Overview

Startup payroll is the system you use to pay people correctly and on time while meeting all tax, labor, and reporting rules. This guide gives founders and finance/ops leads a complete, step-by-step path from first hire through multi-state and international scale. It covers compliance, equity, switching providers, GL mapping, and model choices (in-house vs PEO vs EOR).

You’ll find setup checklists, filing timelines, security expectations, and worked examples for equity and the R&D payroll tax credit. Use it end to end, or jump to the sections you need: pre-hire setup, taxes and filings, founder/equity specifics, classification, expansion, R&D credit, switching providers, GL mapping, terminations, security, costs/ROI, and the decision framework.

What is startup payroll and how it changes by stage

Startup payroll is broader than “cutting checks.” It includes registrations, tax withholding and deposits, benefits deductions, compliance filings, general ledger mapping, and controls. Complexity rises with headcount, remote hiring, benefits, equity events, and audits. The right process at five employees won’t survive at fifty.

Early teams can run on a simple semimonthly cycle with basic approvals. As you add states, programs (401(k), HSA, FSA), and equity, you’ll add pre-payroll validations, multi-entity GL splits, and quarterly compliance reviews. Build for today with a clear path to tomorrow so you don’t have to rebuild under deadline pressure.

Pre-seed to Series B: milestones and complexity inflection points

At pre-seed, the goal is legal compliance with minimal overhead: get tax IDs, select payroll software, set a pay schedule, and run clean, timely payrolls. Complexity spikes with your first remote employee in a new state (registrations, pay rules), the first benefits plan (deductions, ER/EE contributions), and first equity event (taxable RSUs or NSO exercises).

Seed to Series A adds multi-state, 401(k), and expense reimbursements. Controls like dual approvals and monthly reconciliations help prevent errors. By Series B, expect audits/diligence, multi-entity or international activity, and more complex equity. You’ll standardize GL mapping, add pre- and post-pay checklists, and track leave accruals and wage allocations by department or project. Aim to introduce one layer of control just before it’s needed to avoid fire drills.

Common workflows and approval models

Most startups succeed with semimonthly or biweekly pay. Hourly teams often prefer biweekly with integrated time tracking.

A simple approval model is preparer → reviewer → approver. The preparer handles data collection, the reviewer validates rates and deductions, and the approver releases payroll and deposits.

Use pre-payroll validations to catch issues (missing I-9s, rate changes, garnishments, new-state registration status). Post-payroll, reconcile gross-to-net, tax liabilities, and benefits remittances to the GL. Keep roles separate where possible. The person who enters changes shouldn’t be the only one who approves and releases funds.

When to bring on HR/People Ops or a benefits broker

Add a part-time HR/People Ops resource around 15–25 employees to own onboarding/offboarding, policy compliance, and vendor management. Bring in a benefits broker as soon as you add health plans (often 10–15 employees) to structure plans, negotiate renewals, and coordinate COBRA. Dedicated payroll/accounting support becomes valuable once you’re in 3–5 states, running stock events, or facing investor diligence.

Pre-hire compliance and registrations checklist

Before hiring your first employee, you need IDs, state accounts, and a basic control framework. Registering in advance avoids delayed pay and penalties. Use the federal portals for key steps like EIN and E‑Verify, and each state’s tax and unemployment sites for local registrations.

Confirm every account is active before your first payroll. Missing a state withholding ID or UI account can block deposits and trigger notices.

EIN, state withholding, and SUTA/SUI registrations

You’ll need a federal EIN for all payroll tax filings and deposits. Then, register for state withholding and unemployment insurance (SUTA/SUI) anywhere you have employees or enough presence to create nexus. Each state issues separate account numbers and deposit schedules. Localities (e.g., some cities in OH and PA) may also require local withholding accounts.

If you hire in a new state, treat it like a mini-implementation. Get the IDs, set your deposit cadence, and validate the provider setup before the first payday. Keep a central registry of accounts and credentials—lost IDs are a common cause of missed deposits.

New hire reporting and E‑Verify

All employers must report new hires to each state’s directory, generally within 20 days of hire. Some states require faster reporting. E‑Verify compares I‑9 information to federal databases to confirm work authorization. It’s voluntary federally but mandatory for certain employers in several states and for most federal contractors. Decide upfront if you’ll participate and configure your onboarding flow accordingly.

