Indicate by check mark whether the registrant (1) has filed all reports required to be filed by sectionSection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o.

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     oþ.

      Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

      Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes þo          No oþ.

      As of November 30, 2004,2005, the last business day of the most recently completed second fiscal quarter, shares held by non-affiliates of the registrant had an aggregate market value of $11,023,863,500.$14,387,643,144 based on the closing price reported for such date on the NASDAQ Stock Market.

      As of June 30, 2005, 378,705,7012006, 380,333,725 shares of the registrant’s common stock, $.01 par value, were outstanding.

      Portions of the registrant’s Definitive Proxy Statementdefinitive proxy statement to be issued in connection with its Annual Meeting of Stockholders to be held on October 12, 2005,5, 2006, to the extent not set forth herein, are incorporated herein by reference thereto into Part III, Items 10 through 14, inclusive.

      Certain written and oral statements made by management of Paychex, Inc. and its wholly owned subsidiaries (the “Company” or “Paychex”(“our,” “we,” “us”) may constitute “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). Forward-looking statements are identified by such words and phrases as “we expect,” “expected to,” “estimates,” “estimated,” “current outlook,” “we look forward to,” “would equate to,” “projects,” “projections,” “projected to be,” “anticipates,” “anticipated,” “we believe,” “could be,” and other similar phrases. All statements addressing operating performance, events, or developments that the Company expectswe expect or anticipatesanticipate will occur in the future, including statements relating to revenue growth, earnings, earnings-per-share growth, or similar projections, are forward-looking statements within the meaning of the Reform Act. Because they are forward-looking, they should be evaluated in light of important risk factors. These risk factors include, but are not limited to, the following and those that are described in the “Factors That May Affect Future Results of Operations” section of“Risk Factors” under Item 11A and elsewhere in this Annual Report on Form 10-K:10-K (“Form 10-K”):

      AllAny of these factors could cause the Company’sour actual results to differ materially from itsour anticipated results. The information provided in this document is based upon the facts and circumstances known at this time. The Company undertakesWe undertake no obligation to update these forward-looking statements to reflect events or circumstances after the date of filing of this Form 10-K with the Securities and Exchange Commission (“SEC” or “Commission”) to reflect events or circumstances after such date, or to reflect the occurrence of unanticipated events.

      Paychex isWe are a leading national provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses in the United States. The Company,States (“U.S.”). At

      Our company was formed as a Delaware corporation formed in 1979, reports its1979. We report our results of operations and financial condition as one business segment. The Company’sOur fiscal year ends May 31. At May 31, 2005, Paychex serviced

      Paychex isWe are focused on achieving strong long-term financial performance while:by:

      The outsourcing of business processes is a growing trend within the United States.U.S. Outsourcing of the payroll and human resource functions allows small- to medium-sized businesses to minimize the administrative burden and compliance risks associated with increasingly complex and changing administrative requirements and federal, state, and local tax regulations. By utilizing the expertise of outsourcing service providers, businesses are better able to efficiently meet their compliance requirements and administrative burdens while, at the same time, providing competitive benefits for their employees. The technical capabilities, knowledge, and operational expertise that Paychex haswe have built, along with the broad portfolio of ancillary services it offers itswe offer our clients, have enabled the Companyus to capitalize on the outsourcing trend.

      ThereWe believe there are approximately 7.47.6 million employers in the geographic markets that Paychexwe currently servesserve within the United States.U.S. Of those employers, 99% have fewer than 100 employees and are the Company’sour primary customers and target market. Based on publicly available industry data, the Company estimateswe estimate that all payroll processors combined serve somewhere between 15% to 20% of the potential businesses in the target market, with much of the unpenetrated market being composed of businesses with ten or fewer employees. Paychex remainsWe remain focused on servicing small- tosmall-to medium-sized businesses based upon the growth potential that management believeswe believe exists in this market segment.

      Paychex servesWe serve a diverse base of small- to medium-sized clients operating in a broad range of industries located throughout the continental United States.U.S. At May 31, 2005, the Company2006, we serviced approximately 522,000543,000 clients. The Company utilizesWe utilize service agreements and arrangements with clients that are generally terminable by the client at any time or

      The composition of the market and the client base serviced by Paychexwe serve (in the United States)U.S.) by employee size is as follows:

      Paychex offersWe offer a comprehensive portfolio of payroll, payroll-related, and human resource products and services to meet the diverse needs of itsour client base. These include payroll processing, tax filing and payment services, employee payment services, time and attendance solutions, include:

      By offering ancillary services that leverage the information gathered in the base payroll processing service, Paychex iswe are able to provide comprehensive outsourcing services that allow employers to expand their employee benefits offerings at an affordable cost. The Company earns its revenuesWe earn our revenue primarily through recurring fees for services performed. Service revenues are largelyrevenue is primarily driven by the number of clients, utilization of ancillary services, and checks or transactions per client per pay period.

      Payroll processing is the foundation of the Paychexour service portfolio. The PaychexOur payroll service includes the calculation, preparation, and delivery of employee payroll checks; production of internal accounting records and management reports; and the preparation of federal, state, and local payroll tax returns. Payroll processing clients are charged a base fee each period that payroll is processed, plus a fee per employee check processed.

      The Core Payroll service is generally targeted forat clients with one to forty-nine employees, although many clients with fifty or more employees utilize this service. The Company’sOur average Core Payroll client employs approximately thirteen people and processes approximately thirty payrolls each year. These figures are impacted year over yearyear-over-year as larger clients, generally fifty or more employees, convert to the Company’sour Major Market Services (“MMS”).

      Core Payroll clients may communicate their payroll information, including hours worked by each employee and any personnel or compensation changes, by telephone, fax, use of the Paychex Paylink® Paylink^®

      PaychexWe also offersoffer Core Payroll services to itsour clients and their accountants through Paychex Online. This secure Internet site offers clients a suite of interactive, self-service products and services twenty-four hours a day, seven days a week. These include Paychex Online Payroll^smSM, Internet Time Sheet, Paychex Online Reports, and General Ledger Reporting Service. Clients can communicate payroll information through the Internet Time Sheet or use the Online Payroll service, and can access current and historical payroll information using Paychex Online Reports. The General Ledger Reporting Service transfers payroll information calculated by Paychexus to the client’sclients’ general ledger accounting software, eliminating manual entries and improving the accuracy of bookkeeping. Over 150,000180,000 clients are currently utilizing some form of Paychex onlineOnline service.

