You might run a payroll audit if your business runs into pay issues, like high employee costs. While a payroll audit can help you fix current issues, they’re most effective for preventing mistakes and potential problems with payroll.
By running regular payroll audits—ideally, once a year—you’ll identify problems before they turn into something bigger. Although they aren’t legal requirements for any business, payroll audits should happen regardless, even if you have just a handful of employees.
If not, you risk payroll tax discrepancies, compliance issues, inaccurate records, and more. On the other hand, conducting regular audits keeps your company proactive in managing salaries, paid time off, and other employee wages and benefits and can, in turn, improve relationships between employers and employees.
Don’t Wait for an IRS Payroll Audit
If you don’t manage payroll well, you’re at a higher risk of getting audited by the IRS. An IRS audit reviews your employee and accounting records to determine whether the amount you’ve paid in payroll taxes matches your liability.
Depending on the circumstances surrounding your audit, you may have an in-office visit or need to send correspondence by mail. In-office visits are typically much lengthier and more comprehensive.
What triggers an IRS audit? Mistakes in calculations, classifying workers as independent contractors rather than employees, or consistently filing taxes late are a few potential triggers. If the IRS’s systems detect that you’ve paid the wrong tax rates or miscalculated overtime, you might also be audited.
Again, regular payroll audits are the key to avoiding problems with the IRS because they can help you avoid small mistakes that may escalate quickly.
How to Run a Payroll Audit
1. Inspect and Confirm Payroll Data
The first step in a payroll audit is to make sure that employees, hours, pay, and everything else that goes into payroll is accurate.
This step is perhaps the most important because it can identify several key areas where your payroll might be struggling, including having employees who no longer work with the company still listed on payroll or having employees with certain tax forms missing.
This process checks that all employees on the roster for a specific time period actually worked during that period. It also reviews their hours worked, whether their pay rate is correct for that period and whether the company paid overtime correctly and at the correct rate.
One thing that often gets overlooked by companies that don’t run payroll audits is fake employees. Also known as ghost employees, these are names on the payroll of people who never actually worked for an organization.
Ghost employees appear when an employee with access to a company’s payroll management system adds them, usually to commit fraud. A ghost employee gets paid just like a regular employee, cutting into the company’s payroll budget.
Obviously, ghost employees have to be removed from the system, and they can quickly be flagged with regular payroll audits.
This part of the process also checks that all employee records are correct. Look to ensure that updated contact information and employment forms, like W-4s, are included in each employee’s records. It’s a good idea also to have employees verify that their social security numbers are correct for tax purposes.
2. Check for Variable, Off-Cycle, and Other Payments
Variable pay, like commissions and bonuses, needs to be marked separately in a business’s accounting system so they don’t run together with regular wages. If not, it can skew payroll data for salary ranges and make it difficult to determine the accuracy of pay rates.
Audits should also check for off-cycle payments. These are additional pay periods during the year that shouldn’t be there, like 27 pay periods for a company that typically has 26 due to paying biweekly.
Finally, an audit must ensure that other payments made to employees, like paid time off, are accounted for correctly. These payments should be labeled to indicate in accounting records how much time an employee was paid for time they didn’t work.
For example, say an employee used five days of sick leave. They didn’t work those five days but were paid for five days. Including those hours as paid work time blurs how much time that employee actually worked, interfering with accurate accounting and analysis.
3. Review Tax Forms and Reports
Payroll taxes should be a primary focus of a payroll audit. After all, taxes are the IRS’s priority, and audits should ensure that a company pays the right amount in payroll taxes using the correct payroll forms and pays those taxes on time.
First, companies currently using Form 944 to report payroll taxes, also known as Federal Insurance Contributions Act (FICA) taxes, should check that they’re still eligible to use it. This form is reserved for small employers with low tax liability, so it won’t apply to most companies. The IRS will let you know whether you’re approved to use it.
Most companies need to pay quarterly and, therefore, must use Form 941 instead. Also, any employers required to pay the Federal Unemployment Tax Act (FUTA) tax must report their liability on Form 940.
This step of the process is all about comparisons and laser-focused reviews.
Are all employees having the correct amount of taxes withheld from their paychecks? Does the company’s accounting records match the information on its tax forms? If not, there’s an issue somewhere in accounting that the auditor needs to dig into further.
If, after recalculating mistakes, the business underpaid payroll taxes, they should send a payment for the shortage as soon as possible to avoid penalties.
Also, this is the best time to correct any problems during the audit, like switching to the correct forms or having select employees with tax withholding issues complete new tax forms.
4. Check Your Financial Records
After cleaning up employee and tax records, an audit should reconcile the company’s financial records. This process entails reviewing the business’s accounting records in depth to make sure all payroll payments went where they were supposed to and on time.
This process also checks that everything discovered and fixed during the first steps in the audit makes all payroll records balanced. For example, tax payments made after finding a shortage should now bring the business’s tax balance to zero.
Payroll services generally do an excellent job reconciling payroll after changes happen, but they’re not perfect. A payroll audit is the only surefire way to make sure that what a business spent on payroll matches what it should have paid.
5. Verify Compliance
This step should technically happen all the time at a company, simply because laws can change at any time, and it’s necessary to adapt when they do.
But, a payroll audit can be the perfect time to thoroughly check a business’s adherence to payroll and tax compliance. It’s an excellent way to keep it on a schedule that’s easy to remember, similar to changing smoke detector batteries with seasonal time changes for Daylight Savings Time.
Labor and tax laws govern many aspects of a business, and failing to meet the requirements of just one law can result in massive legal trouble.
Audits should save plenty of time to check a company’s current practices with regulations regarding FICA, FUTA, workers’ compensation, overtime pay, paid time off, and independent contractor classification.
The Fair Labor Standards Act (FLSA) is the golden rule for businesses, as it includes regulations for everything from child labor laws to minimum wage. It even has regulations for payroll recordkeeping.
A payroll audit can spot compliance issues the company might need to address, like not paying overtime correctly or not calculating FICA taxes properly. Issues in several areas or ongoing compliance suggest that a company should seek legal help to get its compliance up to par.
Should You Run Your Own Payroll Audit?
You can probably run your own payroll audit. But should you?
The answer is no.
Just like you should leave pay audits to the experts to avoid potential pay issues, like salary compression and gender pay gaps, you should keep payroll audits in the hands of professionals.
I recommend having a third-party auditor take control of your payroll audits.
Not only do they know what they’re doing—this is what they do for a living, after all—a third party is unbiased. They’ll have a completely different perspective than you would on important things that could severely impact your payroll.
Yes, running your own payroll audit can probably be quicker and less expensive. But some things are worth the time and monetary investment, and a payroll audit is one of them.
Look at it this way: By investing in a third party to complete your annual payroll audits, you could avoid even more expensive and time-consuming audits by the IRS in the future.