Late new hire reports can lead to penalties and missed wage garnishment orders. Automate the trigger from your HRIS to reduce manual tracking risk.

Workers’ comp, pay frequency, and payday rules

Workers’ compensation coverage is required in every state, with thresholds and exemptions varying by jurisdiction and job type. Pay frequency (weekly, biweekly, semimonthly) and payday rules also vary. Some states mandate specific frequencies or final pay timing and impose “waiting time” penalties for late final checks.

Confirm state-specific rules before you run payroll in a new location. A single late final paycheck in states with strict rules can cost more than your annual payroll software fee.

Banking, payroll schedule, and recordkeeping

Open a dedicated payroll operating account to isolate payroll cash flows from general operating expenses. Establish dual approvals for payroll runs and for tax/benefits payments, and lock down who can add bank accounts in your payroll system. IRS guidance expects employers to keep payroll tax records for at least four years; see Publication 15, Employer’s Tax Guide for recordkeeping and tax rules.

Set a semimonthly or biweekly schedule that aligns with your cash cycles and contractor billing. Publish your pay calendar for the year and build reminders for cutoffs, especially around holidays.

Payroll taxes and filings: what to file and when

U.S. payroll taxes include federal FICA, federal unemployment (FUTA), and state unemployment (SUTA/SUI), plus state and local income taxes where applicable. You’ll file quarterly and annual returns and make deposits on a monthly or semiweekly schedule based on IRS rules.

Missing a deposit or filing creates penalties and interest. The easiest way to stay current is to use a provider that automates deposits and filings. Then reconcile liabilities to your GL monthly.

FICA, FUTA, and SUTA basics

FICA consists of Social Security and Medicare taxes. Social Security applies up to an annual wage base, and Medicare applies to all wages. There’s also an Additional Medicare Tax withheld from high-earning employees that the employer does not match.

FUTA is a federal unemployment tax at 6.0% on the first $7,000 of wages per employee. It’s typically reduced by credits for state unemployment contributions. In credit reduction states, the net FUTA rate is higher.

SUTA/SUI rates are assigned by each state and change annually based on experience. Confirm your state’s SUTA rate and wage base each January and ensure your payroll system reflects updates. Incorrect SUTA settings are a frequent cause of year-end notices.

Core filings: Form 941/944, W‑2/W‑3, and 1099‑NEC

Most employers file Form 941 quarterly to report wages, tips, and federal income tax, Social Security, and Medicare taxes. Very small employers may file Form 944 annually if notified by the IRS.

Annual W‑2s go to employees and the SSA, and 1099‑NEC forms go to contractors for nonemployee compensation. Mark key dates: 941s are due the last day of the month following the quarter, and W‑2/1099‑NEC recipient and agency deadlines generally fall on January 31. Build your calendar and buffer time for corrections.

Deposit schedules and penalties

Your federal deposit schedule (monthly vs semiweekly) is determined by a lookback period defined by the IRS. Monthly depositors typically deposit by the 15th of the following month. Semiweekly depositors deposit within a few banking days after payday.

Failure-to-deposit penalties scale with lateness and can add up quickly. Confirm your schedule at year start and after any material headcount changes. If you cross thresholds midyear, your provider should flag a schedule change. Verify it happened.

State and local nuances

Some states and cities have local income taxes (e.g., select cities in OH and PA). A handful require state disability insurance with employee withholding (e.g., CA, NJ, RI, HI, NY). Deposit cadences and electronic filing mandates vary by state and sometimes by locality.

Document the requirements for each state you’re in and maintain a single source of truth. When in doubt, check the state’s tax and labor department sites and test a $0 filing to validate registrations.

Founder and equity payroll essentials

Founder pay and equity can change your payroll tax and reporting profile significantly. S‑corp “reasonable compensation,” 2% shareholder benefit rules, and equity withholding (NSOs, RSUs) all interact with payroll.

Treat founder and equity decisions as part of your payroll design. A small setup effort up front prevents messy W‑2 corrections later.

Reasonable compensation for S‑corp and officer rules

If you operate as an S‑corporation and perform services, the IRS expects “reasonable compensation” paid as wages subject to FICA before taking distributions. Reasonable compensation generally reflects what you’d pay someone else for similar work, considering duties, time, and company stage. Corporate officers performing services are employees for federal employment tax purposes and should be on payroll, not just receiving draws.