      The Company’s Major Market ServicesMMS primarily targettargets companies that have more complex payroll and benefits needs or have outgrown the Company’sour Core Payroll service, as well as new clients that have fifty or more employees. The CompanyWe currently offersoffer this service in all of itsour significant markets. Approximately one-third of new MMS clients are conversions from the Company’sour Core Payroll service.

      Most MMS clients communicate their payroll information to Paychexus using the Company’s Preview®our Preview^® software. Preview®Preview provides clients with in-house control of payroll and human resource information because the software and the payroll and human resource database reside on the client’sclients’ personal computer or personal computer network. Clients can produce reports and checks at their convenience. Paychex handlesWe handle the software maintenance and providesprovide the client ancillary products and services as requested.

      Paychex provides itsWe provide our clients with a portfolio of ancillary products and services that have been developed and refined over many years. Ancillary products and services provide the Companyus with additional recurring revenue streams and increased service efficiencies as these products are integrated with payroll processing services. Paychex offersWe offer the following ancillary products and services:

     Payroll Tax Filing and PaymentAdministration Services: As of May 31, 2005, 90%2006, 92% of the Company’sour clients utilized itsour payroll tax filing and paymentadministration services (including Taxpay®Taxpay^®), which provide accurate preparation and timely filing of quarterly and year-end tax returns, as well as the electronic transfer of funds to the appropriateapplicable tax or regulatory agencies (federal, state, and local). More than 95% of new clients purchase the Company’sour payroll tax filing and paymentadministration services. The Company believesWe believe that the client utilization percentage of these services is near maturity. In connection with these services, the Companywe electronically collectscollect payroll taxes from clients’ bank accounts, typically on the payday, filesprepare and file the applicable tax returns, and paysremit taxes to the appropriate taxing authoritiesapplicable tax or regulatory agencies on the respective due dates. These taxes are typically paid between one and thirty days after receipt of collections from clients, with some items extending to ninety days. The Company handlesWe handle all regulatory correspondence, amendments, and penalty and interest disputes, and iswe are subject to cash penalties imposed by tax authoritiesor regulatory agencies for late filings and late-late or under-paymentsunder payments of taxes. Clients utilizing the payroll tax filing and paymentadministration services are charged a base fee and a fee per transaction for each period that payroll is processed. In addition to fees paid by clients, the Company earnswe earn interest on client funds that are collected before due dates and invested until remittance to the appropriate taxing authority.applicable tax or regulatory agencies.

     Employee Payment Services: As of May 31, 2005, 65%2006, 68% of the Company’sour clients utilized itsour employee payment services, which provide the employer the option of paying their employees by direct deposit, Paychex Access Visa®Visa^® Card, a check drawn on a Paychex account (Readychex®(Readychex^®), or a check drawn on the employer’s account and electronically signed by Paychex.us. More than 75% of new clients purchase some form of employee payment services. Except forFor the last method, Paychexfirst three methods, we electronically collectscollect net payroll from the client’sclients’ bank account, typically one day before payroll,payday, and providesprovide payment to the employee on payday. The Company’sOur flexible payment options provide a cost-effective solution that offers the benefit of convenient, one-step payroll account reconciliation for employers. Clients utilizing employee payment services are charged a base fee for each

      The payroll tax filing and paymentadministration services and employee payment services are integrated with the Company’sour payroll processing service. Interest earned on funds held for clients is included in total revenuesrevenue on the Consolidated Statements of Income because the collection, holding, and remittance of these funds are critical components of providing these services.

     Regulatory Compliance Services: We offer new-hire reporting services, which enable clients to comply with federal and state requirements to report information on newly hired employees, to aid the government in enforcing child support orders, and to minimize fraudulent unemployment and workers’ compensation insurance claims. Our garnishment processing service provides deductions from employees’ pay, forwards payments to third-party agencies, including those that require electronic payments, and tracks the obligation to fulfillment. These services enable employers to comply with legal requirements and reduce the risk of penalties.

Time and Attendance Solutions: Paychex offersWe offer Time In A Box®Box^® and other time and attendance solutions, which help businesses or employers minimize the time spent compiling time sheet information. These computer-based systems allow the employer flexibility to handle multiple payroll scenarios and result in improved productivity, accuracy, and reliability in the payroll process. Certain clients are charged a monthly fee for use of hardware, software, and support. Clients also have the option to purchase the hardware and software with annual maintenance contracts. Time In A Box®Box is marketed to Paychex’sour small- to medium-

     Other Human Resource Products and Services: Group health benefits are offered in select geographic areas, as are state unemployment insurance services, which provide clients with prompt processing for all claims, appeals, determinations, change statements, and requests for separation documents. Other Human Resource and BenefitsServices products include employee handbooks, management manuals, and personnel and required regulatory forms. These products are designed to simplify clients’ office processes and enhance their employee benefits programs.

      The Company markets itsWe market our services primarily through itsour direct sales force based in majorthe metropolitan markets serviced by the Company. The Company’swe serve. Our sales representatives specialize in Core Payroll, Major Market ServicesMMS payroll, or Human Resource and BenefitsServices product lines. For fiscal 2006, the Company’s2007, our sales force is expected to total approximately 1,805,2,035, with 1,1151,190 for Core Payroll (including international), 195225 for Major Market ServicesMMS payroll, 470and 620 for various Human Resource and Benefits products and services and 25 for time and attendance solutions.Services products. The Human Resource and BenefitsServices sales force includes 240285 human resources and 401(k) recordkeepingRetirement Services sales representatives, 160 PAS/190 Paychex Premier and PEO sales representatives, and 70110 licensed agents selling workers’ compensation insurance and health and benefits services.services, and 35 time and attendance solution sales representatives. Growth in the direct sales force results from the offering of new products and services, particularly as it relates to licensed agents for health and benefits and the continued expansion within Germany. The direct sales force has grown with the addition of time and attendance solutions. These products are utilized by businesses not generally in Paychex’s client base. Additionally, theThe complexity of the time and attendance solutions requires specialized sales representatives.

