compensation claim? What happens if the person attempts to claim unemployment benefits? If you don't keep accurate records, any claim could lead to an audit. Not to mention the fact that you may also be in direct violation of unemployment and workers' compensation laws. Remember, you are required to pay unemployment tax and workers' compensation insurance.
It may not be illegal to pay employees cash, but you are definitely taking a risk when doing so. The best way to protect against this is to pay each employee via check or direct deposit, which can be done easily using a payroll service. Having a payroll service also automatically gives you payroll reports and pays and files payroll taxes. It's a great way to bypass some of the complications that come with paying employees.