Use market data and time allocation to set founder salaries. Revisit each funding round or major responsibility change. Document your rationale—reasonableness is a facts-and-circumstances standard.

2% S‑corp shareholder benefits and imputed income

S‑corp owners who own more than 2% have special fringe benefit rules. Certain benefits—like employer-paid health insurance—are included in the shareholder’s wages for income tax purposes but may be excluded from FICA if properly structured. The company must add the amount to W‑2 Box 1 and withhold income tax. Some benefits (e.g., HSA contributions) require additional care.

Coordinate with your payroll provider to set benefits as “2% shareholder” items so they flow to the W‑2 correctly. Misclassification here is a classic year-end clean-up headache.

Equity grants and withholding: ISOs, NSOs, and RSUs

NSOs are generally taxable at exercise on the spread between fair market value and exercise price. That spread is subject to income and payroll tax withholding for employees.

ISOs do not trigger regular income tax or withholding at exercise, but they can create Alternative Minimum Tax (AMT). Disqualifying dispositions change reporting.

RSUs are taxable as ordinary income at vest and require employer withholding and remittance at that time. Many companies use same-day sale or net settlement to fund withholding. Plan for liquidity at RSU vest or large NSO exercises.

Ensure your cap table and payroll systems talk to each other so withholding, deposits, and W‑2 boxes reflect equity events.

83(b) elections and payroll implications

An 83(b) election allows a recipient of restricted stock (or early-exercised options) to be taxed on the value at grant rather than at vest. You must file it typically within 30 days of the grant or exercise. This can minimize income recognition if value is low at grant and avoid withholding at future vest dates, but it accelerates taxation earlier.

Track 83(b) elections in your HRIS/equity system and note which awards will not trigger taxable income at vest. Your payroll should reflect the election to avoid unnecessary withholding when vesting occurs.

Employee vs contractor classification: ABC test and DOL 2024 rule

Correct classification determines whether you run payroll taxes and benefits or issue a 1099. Federal and state tests differ, and penalties for misclassification can be significant. In 2024, the U.S. Department of Labor finalized a new “economic reality” rule under the FLSA, returning to a totality-of-the-circumstances analysis with multiple factors; see the DOL’s summary of the Independent Contractor Final Rule.

Use a consistent intake process and document your analysis. When in doubt, default to employee or escalate to an EOR/staffing model.

ABC test and economic realities factors

Several states (notably California) use an “ABC test” that presumes worker employee status unless the hiring entity proves each element. A) The worker is free from control and direction. B) The work is outside the usual course of the hiring entity’s business. C) The worker is engaged in an independently established trade.

The federal DOL rule applies a multi-factor economic realities framework. It weighs control, opportunity for profit or loss, investment, permanence, skill/initiative, and the work’s integral nature. Because standards differ, a worker can be an employee under state law even if they might pass as a contractor under a narrower test. Apply the strictest standard that applies to your situation.

Mitigating misclassification risk

Structure contractor work as project-based, outcome-driven, and time-limited. Avoid providing core employee tools/accounts, managing hours, or integrating contractors into your org chart. Use contracts with clear scope, deliverables, and substitution rights. Periodically audit your contractor population for drift into employee-like roles.

Set a review checkpoint at 90 days for any long-running contractor relationship. If the work is ongoing and integral, convert to employee.

When to use EOR or staffing partners

When classification is ambiguous, or when hiring cross-border without an entity, an Employer of Record (EOR) can be a compliant bridge. EORs hire workers as their employees and lease them back to you, handling local payroll, benefits, and filings. For short-term or specialized needs, staffing firms can shoulder employer-of-record risk onshore, too.

Use an EOR for speed to hire and regulatory coverage. Plan to transition to your own entity once you have stable headcount and predictable costs.

Expansion payroll: multi-state nexus and international basics

Remote teams create tax nexus wherever employees work. This triggers withholding and unemployment registrations, and sometimes local taxes. Internationally, “shadow payroll” and tax equalization may apply for assignments or executives working cross-border.

Approach expansion with a playbook: confirm nexus, register, set deposit rules, and align systems. Avoid running “off the books” while you wait. Retroactive fixes are costly.