      In addition to itsour direct selling and marketing efforts, the Company utilizeswe utilize relationships with existing clients, certified public accountants (“CPAs”), and banks for new client referrals. Approximately two-thirds of the Company’sour new clients (excluding acquisitions) come from these referral sources. To further enhance itsour strong relationship with CPAs, during fiscal 2004, Paychexwe have partnered with the American Institute of Certified Public Accountants (“AICPA”) as the preferred payroll provider for its AICPA Business Solutions Partner Program. In fiscalDuring the year ended May 31, 2005, the program was expanded to include Paychex’s 401(k) recordkeeping servicesour Retirement Services and Major Market Services. The direct sales force for Human Resource and Benefits products and services is primarily focused on selling products and services to existing payroll clients as their processed payroll information provides the data integration necessary to more efficiently provide these services.MMS.

      The Company’s Web siteOur website atwww.paychex.com, which includes online payroll sales presentations and product and service information, is a cost-efficient tool that serves as a source of leads and new sales while complementing the efforts of theour direct sales force. This online tool allows Paychexus to market to clients in more geographically remote areas. The Company’sOur sales representatives are also supported by marketing, advertising, public relations, trade shows, and telemarketing programs. The Company hasWe have grown and expectsexpect to continue to grow itsour direct sales force. In recent years, the Company haswe have increased itsour emphasis on the selling of ancillary services to both new clients and itsour existing client base.

      The acquisition ofIn addition, Advantage Payroll Services, Inc. (“Advantage”) in fiscal 2003 provided Paychex with additional sales channels. Advantage has license agreements with fifteen independently owned associate offices (“Associates”), which are responsible for selling and marketing Advantage payroll services and performing certain operational functions, while Paychex, Inc. and Advantage provide all centralized back-office payroll processing and payroll tax filingadministration services. In addition, Advantage has a relationship with New England Business Service, Inc. (“NEBS®NEBS^®”) whereby Advantage performs all client functions other than sales and marketing. The marketing and selling by both Associates and NEBS is conducted under their respective logos.

      The market for payroll processing and human resource services is highly competitive and fragmented. The Company believes itsWe believe our primary national competitor, ADP®ADP^® (“Automatic Data Processing, Inc.”), is the largest U.S. third-party provider of payroll processing and human resource services in terms of revenue. Paychex competesWe compete with other national, regional, local, and online service providers, all of which it believeswe believe have significantly smaller client bases than Paychex.us.

      In addition to traditional payroll processing and human resource service providers, the Company competeswe compete with in-house payroll and human resource systems and departments. Payroll and human resource systems and software are sold by many vendors. The Company’sOur Human Resource and BenefitsServices products and services also compete with a variety of providers of human resource services, such as retirement services companies, insurance companies, and human resources and benefits consulting firms.

      Competition in the payroll processing and human resource services industry is primarily based on service responsiveness, product quality and reputation, breadth of product and service offering, and price. Paychex believes it isWe believe we are competitive in each of these areas.

      The ever-changing mandates of federal, state, and local taxing authoritiestax or regulatory agencies require Paychexus to regularly update the proprietary software it utilizeswe utilize to provide Payroll and Human Resource and Benefits servicesServices to itsour clients. The Company isWe are continually engaged in developing enhancements to and maintenance of itsour various software platforms to meet the changing requirements of itsour clients and the marketplace.

      As of May 31, 2005, the Company2006, we employed approximately 10,00010,900 people. None of theour employees arewere covered by collective bargaining agreements.

      The Company ownsWe own or licenseslicense and usesuse a number of trademarks, trade names, copyrights, service marks, trade secrets, computer programs and software, and other intellectual property rights. Taken as a whole, the Company’sour intellectual property rights are material to the conduct of itsour business. Where it is determined to be appropriate, the Company takeswe take measures to protect itsour intellectual property rights, including, but not limited to, confidentiality/non-disclosure agreements or policies with employees, vendors, and others,others; license agreements with licensees and licensors of intellectual property,property; and registration of certain trademarks. Paychex believesWe believe that the “Paychex” name, trademark, and logo are of material importance to the Company.us.

      There is no significant seasonality to the Company’sour business. However, during the Company’sour third fiscal quarter, which ends in February, the number of new Payroll clients, new Retirement Services clients, and new PASPaychex Premier and PEO worksite employees tends to be higher than during the rest of the fiscal year, primarily because a majority of new clients begin using Paychexour services in the beginning of a calendar year. In addition, calendar year-end transaction processing and client funds activity are traditionally higher during the third fiscal quarter due to clients paying year-end bonuses and requesting additional year-end services. Historically, as a result of these

      Information about the Company’sour products and services, stockholder information, press releases, and filings with the Securities and Exchange Commission (“SEC”)SEC can be found on the Company’s Web siteour website at www.paychex.com. The Company’s annual reportswww.paychex.com. Our Annual Reports on Form 10-K, quarterly reports Quarterly Reports on Form 10-Q, current reports Current Reports on Form 8-K, and other SEC filings, and any amendments to such reports and filings, are made available, free of charge, on the Investor Relations section of such Web siteour website as soon as reasonably practical after such material is filed with, or furnished to, the SEC. Also, copies of the Company’sour Annual Report to Stockholders and Proxy Statement, to be issued in connection with its 2005our 2006 Annual Meeting of Stockholders, will be made available, free of charge, upon written request submitted to Paychex, Inc., c/o Corporate Secretary, 911 Panorama Trail South, Rochester, New York 14625-2396.

      Our future results of operations are subject to a number of risks and uncertainties. These risks and uncertainties could cause actual results to differ materially from historical and current results and from Companyour projections. Important factors known to the Companyus that could cause such differences include, but are not limited to, those discussed below and those contained in the “Safe Harbor” statement at the beginning of Part I of this Form 10-K.

     The CompanyWe may make errors and omissions in providing services, which could result in significant penalties and liabilities for the Company:us: Processing, tracking, collecting, and remitting client funds to the various taxing authorities,applicable tax or regulatory agencies, client employees, and other third parties are complex operations. These tasks could be subject to error and these errors could include, but are not limited to, late filing with applicable tax or regulatory agencies, underpayment of taxes, and failure to comply with applicable banking regulations and laws relating to employee benefits administration, which could result in significant penalties and liabilities that would adversely affect the Company’sour results of operations. The CompanyWe could also transfer funds in error to an incorrect party or for the wrong amount, and may be unable to correct the error or recover the funds, resulting in a loss to the Company.us.

     ChangesOur business and reputation may be affected by our ability to keep clients’ information confidential: Our business involves the use of significant amounts of private and confidential client information including employees identification numbers, bank accounts, and retirement account information. This information is critical to the accurate and timely provision of services to our clients, and certain information may be transmitted via the Internet. There is no guarantee that our systems and processes are adequate to protect against all security breaches. If our systems are disrupted or fail for any reason, or if our systems are infiltrated by unauthorized persons, our clients could experience data loss, financial loss, harm to reputation, or significant business interruption. Such events may expose us to unexpected liability, litigation, regulation investigation and penalties, loss of clients business, unfavorable impact to business reputation, and there could be a material adverse effect on our business and results of operations.

We may be adversely impacted by changes in government regulations and policies could adversely impact the business:policies: Many of the Company’sour services, particularly payroll tax filing and paymentadministration services and benefit plan administration services, are designed according to government regulations that continue to change. Changes in regulations could affect the extent and type of benefits employers are required, or may choose, to provide employees or the amount and type of taxes employers and employees are required to pay. Such changes could reduce or eliminate the need for some of the Company’sour services and substantially decrease itsour revenue. Added requirements could also increase the Company’sour cost of doing business. Failure by the Companyus to modify itsour services in a timely fashion in response to regulatory changes could have adverse effects on the Company’sour business and results of operations.

     FailureWe may be adversely impacted by failure of third-party service providers to perform their functions could harm the Company’s business:functions: As part of providing services to clients, Paychex relieswe rely on a number of third-party service providers. These providers include, but are not limited to, couriers used to deliver client payroll checks and banks whichused to electronically transfer funds from clients to their employees. Failure by these providers, for any reason, to deliver their

     Failure of the Company’s Business Continuity Plan inIn the event of a catastrophe our business continuity plan may fail, which could result in the loss of client data and adversely interrupt operations: The Company’sOur operations are dependent on itsour ability to protect itsour infrastructure against damage from catastrophe or natural disaster, unauthorized security breach, power loss, telecommunications failure, terrorist attack, or similar event. The Company hasother events that could have a Business Continuity Plansignificant disruptive effect on our operations. We have a business continuity plan in place in the event of system failure due to any of these events. If the Business Continuity Planbusiness continuity plan is unsuccessful in a disaster recovery scenario, the Companywe could potentially lose client data or experience material adverse interruptions to itsour operations or delivery of services to itsour clients.

     Investments in new technology for the Company’s internal useWe may not be implementedable to keep pace with changes in a timely or cost-effective manner which could impact the Company’s results of operations:technology: To maintain itsour growth strategy, the Companywe must adapt and respond to technological advances offered by its competitors and technological requirements of itsour clients. The Company has madeOur future success will depend on our ability to enhance capabilities and increase the performance of our internal use systems, particularly our systems that meet our clients’ requirements. We continue to make significant investments related to the development of new technologies for internal use. Such technologiestechnology. If our systems become outdated, we may be at a disadvantage when competing in our industry. There can be no assurance that our efforts to update and integrate systems will be successful. If we do not timely integrate and update our systems, or if our investments in technology fail to provide the expected results, there could be implemented in a timely manner or within targeted costs. Delays or difficulties in implementation or added costs couldan adverse impact the Company’sto our business and results of operations.

     AcquisitionsWe may not providerealize the anticipated benefits:benefits from acquisitions: The effective integration of acquired companies may be difficult to achieve. It is also possible that the Companywe may not realize any or all expected benefits from acquisitions or achieve benefits from acquisitions in a timely manner. In addition, the Companywe may incur significant costs and management’s time and attention may be diverted in connection with the integration of acquisitions. Failure to effectively integrate future acquisitions could affect the Company’sour results of operations. The CompanyWe currently hashave no definitive agreements or current plans with respect to any material prospective acquisitions.

     TheWe may have an adverse outcome of legal matters, which could harm the Company’sour business: The Company isWe are subject to various claims and legal matters that arise in the normal course of business. These include disputes or potential disputes related to breach of contract, employment-related claims, tax claims, and other matters. As of May 31, 2005, the Company has2006, we have a reserve of $25.3$15.6 million for pending legal matters. See Item 3 of this Form 10-K for additional disclosure. In light of the legal reserve recorded, the Company’sour management currently believes that resolution of these matters will not have a material adverse effect on the Company’sour financial position or results of our operations. However, these matters are subject to inherent uncertainties and there exists the possibility that their ultimate resolution could have a material adverse impact on the Company’sour financial position and results of operations in the period in which any such effect is recorded.

     PaychexWe may experience a loss as the result of our clients could havehaving insufficient funds to cover payments the Company haswe have made on their behalf to taxing authoritiesapplicable tax or regulatory agencies and employees resulting in loss to the Company:employees: As part of the payroll processing service, Paychex iswe are authorized by itsour clients to transfer money from their bank accounts to fund amounts owed to their employees and various taxing authorities.applicable tax or regulatory agencies. It is possible that the Companywe would be held liable for such amounts in the event the client has insufficient funds to cover them. The Company hasWe have in the past, and may in the future, make payments on itsour clients’ behalf for which it iswe are not reimbursed, resulting in a loss to the Company.us.

     InterestOur interest earned on funds held for clients couldmay be impacted by changes in government regulations mandating the amount of tax withheld or timing of remittance: The Company receivesWe receive interest income from investing client funds collected but not yet remitted to taxing authoritiesapplicable tax or regulatory agencies or to client employees. A change in regulations either decreasing the amount of taxes to be withheld or allowing less time to remit taxes to government authoritiesapplicable tax or regulatory agencies would adversely impact this interest income.