Remote employees and state tax nexus triggers

Hiring or allowing an employee to work from a new state typically triggers payroll registrations there for income tax withholding and SUTA. Some localities require separate registrations and filings. A single remote engineer can create registration and withholding obligations even if your company has no sales in that state.

Add a pre-offer step to validate tax and labor requirements for the employee’s location. Don’t onboard until accounts are active and set in your payroll system.

Reciprocity agreements and resident vs nonresident withholding

Some neighboring states have reciprocity agreements allowing withholding only for the employee’s state of residence. Employees provide a certificate to claim reciprocity. In the absence of reciprocity, you may withhold in the work state. The resident state typically provides a credit.

Capture residency at onboarding and collect any required reciprocity forms. Review city taxes separately—some apply based on work location regardless of state reciprocity.

Shadow payroll and tax equalization basics

Shadow payroll is a compliance mechanism where you run a notional payroll in a host country to withhold and report income for an employee on assignment. Pay continues from the home entity. Tax equalization policies ensure the employee pays no more or less tax than they would at home, with the company covering differences.

You’ll typically engage a global mobility tax advisor to design shadow payroll and equalization. Implement before the assignment starts. Retroactive reporting can trigger penalties.

EOR vs entity: when each makes sense

Use an EOR to validate market fit, hire the first 1–5 employees in a country, or meet urgent customer needs without waiting months for entity setup. Incorporate once you have durable headcount, need custom benefits, or want to optimize taxes and intercompany flows.

Model both: EOR fees are predictable per-employee, while entities have fixed and variable compliance costs. Switch once the annualized savings and control justify the setup and ongoing overhead.

R&D payroll tax credit: how to claim via payroll

Eligible startups can monetize the federal R&D credit against payroll taxes instead of income tax. This improves cash flow in early years. Since 2023, the maximum offset is up to $500,000 per year for qualified small businesses (subject to ordering and eligibility rules)—see the IRS’s research credit guidance on Form 6765.

Build this into your annual tax process. Make the election on your income tax return, then apply the credit via quarterly payroll filings until it’s fully used.

Eligibility and limits

To use the payroll tax offset, you must be a qualified small business under the R&D rules. Generally, you need below-threshold gross receipts and no prior net income tax liability for the credit year. The current annual limit allows up to $500,000 of R&D credit to offset employer payroll taxes. Detailed limits and ordering appear in the form’s instructions.

Confirm eligibility early and estimate your credit before year-end so you can plan headcount and cash. Keep contemporaneous documentation of qualifying activities and costs.

From Form 6765 to Form 941: applying the credit

You elect the payroll tax offset on your income tax return using Form 6765. Each quarter thereafter, attach Form 8974 to your payroll return to compute the allowable credit and carryforward. Then reflect it on your quarterly Form 941. Your payroll provider should support importing the Form 8974 amounts and applying them to the employer Social Security and (for years beginning after 2022) Medicare tax.

Time the application carefully. It applies prospectively after the election year return is filed. Coordinate with your CPA so the amounts on Form 8974 tie to your general ledger.

Common pitfalls and documentation

Frequent errors include skipping Form 8974, claiming beyond quarterly tax limits, and weak substantiation of R&D activities. Ensure your project logs, time tracking, and cost records support the credit calculation. Maintain a reconciliation from your projects to the amounts on Form 6765 and Form 8974.

Schedule a quarterly check-in between finance, engineering leadership, and your CPA to validate assumptions and adjust carryforwards.

Switching payroll providers mid-year without losing YTD data

You can switch providers mid-year without breaking W‑2s if you migrate complete year-to-date data and coordinate cutover. The key is a thorough export/import, a controlled first run, and a reconciliation that proves parity.

Pick a cutover date that gives you at least two weeks to test and fix issues. Make sure both systems are active during transition for a parallel run.

Data migration: YTD wages, taxes, and benefits

Export every field the new system needs to recreate year-to-date totals and settings. At minimum, migrate:

Validate one employee per scenario (salaried, hourly, multi-state, 401(k), HSA, garnishment) by recalculating net pay and comparing to prior pay stubs.

Cutover timing, parallel run, and first reconciliation

Avoid mid-period cutovers; switch at a pay period boundary after the prior provider has closed and posted the last payroll. Run a parallel payroll in the new system and compare registers line by line—gross, taxes, deductions, net—before funding.