     The price of the Company’s stockWe may be volatileexposed to additional risks related to a foreign operation as a result of factorsour business in Germany: We currently have approximately 500 clients in Germany. As a result, our business is subject to political and eventseconomic instability unrelated to our operations in the U.S. Additionally, our business in Germany exposes us to currency fluctuations and we must operate under legal and tax regulations that are beyond the Company’s control: The market pricediffer from those of the Company’s common stock may be influenced by factors such as quarterly variations in operating results, announcements of new services or technological innovations by the Company or its competitors, market conditions in the business process outsourcing industry, changes in ratings or financial estimates by securities analysts, general economic conditions, fluctuations in the stock market that areU.S. We do not directly relatedcurrently hedge our foreign currency transactions due to the Company’s operating performance,relatively

     Quantitative and qualitative disclosures about market risk: Refer to Item 7A of this Form 10-K for a discussion on Market Risk Factors.

      The Company’sWe owned and leased the following properties at May 31, 2006:

      Our facilities in Rochester, New York 14625 in a 140,000-square-foot building complex owned by the Company. In addition, within the Rochester area, the Company owns four facilities, which account for a combined total of 501,000 square feet, and leases approximately 69,000 square feet in two other office complexes. These facilities house various distribution, processing, and technology functions, certain ancillary service functions, a telemarketing unit, and other back officeback-office functions.

      Contingencies: The Company isWe are subject to various claims and legal matters that arise in the normal course of itsour business. These include disputes or potential disputes related to breach of contract, employment-related claims, tax claims, and other matters.

      The CompanyWe and itsour wholly owned subsidiary, Rapid Payroll, Inc. (“Rapid Payroll”), are currently defendants in three lawsuits pending in Los Angeles Superior Court, the United States DistrictBankruptcy Court, for the Central District of California, thirteen lawsuits pending in the United States Court of Appeals for the Ninth Circuit, and one lawsuit pending in the California Court of Appeal, Second District, all brought betweenin calendar years 2002 and 20042003 by licensees of payroll processing software owned by Rapid Payroll.

      In August 2001, Rapid Payroll informed seventy-six licensees that it intended to stop supporting the payroll processing software in August of 2002. Thereafter, lawsuits were commenced by licensees asserting various claims, including breach of contract and related tort and fraud causes of action. These lawsuits seeksought compensatory damages, punitive damages, and injunctive relief against Rapid Payroll, the Company, the Company’sus, our former Chief Executive Officer, and itsour Senior Vice President of Sales and Marketing. In accordance with the Company’sour indemnification agreements with itsour senior executives, the Companywe will defend and, if necessary, indemnify the individual defendants as it relates tothem in connection with these pending matters.

      On July 5, 2002, the federal district court entered a preliminary injunction requiring that Rapid Payroll and the Companyus continue to support and maintain the subject software pursuant to the license agreements.

      In February 2005, the court held that the preliminary injunction will be lifted on April 30, 2006.

      On February 28 and March 1, 2005, the federal district courtUnited States District Court, Central District of California entered judgment in thirteen of the cases pending before it. Those judgments provideprovided that Rapid Payroll’s liability is limited by the license fees paid to it by the plaintiff licensees, pursuant to express contractual provisions of the license agreements. Those judgments also provideextended the court’s preliminary injunction, ordering that Rapid Payroll must support the licensed software untilthrough April 30, 2006, and, at that time, refund to each of the licensee plaintiffs the license fees paid by that plaintiff. The license fees received by Rapid Payroll under the agreements from these thirteen licensee plaintiffs total approximately $2.5 million. The federal court also ordered the release of the source code pursuant to the escrow terms of the license agreements. The federal court judgments also rejected the fraud and other tort claims brought by those plaintiffs against all of the defendants. Plaintiffs have appealed the federal court rulings and we have cross-appealed.

      Through June 27, 2005,On May 4, 2006, following expiration of the Company has settled thirteen cases discussed abovefederal district court’s injunction, Rapid Payroll filed a petition under Chapter 11 of the U.S. Bankruptcy Code in order to develop a plan that allows Rapid Payroll to discontinue support for approximately $8.0 million.the software in a manner that deals fairly with its few remaining licensees. Rapid Payroll is continuing to operate as adebtor-in-possession, paying all of its post-petition debts as they become due.

      Based on the application of Statement of Financial Accounting Standard (“SFAS”) No. 5, “Accounting for Contingencies,” the Company iswe are required to record a reserve if it believeswe believe an unfavorable outcome is probable and the amount of the probable loss can be reasonably estimated. The Company’sOur legal reserve for all pending legal matterslitigation totaled $25.3$15.6 million at May 31, 2005,2006, and is included in current liabilities on the Consolidated Balance Sheets. The legal reserve has been reduced induring fiscal 20052006 as actual settlements and incurred professional fees have been charged against the legal reserve.it.

      In light of the legal reserve recorded, the Company’sour management currently believes that resolution of pending legalthese matters will not have a material adverse effect on the Company’sour financial position or results of operations. However, these matters are subject to inherent uncertainties and there exists the possibility that

      No matter wasmatters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal yearthree months ended May 31, 2005.

      The Company’sOur common stock trades on The NASDAQ Stock Market®Market^® under the symbol “PAYX.” Dividends have historically been paid in August, November, February, and May. The level and continuation of future dividends are dependent on the Company’sour future earnings and cash flows, and are subject to the discretion of the Board of Directors.

      On June 30, 2005,2006, there were 18,59618,240 holders of record of the Company’sour common stock, which includes registered holders and participants in the Paychex, Inc. Dividend Reinvestment and Stock Purchase Plan. There were also 8,7559,284 participants in the Paychex, Inc. Employee Stock Purchase Plan and 6,1586,556 participants in the Paychex, Inc. Employee Stock Ownership Plan.

      The high and low sale prices for the Company’sour common stock as reported on The NASDAQ Stock Market and dividends for each of the two fiscal years ended May 31, 20052006 and 2004,2005, are as follows:

      The closing price of the Company’sour common stock on May 31, 2005,2006, as reported on The NASDAQ Stock Market, was $28.88$36.71 per share.

      Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews ourthe operating results of Paychex, Inc. (“we,” “our,” or “us”) for each of the three fiscal years in the period ended May 31, 2006 (“fiscal 2006”), May 31, 2005 (fiscal 2005,(“fiscal 2005”), and May 31, 2004 and 2003)(“fiscal 2004”), and our financial condition at May 31, 2005.2006. This review should be read in conjunction with the accompanying Consolidated Financial Statements and the related Notes to Consolidated Financial Statements contained in Item 8 of this Annual Report on Form 10-K (“Form 10-K”) and the “Factors That May Affect Future Results of Operations” section“Risk Factors” discussed in Item 11A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading “Safe Harbor” Statement under the Private Securities Litigation Reform Act of 1995 contained at the beginning of Part I of this Form 10-K.

      We are a leading national provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses. We haveOur Payroll and Human Resource Services product lines offer a broad portfolio of products and services that allow our clients to meet their diverse payroll and human resource needs, whichneeds.

      Our Payroll services are provided through either our Core Payroll or Major Market Services (“MMS”) and include:

      Our strategy is focused on growing our client base, increasing utilization of our ancillary services, and leveraging our technological and operating infrastructure. We earn revenuesrevenue primarily through recurring fees

      Fiscal 20052006 was our fifteenthsixteenth consecutive year of record total revenues,revenue, net income, and diluted earnings per share. Our financial results for fiscal 20052006 included the following highlights:

      Our growth ratesfinancial performance in fiscal 2005 were2006 was largely due to strong service revenue growth of 12%14%. This growth in service revenue was attributable to growth in client base, check volume, and the impactutilization of expense charges recorded in fiscal 2004 related to pending legal matters. These expense charges reduced diluted earnings per share for fiscal 2004 by approximately $0.06 per share.ancillary services.

      During fiscal 2005, we began to see positive signsOur financial performance was also positively impacted by the effects of economic improvement, especiallyincreases in the interest rate environment.rates earned on our funds held for clients and corporate investment portfolios. The Federal Reserve increased the Federal Funds rate by 200 basis points since June 2004in fiscal 2005 and by another 200 basis points in fiscal 2006 to 3.00% asa rate of 5.00% at May 31, 2005.2006. Our combined interest on funds held for clients and corporate investment income increased 3% year-over-year73% for fiscal 2005.2006. In fiscal 2005,2006, our combined portfolios earned an average rate of return of 3.2%, increased from 2.2% compared within fiscal 2005 and 1.8% in fiscal 2004 and 2.5% in fiscal 2003. During fiscal 2004 and fiscal 2003, we were able to offset some of the impact of lower interest rates by realizing gains on the sale of available-for-sale securities of $19.1 million for fiscal 2004 and $17.8 million for fiscal 2003. This compares to net realized gains of $0.2 million in fiscal 2005.2004. The impact of changing interest rates and related risks is discussed in more detail in the “Market Risk Factors” section in Item 7A of this Form 10-K.

      We continue to make investments in our business as part of our growth strategy. Some of these investments include the following:

     Growing the client base and increasing utilization of ancillary services: Our client base increased to approximately 543,000 clients at May 31, 2006. This compares with approximately 522,000 clients at May 31, 2005. This compares with2005, and approximately 505,000 clients at May 31, 2004, and2004. Client growth was approximately 490,000 clients at May 31, 2003. Year-over-year client growth was4.0% for fiscal 2006, compared with approximately 3.5% for fiscal 2005, compared with 3.1% for fiscal 2004. Client growth excluding the impact of the Advantage and InterPay, Inc. (“InterPay”) acquisitions was approximately 6% for fiscal 2005 and 7% for fiscal 2004.2005.

      We have continued to invest in our direct sales force, as we believe there is opportunity for growth within our target market of small- to medium-sized businesses. The approximate composition of our direct sales force is summarized in the following table:

      We believe there are opportunities for growth within our current client base, as well as with new clients, through increased utilization of our payroll-related and human resource ancillary services. Ancillary services effectively leverage the payroll processing data and, therefore, are beneficial to our operating margin. Penetration of our payroll tax filing and payment services and our employee paymentadministration services has continued to increase, and total 90% and 65%, respectively,was 92% at May 31, 2005.2006, compared with 90% at May 31, 2005, and 89% at May 31, 2004. Employee payment services penetration has increased to 68% at May 31, 2006, compared with 65% at May 31, 2005, and 63% at May 31, 2004. Our client bases in the human resource and employee benefitsHuman Resource Services areas have continued to grow, as shown in the following table:

     Acquired businesses:Product and service initiatives: During fiscal 2006, we made investments to broaden our portfolio of products and services and expand into new markets, and:

Business acquisitions: We will supplement our growth through strategic acquisition when opportunities arise. In the fiscal year ended May 31, 2003, we acquired two payroll service providers servicing small- to medium-sized businesses inexpanded our client base through the United States.acquisitions of Advantage was purchased on September 20, 2002Payroll Services, Inc. (“Advantage”) and InterPay, was purchased on April 1, 2003. SinceInc. (“InterPay”). In fiscal 2004, the completionacquisition of the acquisitions, we have integrated the sales force, branch operations, and corporate support of these acquired businesses to provide efficiencies in operations and services provided to our clients. By November 2004, we had successfully converted all InterPay clients to our Paychex software platforms and fully completed the integration of InterPay. The Advantage payroll system is being retained for the foreseeable future in order to service clients affiliated with independently owned associate offices and Advantage co-branded products.

     Focus on customer service: We have always focused on customer service and maximizingthe maximization of client retention. Fiscal year2006 client retention is at record levels of slightly less than 80% of our beginning client base. The most significant factor contributing to our client losses is companies going out of business. In fiscal 2006, we reduced the number of clients per payroll specialist due to our commitment to continuously improve client service.

Financial position: At May 31, 2005,2006, we maintained a strong financial position with total cash and corporate investments of $707.6$577.4 million. We also had $384.5 million in long-term corporate investments at May 31, 2006. Our primary source of cash is our ongoing operations. Cash flow from operations was $467.9$569.2 million in fiscal 2005 and $389.92006 compared to $466.6 million in fiscal 2004.2005. Historically, we have funded our operations, capital purchases, and dividend payments from our operating activities. The acquisitions of Advantage and InterPay in fiscal 2003 and Stromberg in fiscal 2004, were funded from our cash and corporate investments. It is anticipated that current cash and corporate investment balances, along with projected operating cash flows, will support our normal business operations, capital purchases, and current dividend payments for the foreseeable future.