After the first live run, reconcile payroll liabilities to the bank and GL. Resolve variances immediately so they don’t cascade into quarter-end.

W‑2 continuity and EIN mapping

If you keep the same EIN all year, you can produce a single W‑2 per employee from the new system as long as YTD data is complete. If you are leaving a PEO that files under its EIN, you’ll generally have two W‑2s per employee for that year—one from the PEO and one from your company.

Confirm which EIN each provider will use before you sign the new contract. Set expectations with employees about their year-end forms.

Payroll to general ledger mapping and monthly close

Clean GL mapping turns payroll from a black box into actionable cost data. Map wages, taxes, and benefits to the right departments and projects, and reconcile liabilities each month. A standard close checklist keeps audits simple and forecasts accurate.

Design your chart of accounts and dimensions once, then automate as much posting as possible from your payroll system into your accounting software.

Chart of accounts and departmental allocation

Create distinct accounts for gross wages (by department if material), employer taxes (FICA, FUTA, SUTA), and employer-paid benefits (health, dental, vision, life, 401(k) match). Use dimensions for department, location, and project codes to allocate costs at the journal line level.

Align your payroll earning codes to accounts and dimensions so engineers’ wages hit R&D and sales wages hit GTM. This improves unit economics and R&D credit support.

Accruals for wages, taxes, and PTO

Accrue wages for days worked after the last payroll date through month-end, plus associated employer taxes and benefits. Reverse the accrual on the first day of the next month when the payroll is recorded. If you accrue PTO, book the liability monthly using an updated rollforward of earned, used, and forfeited hours valued at current pay rates.

Tie accrual logic to your pay calendar. Keep a standard model for quarter-ends to avoid surprises.

Sample journal entries and checklist

Sample entries you’ll post each cycle:

Close checklist: confirm payroll register to GL tie-out, reconcile tax and benefits liabilities to agency/vendor statements, and verify cash disbursements. Post accruals and reversals, and archive reports for audit.

Terminations, layoffs, and final pay compliance

Final pay is where startups most often trip compliance. States set strict deadlines and rules for paying final wages and accrued PTO. Severance has unique tax rules, and benefits handoff to COBRA requires coordination.

Plan the process before any layoff. Draft timelines, set payroll cutoffs, coordinate with your benefits broker, and prepare communications.

Final paycheck timing and PTO payout

Several states require immediate or next-business-day final pay for involuntary terminations. Others allow payment on the next regular payday. Whether you must pay out unused PTO depends on state law and your written policy. Late payment in strict states can trigger daily penalties or waiting time penalties.

Build a state-specific playbook and aim to deliver final pay on the termination date when feasible. Decide ahead of time if you’ll cut live checks, direct deposits, or paycards for same-day delivery.

Severance taxation and supplemental wage methods

Severance and bonuses are “supplemental wages” for federal withholding and can be taxed using either the flat-rate method or the aggregate method. Deposit rules are defined in IRS guidance. Supplemental wages also incur FICA and FUTA/SUTA as applicable.

Choose one method and apply it consistently. Communicate net expectations to employees receiving severance, especially if you also pay out PTO.

COBRA handoff and notices

For eligible group health plans, terminated employees typically receive COBRA continuation rights, with strict notice and election timelines administered by the plan or a TPA. Payroll must coordinate final deductions, employer premium contributions through the separation date, and any severance-paid premiums.

Loop in your broker/COBRA administrator before notices go out. Ensure dates, rates, and eligibility are correct.

Data security, privacy, and audit readiness

Payroll holds some of your most sensitive data—SSNs, salaries, bank accounts—so vendor security and your internal controls matter. Expect modern certifications and practical controls that stand up in audits and diligence.

Bake security requirements into procurement, not as an afterthought. Then set least-privilege access and audit logging from day one.

SOC 2, ISO 27001, and payroll data controls

Look for vendors with audited SOC 2 Type II and/or ISO 27001 certifications, which signal mature security programs. Practical controls include SSO and MFA, role-based access, encryption at rest and in transit, segregation of duties (preparer/reviewer/approver), change logs, and downloadable audit trails.

Ask for the most recent SOC 2 report and review the “complementary user entity controls” you must implement on your side. Most findings involve missing customer-side controls, not just vendor gaps.