      For further analysis of our results of operations for fiscal years 2006, 2005, 2004, and 2003,2004, and our financial position at May 31, 2005,2006, refer to the tables and analysis in the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item 7 and the discussion in the “Critical Accounting Policies” section of this Item 7.

      Our current outlook for the full fiscal year ended May 31, 2007 (“fiscal 2007”) is based upon current economic conditions and interest rate levels as of May 31, 2006, and is summarized as follows:

      Purchases of property and equipment in fiscal 20062007 are expected to be in the range of $75$85 million to $80 million. The expected increase$90 million, in fiscal 2006 capital expenditures reflects printing equipment, communication system upgrades, and branch expansions.line with our growth rates. Fiscal 20062007 depreciation expense is projected to be in the range of $50approximately $55 million, to $55 million. In addition,and we project amortization of intangible assets for fiscal 20062007 to be in the range ofapproximately $14 million to $15 million.

      Our projections are based on current economic and interest rate conditions continuing with no significant changes. We estimate that the earnings effect of a 25-basis-point change in interest rates (17 basis points for tax-exempt investments) at the beginning of fiscal 20062007 would be in the range of $3.7$4.5 million to $4.2$5.0 million for fiscal 2006.2007. The total investment portfolio (funds held for clients and corporate investments) is expected to average approximately $3.8$4.5 billion in fiscal 2006.2007. Given current accounting interpretations, in order to preserve the accounting treatment on available-for-sale securities of recording market value fluctuations through comprehensive income instead of through the income statement, we do not expect to realize any losses in the investment portfolios in fiscal 2006.2007.

      Details regarding our combined funds held for clients and corporate investment portfolios are as follows:

     Revenues:Revenue: Our total service revenues are comprised of revenues from the Payroll and Human Resource and Benefits services.The increases in Payroll service revenues are earned primarily from payroll processing, tax filing and payment services, employee payment services, and other ancillary services through either our Core Payroll or Major Market Services. Human Resource and Benefits service revenues are earned primarily from retirement services, workers’ compensation insurance administration, section 125 plan administration, Paychex Administrative Services (“PAS”) and Professional Employer Organization (“PEO”) services, and time and attendance solutions.

      As of May 31, 2005, 90%2006, 92% of all clients utilized our payroll tax filing and paymentadministration services, compared with 90% at May 31, 2005, and 89% at May 31, 2004, and 87% at May 31, 2003.2004. We believe our client utilization percentage of the tax filing and paymentthese services is near maturity. Our employee payment services were utilized by 65%68% of our clients at May 31, 2005,2006, compared with 65% at May 31, 2005, and 63% at May 31, 2004, and 60% at May 31, 2003.2004. More than 95% of new clients purchase our payroll tax filing and paymentadministration services and more than 75% of new clients purchase our employee

      MMS revenue increased 27% for both fiscal 2006 and fiscal 2005 to $225.0 million and $101.7$176.9 million, for fiscal years 2005, 2004, and 2003, respectively. This represents year-over-year revenue growth of 27% for fiscal 2005 and 37% for fiscal 2004. Approximately one-third of our new Major Market ServicesMMS clients are conversions from our Core Payroll service.

      Human Resource Services revenue increased 29% in fiscal 2006 and 2004, respectively.

      The PEO service is available primarilyincrease in the states of Florida and Georgia, where PEOs are more prevalent. Sales of the PAS and PEO products have been strong, with administrative fee revenues from these services increasing 39% and 34%interest on funds held for clients in fiscal 2006 compared to fiscal 2005 is the result of higher average interest rates earned in fiscal 2006 and 2004, respectively. Our PAS and PEO products serviced over 225,000 and 157,000 client employees as of May 31, 2005 and 2004, respectively.

     Combined Operating and SG&A Expenses: The following table summarizes total combined operating and selling, general and administrative (“SG&A”) expenses for the fiscal year ended May 31:

      Combined operating and selling, general, and administrativeSG&A expenses increased 12% in fiscal 2006 and 10% in fiscal 2005, and 18% in fiscal 2004, excluding the expense charge to increase the legal reserve. Thesereserve in fiscal 2004. The increases are primarilyin both fiscal 2006 and in fiscal 2005 were the result of our investmentscontinued investment in personnel, information technology to create more efficient processes and systems as well as investment in personnel and other costs to support organic growth. During fiscal 2006, total expenses were affected by a strong sales year as our sales force exceeded its targets resulting in higher than normal levels of sales expense, continued investments in new products and services, geographic expansion within Germany, and other expenditures to continually improve client service. Fiscal 2005 growth andwas impacted by additional expenses as a result of our April 2004 acquisition of Stromberg. Our acquisitions of Advantage and InterPay in fiscal 2003 contributed to the increases in expenses in fiscal 2004. At May 31, 2005,2006, we had approximately 10,00010,900 employees compared with approximately 10,000 at May 31, 2005 and 9,400 at May 31, 2004, and 8,850 at May 31, 2003.2004.

      Depreciation expense is primarily related to buildings, furniture and fixtures, data processing equipment, and software. In addition to the impact from the 2003 acquisitions of businesses, depreciationDepreciation expense increased in fiscal 2004 was higher2006 compared to fiscal 2005 due in part to the purchase in May 2005 of a 220,000-square-foot facility127,000-square foot building in Rochester, New York and the placement into servicehigher levels of our $30.0 million consolidated data center, both of which occurred during the first half of fiscal 2003.capital expenditures. Amortization of intangible assets is primarily related to client lists obtained from our fiscal 2003 acquisitions.previous acquisitions, which are amortized using accelerated methods. Other expenses include items such as delivery, forms and supplies, communications, travel and entertainment, professional services, and other costs incurred to support our business.

     Operating Income: Operating income year-over-year growth was 22% for fiscal 2006 and 23% for fiscal 2005 and 8% for fiscal 2004.2005. The increases in operating income in fiscal 20052006 and fiscal 20042005 are attributable to the factors previously discussed. Operating income growth in fiscal 2005 was impacted by the $35.8 million expense charge for the reserve for pending legal matters in fiscal 2004, net incremental PEO revenue of $6.7 million in fiscal 2005 and $6.4 million in fiscal 2004, and $3.2 million of expense charges related to our captive insurance company in fiscal 2005. Operating income exclusive of interest on funds held for clients and these unusual items increased approximately 15% for fiscal 2005 and approximately 17% in fiscal 2004.

     Investment Income, Net: Investment income, net primarily represents earnings from our cash and cash equivalents and investments in available-for-sale investment securities. Investment income does not include interest on funds held for clients, which is included in total revenues.revenue. The increase in investment income in fiscal 2006 compared with fiscal 2005 is mainly due to higher average interest rates earned in fiscal 2006 and higher average portfolio balances resulting from investment of cash generated from ongoing operations. The decrease in investment income in fiscal 2005 compared with fiscal 2004 is mainly due to lower net realized gains on the sales of available-for-sale securities and lower average interest rates earned in fiscal 2005 on longer-term investments, offset by an increase in average daily invested balances. The decrease in investment income in fiscal 2004 compared with fiscal 2003 is mainly due to a decrease in average daily invested balances, lower average interest rates earned, and lower net realized gains on the sales of available-for-sale investments. The decrease in average daily invested balances in fiscal 2004 is primarily the result of the sale of corporate investments to fund our Advantage and InterPay acquisitions in fiscal 2003.

     Income Taxes: Our effective income tax rate was 31.1% in fiscal 2006, compared with 32.5% in fiscal 2005, compared withand 32.6% in fiscal 2004, and 32.0% in fiscal 2003.2004. The increasedecrease in our effective income tax rate in fiscal 20042006 was primarily the result of lowerhigher levels of tax-exempt income, which is derived primarily from municipal debt securities in the funds held for clients and corporate investment portfolios.portfolios and a lower effective state income tax rate. See Note H of the Notes to Consolidated Financial Statements, contained in Item 8 of this Form 10-K, for additional disclosures on income taxes.

     Net Income: Net income year-over-year growth was 26% for fiscal 2006 and 22% for fiscal 2005 and 3% for fiscal 2004.2005. The increases in net income for fiscal 20052006 and fiscal 20042005 are attributable to the factors previously discussed.

      At May 31, 2005,2006, our principal source of liquidity was $707.6$577.4 million of cash and corporate investment balances.investments. We also had $384.5 million in long-term corporate investments at May 31, 2006. Current cash and corporate investments and projected operating cash flows are expected to support our normal business operations, capital purchases, and current dividend payments for the foreseeable future.

      We have unused borrowing capacity available under four uncommitted, secured, short-term lines of credit with financial institutions at market rates of interest as follows:

      Our Credit Facilitiescredit facilities are evidenced by Promissory Notes and are secured by separate Pledge Security Agreements by and between Paychex, Inc. and each of the financial institutions (the “Lenders”), pursuant to which we have granted each of the Lenders a security interest in certain of our investment securities accounts.

      The primary uses of the lines of credit would be to meet short-term funding requirements related to deposit account overdrafts and client fund deposit obligations arising from electronic payment transactions on behalf of our clients in the ordinary course of business, if necessary. No amounts were outstanding against ourthese lines of credit during fiscal 20052006 or at May 31, 2005.2006.

   ��      We had standby letters of credit outstanding totaling $53.1 million and $8.4$53.4 million at May 31, 2005 and 2004, respectively,2006, required to secure commitments for certain of our insurance policies. These letters of credit at May 31, 2005, expire at various dates between July 2006 and December 20052008 and July 2006. Included in the $53.1 million is a $44.2 million letter of credit arrangement entered into in fiscal 2005. The letters of credit are secured by securities held in our corporate investment portfolios, including thea $44.2 million letter of credit for which funds have been segregated into a separate account. Effective June 28, 2006, this $44.2 million letter of credit was increased to $50.9 million, bringing the total letters of credit outstanding to $60.2 million. No amounts were outstanding on these letters of credit during fiscal 20052006 or at May 31, 2005.2006.

      We have entered into various operating leases and purchase obligations that, under U.S. generally accepted accounting principles, are not reflected on the Consolidated Balance Sheets at May 31, 2005.2006. The table below summarizes our estimated annual payment obligations under these commitments, as well as other contractual obligations shown as other liabilities on the Consolidated Balance Sheets at May 31, 2005:2006:

      Advantage has license agreements with fifteen independently owned associate offices (“Associates”), which are responsible for selling and marketing Advantage payroll services and performing certain operational functions, while Paychex, Inc. and Advantage provide all centralized back-office payroll processing and payroll tax filingadministration services. In addition, Advantage has a relationship with New England Business Services, Inc. (“NEBS^®”) whereby Advantage performs all client functions other than sales and marketing. Under these arrangements, Advantage pays the Associates and NEBS commissions based on processing activity for the related clients. Since the actual amounts of future payments isare uncertain, obligations under these arrangements are not included in the table above. Commission expense for the Associates and NEBS in fiscal 20052006 and fiscal 20042005 was $19.0 million and $16.7 million, and $14.4 million, respectively.

      We guarantee performance of service on annual maintenance contracts for clients who financed their service contracts through a third party. In the normal course of business, we make representations and warranties that guarantee the performance of our services under service arrangements with clients. In addition, we have entered into indemnification agreements with our officers and directors, which require us to defend and, if necessary, indemnify these individuals for certain pending or future legal claims as they relate to their services to Paychex and our subsidiaries. Historically, there have been no material losses related to such guarantees and indemnifications.

      We currently self-insure the deductible portion of various insured exposures under certain of our employee benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities. Historically, the amounts accrued have not been material. We have insurance coverage in addition to our purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, and acts of terrorism, and capacity for deductibles and self-insured retentions through our captive insurance company.

      As part of our ongoing business, we do not participate in transactions with unconsolidated entities such as special purpose entities or structured finance entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. We do maintain investments as a limited partner in low-income housing projects that are not considered part of our ongoing operations. These investments are accounted for under the equity method of accounting.