GDPR/CCPA and PII handling

If you hire in the EU/UK or process EU resident data, GDPR compliance requires a lawful basis, data minimization, defined retention, and data subject request workflows. CCPA/CPRA impose notice, opt-out, and rights for California residents. Ensure your payroll vendor provides data processing agreements and lists subprocessors. Set retention periods consistent with payroll record rules and privacy laws.

Centralize privacy requests. Verify you can search, export, and delete personal data appropriately in your HRIS/payroll stack.

HIPAA implications for benefits data

Payroll systems often exchange enrollment and deduction data with benefits carriers. While payroll vendors aren’t always HIPAA-covered entities, PHI can appear in eligibility files and leave records. Use secure file transfer, restrict access, and consider BAAs with brokers/administrators when PHI flows are material.

Separate medical data from payroll change logs when possible. This reduces exposure and simplifies access controls.

Cost and ROI benchmarks for startup payroll

The total cost of payroll combines software, employer taxes, benefits, and admin time. Costs scale with headcount, number of states, pay frequency, and benefits complexity. PEO and EOR models add fees but can offset internal overhead.

Price the whole operating model, not just software. Then decide if simplicity, speed to hire, or control matter most at your stage.

Software fees and per-employee costs by stage

For 1–10 employees in one or two states, expect modern payroll software to run a base fee plus a per-employee charge, with modest add-ons for state filings and benefits integrations. At 10–50 employees in several states, costs rise with time tracking, 401(k) integrations, and HR features. Volume discounts can offset per-employee rates. At 50–100 employees, bundle pricing and HRIS modules can be cost-effective relative to point tools.

Budget for add-ons like multi-state filings, garnishment services, and off-cycle runs. The cheapest sticker price can cost more if filings or integrations are extra.

Total load: taxes, benefits, and admin time

Employer FICA (Social Security and Medicare), FUTA (net after credits), and SUTA add a baseline tax load to wages. Verify rates annually. Benefits typically add 10–25% of base pay depending on plan richness and company contribution strategy. Admin time—setup, changes, reconciliations, vendor coordination—often runs 2–6 hours per pay cycle early on and more as you add states and benefits.

Include payroll cash timing in your forecast. Payroll, taxes, and benefits often clear on different days, and missed timing causes overdrafts.

Breakeven vs PEO/EOR

A PEO bundles payroll, HR, benefits, and compliance under a co-employment model. It can unlock large-group benefits pricing at small headcount but introduces admin fees and platform lock-in. The breakeven versus standalone payroll typically shifts as you pass ~25–50 employees with healthy benefits participation and a stable multi-state footprint. EORs price per employee per country and are ideal for first hires abroad. Costs are high relative to running your own entity but save months of setup.

Model three scenarios—standalone, PEO, EOR—with your real headcount, states, benefits, and expected growth. Include migration costs when you outgrow a model.

Decision framework: in-house payroll vs PEO vs EOR

Choose the operating model that matches your footprint, benefits goals, and urgency. In-house payroll maximizes control and cost efficiency as you scale domestically. PEOs trade some control for bundled benefits and admin simplicity. EORs trade cost for speed and compliance abroad.

Decide with trigger conditions and a clear migration path so today’s choice doesn’t box you in tomorrow.

Trigger conditions and best-fit scenarios

Use urgency (start date), footprint (states/countries), and benefits strategy as the top three decision drivers.

Pros, cons, and hidden costs

In-house pros: control, flexibility, lower long-run cost. Cons: more coordination, you own compliance. PEO pros: bundled benefits, less admin. Cons: co-employment complexity, fees, benefit lock-in, and potential dual W‑2s when you leave. EOR pros: speed and compliance abroad. Cons: per-employee premiums, limited customization, and potential permanent establishment considerations.

Hidden costs include migration effort, downstream GL cleanup, and the friction of changing benefits during a PEO exit. Put those on the spreadsheet.

Migration paths when you outgrow a model

EOR to entity: form the entity, register for payroll, replicate benefits, and transition employment agreements country by country. PEO to in-house: plan a calendar-year exit to simplify W‑2s, replicate benefits with a broker, and migrate payroll with YTD data. In-house vendor switch: follow the mid-year migration steps above and run a parallel payroll.

Time major migrations for off-peak cycles. Lock in broker and vendor support before you announce changes.

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